Carried Interest

Risky Business

In the past few months I've watched two private equity transactions collapse because the vendor and the potential buyer couldn't come to an agreement on reps and warranties.

It's hardly surprising then that warranty and indemnity insurance (W&I) is becoming part of the Australian private equity landscape.  Insurance brokers like Aon and Willis are marketing W&I to both buyers and sellers as a way to supplement or replace traditional warranties. 

W&I insurance covers the buyer of a business if he suffers a financial loss due to a breach of the reps or warranties.  It's attractive to the seller because it reduces or eliminates a nasty liability that could emerge after they've sold their business. 

It sounds like a win for all parties, but as always there's a catch.  For one thing, the price of W&I makes insuring your chipped 911 Turbo look like taking out a policy on Granny's VW Bug.  Typical premiums are 3%-5% of the amount insured.  So if it's a $100m transaction, with a warranty cap of 50%, then you're looking at a policy cost of $1.5m+.  I also wonder about the ease of collecting against these policies . . .  it's tough enough getting these guys to pay for a ding on the front bumper.

Still, W&I might be a bargain compared to the cost of letting a good deal slip away. 

Take that Carlyle and Blackstone!

I just came across this terrific Jon Moulton quote in an English magazine, The Business.  Jon is the head of Alchemy Partners, one of the UK's most successful mid-market firms.  And doesn't the truth hurt!

"Large funds have far too much staff.  They have teams of 30 people doing one deal - most never do anything, it only needs five people.  There's a morale issue; what are you going to pass your days doing? 

We've been out recruiting for the last year, and we've seen people from large funds:  they've got a good Harvard degree, been at a large fund four or five years.  We call them 'deal virgins.'  They're highly paid people who've never done anything - and they know it."

Envy Ratio

The ratio between the price paid by the management team and that paid by the investing institution for their respective share of the equity in a management buyout/in. 

For example if a private equity firm paid $40m for 80% of a company's equity and management paid $3m for 20%, then the Envy Ratio would be 3.33x:

40/80   /  3/20  =  3.33x

I first heard this expression used in London, but it now seems to be catching on in Australia.

Effective Private Equity Boards

Useful post by Fred Wilson on building an effective portfolio company board.  His points are equally relevant to mid-market or buyout investments. 

To Fred's list I'd add the importance of recruiting non-exec directors who are eager to "have skin in the game."  I've found you get a far deeper level of commitment from a director who has personally written a cheque for a million dollars.

Here's a cut and paste from Fred's blog:

1 - Have at least one founder on the board. Many VCs like to move the founders out of the way. They think they will be difficult and meddle. That's always a risk, but the benefit of having founders on the board vastly outweighs any downside in my mind. Having too many founders on the board is bad too. You want a diverse set of people on your board, not any one concentrated group.

2 - Keep the number of VCs on the board to two or three. The number of VCs on the board is in inverse proportion to the success of the deal.

3 - Local board members are better. They will come to the meetings. Avoid too many board members who live elsewhere. They'll call into the meetings. Trust me. And that sucks.

4 - Have at least one and ideally two industry insiders on the board who are independent of the founders and the VCs. They should bring operating experience. They should be mentors to the CEO. They should be local so they come to the meetings.

5 - Do the meetings first thing in the morning when people are fresh. No laptops and no blackberries other than the laptop that drives the presentation if one is needed.

6 - Bring the senior management to the board meetings. They should know the board and the board should know them.

7 - Try to do a dinner the night before at least four times a year with all the directors attending. Don't bring senior management to these dinners. They should be for board bonding which is key to a well functioning board.

8 - Always send the agenda and board materials at least one day in advance of the meeting and expect/demand that the members read it before coming to the meeting.

9 - Do not spend the meeting going through the materials slide by slide. People can read, expect that they will.

10 - Do spend the meeting reviewing where the business is, where it needs to go, and what strategic decisions need to be made to get there.

11 - Remember that the board works for the Company as much as the management works for the board. Expect board members to do what you need from them and manage them to make sure they do.

12 - Keep your board to seven members or less. Five is ideal in my experience but sometimes you need seven to get the right diversity. Two insiders, one to three VCs, and one to two industry people is ideal once the company gets to a certain scale.

Venture Capital Blogs

A list of 65 venture capital blogs.  Happy reading:

http://andrewbfife.blogspot.com/2006/06/65-vc-angel-investor-blogs.html

AMP's Private Equity Team Jumps Ship

When it comes to captive private equity teams I'm at risk of sounding like a broken record.  Don't believe in them.  Don't believe they're sustainable.  In particular, I don't believe that captive teams which raise and invest third party money are sustainable.

This week AMP Private Equity (Australia's oldest captive) lost two of its senior staff.  Marcus Darville is heading over to Quadrant Private Equity.  His colleague Craig Cartner has been poached by Archer Capital to help launch a new mid-market fund.

Will AMP wave the private equity white flag?  I doubt it.  Big financial institutions are slow to learn and don't like accepting (very public) defeat.

Entries and Exits - Myer

A consortium led by Newbridge Capital has set a new deal size benchmark for Australian private equity by paying $1.40 billion for the Myer department store business including its flagship Melbourne building.

Myer is in the midst of a difficult turnaround and the execution risk kept local Australian private equity firms away from the auction.  In the end, three overseas bidders slugged it out and Newbridge paid a very full price for a business that some analysts were valuing at zero not long ago. 

Still, if any one can pull off this deal it's Newbridge and their American parent Texas Pacific.  Together they have led many of the world's largest retail buyouts including Neiman Marcus, Debenhams, J Crew and Bally.

Entries and Exits - Kids Campus

Investec Wentworth Private Equity has sold it's stake in listed child care group Kids Campus to industry giant ABC Learning Centres.  Investec acquired its equity just two years ago for about 40 cents/share, or approximately $12 million.  I hear they have more than doubled their money . . . not a bad result at all.

The Kids Campus investment was a classic example of a private equity PIPE transaction.  In addition to providing capital for operations, Investec also added value by raising a $25 million property trust which funded the building of new greenfield child care centres.

It's All About Access

In my last post I commented that getting "access" to the star funds in Australia is no longer easy.  The $1.2 billion fund raised by Pacific Equity Partners was reputedly three times over-subscribed.

Access is enormously important in private equity investing.  In public markets, investment returns are largely determined by asset allocation.  What really matters is whether you put your money into stocks, bonds, property or cash-- not which stock you choose or which fund manager.  In fact, over a decade, the spread between a top quartile bond fund's perfomance and a third quartile fund is only about 1%.  For shares the spread in returns rises to about 3%.

But get this, depending on which piece of research you accept, the spread between top quartile and third quartile private equity performance sits somewhere between 15% and 22%.  Massive.

Implication?  If you can't get your money into a top-performing private equity fund you're better off staying out of the asset class.  It's all about access.

Who Do I Rate?

I get a surprising number of emails from overseas investors who are considering allocating capital to Australian private equity and want to know more about the players in this market.  It got me thinking . . .  which firms would I trust with my own money? 

There have been some clear winners in the buyout and mid-market areas, and I'd be pretty confident putting my bank balance in the hands of any of the firms listed below (in fact, getting access to some of these funds is becoming a challenge for LPs).  Early stage is much tougher to pick-- so few firms have a real track record. 

Here goes.  And to make it interesting let's limit it to just three star firms in each segment:

BUYOUT (EV>$150m):  CHAMP, Ironbridge, Archer Capital.

MID-MKT ($30m-$150m): Quadrant, Champ Ventures, RMB Capital Partners.

EARLY STAGE:  GBS Venture Partners, Starfish Ventures, CM Capital.