Carried Interest

Dating a Banker?

 

A shoulder to cry on in these tough times . . . .  Dating A Banker Anonymous

Glass Half Full

       

Continuing on from yesterday's post . . .

The Good News:  Glass Half Full

1.  Bargain prices.  For private equity teams with cash and courage, 2009 and 2010 will offer "once in a career" investment opportunities.  We will see a boom in P2P activity, corporate divestments, and balance sheet restructures.  5x EBITDA is the new 8x EBITDA.

2.  Less competition for PE deals.  Not only are fewer private equity firms investing, but we are also no longer competing with a bull market stock exchange.  This year cashed up GPs will refuse to accept competitive sale processes (auctions) and instead demand exclusivity before starting due diligence.  [For More:  Is Private Equity the Next F!cked Company?]

3.  If you can find a lender, interest rates are very low.

4.  PE firms have plenty of dry powder.  Australian GPs are sitting on $10-12 billion in committed capital.  Globally the industry has undrawn commitments of over a trillion dollars.

5.  Banks will be surprisingly patient.  Many PE backed companies have breached their lending covenants, but the banks are also wrestling with massive defaults in sectors like commercial property, leasing, consumer finance, automotive and retail.  The banking industry simply doesn't have the resources to take a hardline approach to all these problems.  There are only so many insolvency and "bad bank" execs on the planet.  If a GP is actively supporting managment's turnaround plan, and has made even a small equity injection, then the lenders will be less likely to take action than in the past.  [For More:  The Telegraph reports that the BVCA is sitting down with the major banks to discuss PE covenant breaches and to promote a patient rescue culture]

6.  The carried interest tax debate is finished for the foreseeable future.  Governments have bigger fish to fry and no one is getting carry cheques in 2009 anyway.  [For More:  Fred Wilson on the carry tax debate]

7.  It will be a great year for recruiting.  In 2007 my firm struggled to match the bonuses and international career opportunities offered by investment banks.  Today it's a very different game.  There are over one million Australians living overseas, and based on the number of calls we're getting, every one of them is an ex-banker in New York, Hong Kong and London.  Also, if the predictions about 40% of buyout funds collapsing are true, then some great people will hit the streets.

Glass Half Empty

   

Last week I was invited to present at a forum for chief executives.  They asked me to address this cheerful topic:  Is The Death of Private Equity Exaggerated? 

I structured my speaking notes around "the Good News" and "the Bad News":

The Bad News:  Glass Half Empty

1.  In 2009 fundraising will be hell, and close to impossible for first time GPs.  We will watch experienced private equity teams fail to reach a first closing and exit the industry. [For more:  The Fundraising Desert of 2009]

2.  No exits.  I can't see the IPO window opening for at least another year.  Most trade buyers are side-lined while they deal with a faltering economy and the challenge of finding a bank that's still lending.  Likewise, our private equity colleagues are struggling with serious portfolio problems and the evaporation of the leveraged finance industry.  No exits in 2009 means no carry and no recirculation of capital by the limited partners.

3.  Carrying values on existing portfolio companies are being decimated this year thanks to mark to market accounting.  Among other things, this will further hinder fundraising because only "realised exits" will demonstrate any value building track-record by the GP. [For more: What Do You Want The Answer to Be? ]

4.  Not all LPs are meeting capital calls. For funds with a diversified investor base this will just be a nuisance, but managers that rely on "anchor" LPs, investors representing 25% or more of their committed capital, are suddenly in a scary, scary place. [For more:  The Cheque is in The Mail]

5.  The secondary market has turned predatory.  Desperate LPs are selling down positions at discounts of 60% or more.  An old friend at one of the top secondary firms [think Coller, Harbourvest, Lexington] told me that his mob will not even begin due diligence unless the seller is clearly distressed  . . . "why waste our time when there are plenty of banks and endowments out there who will accept a serious haircut?".

6.  Portfolio companies are struggling alongside the rest of the economy.  Unfortunately the private equity industry is over-exposed to consumer facing sectors, especially retail.  Sales are falling, margins are being squeezed.  In 2009 there will be no such thing as a "hands off" private equity investor.

7.  Many (most?) portfolio companies are over-leveraged for this environment.  An institutional banker from one of Australia's Big Four told me over a beer that about half the PE-backed companies he manages have breached lending covenants.

8.  Local banks are barely open for business and the international banks are quickly retreating to their home markets.  In Australia today I doubt a PE firm could raise more than about $200 million in debt.

9.  Valuable talent and experience will leave our industry.  As it becomes undeniable that certain firms will never raise another fund, and that some funds will not earn carry for the GP, executives will start quietly moving on.  The first to go will be the younger guys, who see less of the management fee and can still start again in another sector.

 

Valuation, or What Do You Want the Answer to Be?

One of the hottest topics in the private equity world right now is mark to market valuation.  There are two reasons for this:

1.  It's January, so private equity managers are about to send out end of year portfolio company valuations to their LP investors.  This is a "come to Jesus" moment because they must fess up about how bad things really are in portfolio land.

2.  For the first time American PE funds must conform to an accounting rule called FAS157 which requires them to value their portfolio based on "Fair Market Value" rather than historical cost or a modelled value.

For those interested, here are some recent posts on the topic:

• Fred Wilson from A VC on why FAS157 is tortuous to implement but important 
• peHUB quoting a Reuters story on the expected magnitude of PE write downs
• Information Arbitrage in support of FAS157 and rejecting Blackstones' arguments against it
• The Economist defending fair-value accounting
• For Aussies, The Australian on the coming impact of PE write downs on super funds.

I strongly support the use of fair-value accounting in private equity.  Given the events of the past year, I find it baffling that anyone objects to more transparency in the financial services industry.  When Joe and Jane Sixpack put their savings into a managed fund they have a right to expect that the unit price fairly reflects the value of all the underlying assets in the fund, including alternative assets like private equity.

I do however have a serious concern about the mark to market methodology we are required to use under IPEV guidelines. PE firms typically value their portfolio companies using an earnings multiple derived from a set of listed company comps.  My issue is that the IPEV rules don't provide for the inclusion of a control premium.  This is deeply flawed. 

While it's true that private equity companies normally own only a portion of a business (say, 60% of the equity), it's also a fact that they virtually always exit this shareholding via a sale of the entire company.  As a result, private equity sellers usually do extract a control premium.

This oversight really matters during a time of financial crisis.  Right now we can all point to examples of solid, well managed companies that are trading on the stock exchange at very, very low multiples.  But it would be ridiculous to suggest that these multiples reflect the value at which you could acquire these businesses in their entirety.  In reality, if you approached their board of directors with an M&A offer you would quickly discover that the traditional 20%-30% control premium has blown out to a 100%-300% premium. 

Private equity carrying values should reflect this reality.  They should be based on an earnings multiple which incorporates a control premium, not the multiple my dad pays to buy a few shares on E*Trade.

The Fundraising Desert of 2009

 

Preqin (formerly known as Private Equity Intelligence) published some new research on fundraising a couple of days ago.  It's nicely summarised in their press release.

At a glance the research looks like good news, but if you dig down it contains a sobering message for many General Partners.  Here are five points I found intriguing:

1.  2008 wasn't nearly as bad an environment for fundraising as I'd assumed.  In fact, it was terrific-- 768 closings added up to the second highest fundraising year in history.

2.  Even during the fourth quarter of 2008, those darkest days when it felt like the world was collapsing, 148 funds successfully closed and raised an aggregate of US$98 billion.

3.  Thanks to the strong fundraising result, the global private equity industry is now sitting on dry powder of over one trillion dollars! [said in the Dr Evil voice for best effect]  Let's face it, a few LPs may default on their commitments, but the industry is massively cashed up and brilliantly positioned to take advantage of buying opportunities in 2009 and 2010.

4.  The vast majority of limited partners remain supportive of the industry, with 29% intending to increase their allocation to private equity and virtually none intending to decrease their allocation. 

This is the point where I start to question the rosy tone of the research.  The slant is a little too pro-industry for me.  You see, while percentage allocations may well be maintained, Preqin doesn't state whether absolute dollar allocations are changing.  And I'm certain they are.  Overall funds under management has been decimated by the financial crisis, which can only mean that the absolute dollars available for private equity are now far lower, regardless of allocations.

5.  A staggering 1,684 PE funds are currently out pounding the streets trying to raise new capital.  That's more than double the 768 funds that were closed last year. 

This is where the serious pain is about to be felt in the US, UK, Asia, Australia and any other active private equity market.  LPs are going to have to ration out the precious remains of their massively reduced capital pools to these thirsty fund managers. 

Prediction?  A unprecedented flight to quality.  LPs will put much smaller amounts to work in each fund and direct their placement decisions based on protecting access to "top tier" General Partners.  [See my previous post It's All About Access].  They'll give priority to firms in their local market (this could be bad news for Australian PE), they'll decline to reinvest with average performers, and first time funds will discover that fundraising has suddenly become close to impossible.

In short, the fundraising environment is going to polarise in 2009.  Top tier firms will raise their funds with little difficulty but the balance of the market will find conditions very, very, very tough.

Carry structures in Australia, USA and Europe

A reader writes:  "Do Australian private equity funds have different carry terms to US or European funds?"

A subject near and dear to my heart!  "Carry" or "carried interest" refers to the share of investment profits paid to the manager of a private equity fund.  I've posted about carry before (Who Keeps the Carried Interest?).

The most generous carry regime can be found in the US market, where limited partners typically allow GPs the discretion to pay themselves carry as soon as a fund starts generating profitable exits.  While popular with fund managers, this trusting "deal by deal" approach is not without risk.  Imagine a situation where a fund's first exit is a blockbuster, and the manager receives a large carry payment.  He buys a Ferrari.  Then things change.  It's April 2008.  The market tanks and the remainder of the deals in the portfolio turn out to be over-leveraged dogs.  It takes a few years, but these investments are eventually sold at a substantial loss. 

What happens in this painful situation?  Theoretically it's simple:  the manager is expected to repay all the carry he "incorrectly" received on the first deal  . . . this is the dreaded "clawback" provision. 

Needless to say, clawback can be difficult to enforce, especially in situations where staff have left the firm or suffered major financial setbacks-- like getting divorced or buying shares in 2008.  Some funds require a portion of carry payments to be placed in escrow to increase the likelihood that a clawback can be honoured.  With the recent collapse in equity and debt markets, you can be sure that clawback provisions are about to become front page news again.

In Europe clawback doesn't usually feature.  Instead, the GPs must wait far longer to pay themselves carry.  European fund managers can typically only distribute carry once all cash drawn down from their limited partners has been returned.  Sometimes the Europeans prohibit the payment of carry before the end of the fund's investment period, typically the first five years.  In a few draconian cases the manager must first repay any cash that will ever be drawn down from a particular fund (ie, committed capital) before carry can be distributed.

In Australia our fund terms tend to be conservative.  This in part reflects the dominant position held by a small group of limited partners in years gone by (you know who you are).  As a result, our carry structures follow the European model.  We must repay all drawn down capital before paying carry.

As always, however, supply and demand governs.  A group of "top decile" performers is emerging and they are no doubt already pressing for more generous carry distribution terms.

Survivor - The Australian Private Equity Tribe

After my gloomy post a few days ago, several readers asked whether I would share my Australian General Partner "survivability banding" as well as the full universe of local firms I included in the exercise [to call it "analysis" is definitely more than it deserves].

On reflection, I'm not comfortable providing the names of firms that I don't believe will survive through the current cycle.  What I have done though is to provide my full list and to indicate 15 14 of the GPs that I believe are in a particularly strong position to survive the downturn.

This is just one guy's view . . . please spare me the evil spam and threats of violence!

Larger Buyout

1.      Archer  **

2.      CHAMP **

3.      Ironbridge

4.      PEP **

Smaller Buyout

5.      Catalyst 

6.      GS JBWere

7.      Gresham

8.      Tasman Capital

9.      Quadrant **

Midmarket

10.  Accretion

11.  Advent  **

12.  Allegro

13.  AMP Capital

14.  Anacacia

15.Anchorage **

16.  Archer dev fund

17.  CHAMP Ventures  **

18.  Crescent  **

19.  Equity Partners

20.  Fulcrum Capital

21.  Hawkesbridge

22.  Helmsman

23.  Investec Wentworth  **

24.  Mainridge (Hastings)

25.  NBC

26.  Next **

27.  Propel

28.  RMB Capital Partners **

29.  Souls Private Equity

30.  Wolseley **

31.  Yarra Capital

Venture Capital

32.  Allen & Buckeridge

33.  CM Capital 

34.  Innovation Capital

35.  GBS  **

36.  Southern Cross 

37.  Starfish  **

38.  TVP

39.  Uniseed

Is Private Equity the Next F!cked Company?

 

Just how bad are things going to get for Australian private equity?  Internationally, the Financial Times warns that December quarter private equity valuations will be marked down by more than 30%.  This strikes me as a best case scenario.  After all, listed equity markets are down by over 40% and private equity investments are typically leveraged at two or more times the levels of their listed peers.  And let's not forget private equity's disproportionate exposure to hard hit consumer sectors, including retail.

So, are the private equity guys going to get savaged?  Is the industry buggered?  The Boston Consulting Group are smart people and they certainly think so.  BCG is predicting a massive industry shakeout, a perfect storm, culminating in 40% of LBO firms going out of business.

I had planned to write a post explaining why I believed Australian private equity would escape most of this carnage.  But then I decided to take a bottom up look at the 45 or so firms that I consider the core of our local industry.  I removed the international players like KKR or NAVIS, which left me with a focused list of about 40 locals. 

I then did a back of the envelope assessment of their prospects for survival assuming that the fund raising environment remains very challenging for at least three more years. My analysis wouldn't win an award for rigour, but I know most of the firms pretty well and I also looked at websites, past editions of the AVCJ, and other obvious sources.  It was surprisingly easy to assign the managers into "survivability bands" based on their deal track records, current portfolio prospects, team continuity, and capital reserves (obviously a firm like PEP, who just raised $4 billion, can sleep easy).

I was surprised by the result.  Very surprised.  I could only confidently say that just over 20 of the firms, call it 60%, had a clearly sustainable business and would survive through the cycle.  Maybe the powerpoint jockeys at BCG aren't being excessively gloomy after all.

Last thought on this:  private equity is a notoriously "inefficient" industry.  The ten year structure of funds and the passive nature of most limited partners encourages poorly performing GPs to remain in business longer than they should, to hang on for years after it becomes obvious that they have failed to deliver good returns. 

My point?  A handful of Australian firms will disappear quickly-- perhaps even during 2009.  They will merge with peers, key men will resign as hopes of carry evaporate, and we may even see limited partners become more active and vote out a GP.  But the majority of private equity managers caught in BCG's "perfect storm" will simply become living dead firms.  They will very slowly withter away over the next decade . . . cheerful stuff, huh?