Carried Interest

Jim Rogers Speaks, I Listen

 

Source: Channel 4 News

Saved By The Bank

Here's a great post from The Private Equiteer about the hidden value of the bank credit team.

The most important insight is this:  Maybe you don’t need to be doing those deals that are borderline with the banks.

I have a seriously nasty memory of a BIG deal our team badly wanted to win in the weeks just before the GFC took hold.  To our surprise, our two primary bank lenders both turned it down.  We thought they were being too conservative, or had failed to really understand the opportunity, so we decided to keep shopping it. 

Three weeks later we believed we had approval from a European bank, and were about to get started on the legal docs.  But to our shock, and the shock of the bank's lending manager, their credit officer stood firm and said no.  That was it. Deal dead.

Thank God.  Without exaggeration, that deal would have killed our entire fund, and maybe our firm.

Defaulting LPs . . . there's a silver lining

I've posted before about the problem of defaulting limited partners (see The Cheque Is In The Mail).

The media has made lots of noise about this risk, and the disaster it supposedly represents for the PE industry, but on the ground the reality is a bit different.  An LP default can actually be great news for a private equity fund manager. 

For example, imagine a situation where a fund is four years old, is two-thirds drawn down, has a solid portfolio, and issues a capital call for what may be its final investment.   The days tick by and then an LP (let's call them a large American bank) breaks the shameful news that they can't honour the call.  They're in default.

Shock! Horror! What happens now?

Well, if the PE fund has a diversified group of, say, twenty LP investors, then the manager will simply increase the capital call to these other partners and make the acquisition.  He then has to deal with the defaulting LP . . . and his powers are usually draconian. 

It's not uncommon for the manager to seize defaulting units without paying any compensation.  Notice the important detail?  The manager gets the units.  These units have already been partly paid to 66% and the GP is now free to sell them to a secondary buyer, or hold them and meet future calls himself.

So . . . a fund is performing solidly and is almost fully invested.  An investor defaults by failing to meet a call.  A disaster?  Not at all, it can be a financial windfall for the fund manager.

On this theme, I know of cashed up managers who are actually approaching their LPs and offering them liquidity . . . offering to buy their units at a big discount.  The GP is in an unbeatable position to recognise the potential for a secondaries bargain.

At the Risk of Beating a Dead Horse . . .

The Financial Times just published a cheery health check on the Private Equity industry:  Bombed-out buy-out.

All well covered territory on this blog and many others, but I did like David Rubenstein's summary of private equity in 2009:

"Private equity firms will spend 70 per cent of their time shoring up their investments, 20 per cent of their time shoring up their investor base, 5 per cent trying to raise new money and 5 per cent trying to do new deals."

Warren Buffett versus Private Equity

Warren's well publicised dislike of private equity has featured in the press again this week.  Over the years he has attacked four aspects of the industry:

1.  Excessive use of leverage which can result in the destruction of quality businesses.

2.  Short hold periods and a resulting focus on exit strategies rather than building long term value.

3.  Stripping out profits by imposing burdens such as transaction fees and monitoring fees.

4.  The 2% / 20% compensation model. 

I agree with him on all counts, though I think he's guilty of carelessly lumping all private equity activity into a single axis of evil.  When Warren complains about LBO firms and private equity he's really referring to the global buyout firms which emerged over the past decade (think Blackstone, Carlyle, KKR, CVC) rather than old fashioned mid-market private equity.

Excessive use of leverage became the defining feature of the global buyout game.  As more and more cheap leverage became available the prices these funds paid for deals rocketed while the equity component shrank.

By contrast, mid-market debt multiples rarely went above 4x EBITDA, even at the height of the boom.  Many mid-market deals were being leveraged 3x EBITDA while the buyout guys were pumping 8x or more into their acquisitions.

Likewise, the charging of large transaction or monitoring fees is a practice almost exclusively seen in the buyout sector.  I don't totally agree with Warren that this is an evil practice.  It's true that the amount of money going into the GP's pocket can reach offensive levels (2% of a $5 billion transaction!), but the reality is that buyout funds usually own all or most of the equity in their portfolio companies.  So it's their money [their LP's money, to be precise].  Whether profits are taken out as dividends or as monitoring fees is irrelevant to the health of the portfolio company.  Last time I looked Warren was very happy to receive dividend cheques from Berkshire's portfolio.

Finally, I'd argue that the 2% / 20% model is like democracy.  It's a lousy system but better than all the other ones.  However, the large global buyout funds have abused the model . . . it's become democracy Zimbabwe style.  

Traditionally the 2% management fee was supposed to keep the lights on and pay the staff.  When funds were smaller the General Partners only built personal wealth if the portfolio companies performed  . . .  they were therefore fully aligned with their limited partner investors.  Today, with funds in the tens of billions, GPs are becoming wealthy on fees alone, regardless of how the portfolio performs.  That needs to change.

A final word:  let's not forget that Warren is increasingly competing with private equity firms when he tries to scoop up businesses.  The Deal.com puts it nicely:

Buffett may be the perfect buyer for some companies. But he often wants to pretend that he should be the only buyer, that his way is the only way and that, given his self-evident (and assiduously self-promoted) virtue, he should not face competition. Again, you can't argue with his record, but you can wonder about his moral self-regard and where his wisdom ends and his self-interest begins.

 

Warren Speaks, I Listen

       

Picture: Nati Harnik/AP

I was going to put together a summary of Warren Buffett's annual letter, but Fred Wilson has saved me the trouble:

1) The economy - It's really bad. Warren says the "freefall in business activity" is "accelerating at a pace that I have never witnessed before."

2) TARP and related efforts to stablize the financial system - The Fed "stepped in to avoid a financial chain reaction of unpredictable magnitude. In my opinion, the Fed was right to do so." But it will "bring on unwelcome aftereffects." One likely consequence is "an onslaught of inflation." And "major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won't leave willingly." That last line is classic and true and Obama's greatest challenge.

3) Berkshire's two most important businesses are insurance and utilities, sectors that "produce earnings that are not correlated to those of the general economy."

4) Buffet and Munger are value investors and contrarians. Warren says "When investing, pessimism is your friend, euphoria the enemy" and "Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down" and "Beware the investment activity that produces applause; the great moves are usually greeted by yawns." Words to live by.

5) Housing - Berkshire has exposure to the mortgage and housing market by virtue of its ownership of Clayton Homes, the largest company in the prefab home market. Buffett says "Enjoyment and utility should be the primary motives for [home] purchase, not profit or refi possibilities. And the home purchased ought to fit the income of the purchaser." And "an honest to God down payment of at least 10% [I think 20%] and monthly payments that can be comfortably handled by the borrowers income. That income should be carefully verified."

6) History as a predictor of the future - "If merely looking up past financial data would tell you what the future holds, the Forbes 400 would consist of librarians."

7) Quants - "Beware of geeks bearing formulas."

8) Lean and mean organizations - "BHAC: Who, you may wonder, runs this operation? While I help set policy, all the heavy lifting is done by Ajit and his crew. Sure they were already generating $24 billion of float along with hundreds of millions of operating profit annually. But how busy can that keep a 31-person group? Charlie and I decided it was high time for them to start doing a full day's work." Wow. I'm stunned. And now I have something other than Craigslist to use as an example of a lean and mean profit generating machine.

9) Bubbles and Panics - "The investment world has gone from underpricing risk to overpricing it." And "When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the US Treasury bond bubble of late 2008 may be regarded as almost as extraordinary."

10) Derivatives - "Derivatives are dangerous" and "When Berkshire purchashed General Re in 1998, we knew we could not get our minds around the book of 23,218 derivative contracts, made with 884 counterparties. So we decided to close up shop. Though we were under no pressure and we operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Upon leaving, our feelings about the business mirrored a line in a country song: "I liked you better before I got to know you so well."

11) Risk and Responsibility - "It is my belief that the CEO of any large financial organization must be the Chief Risk Officer as well. If we lose money on our derivatives, it will be my fault."

I'll stop there because I really like lists with eleven entries. It's a quirk of my personality. All you have to do is read Warren's letter (or even my cliff notes version) to understand why he's the best investor of the past century. Common sense married with a native understanding of markets and value is what produces the returns at the top of this post. Everyone who invests and manages money for a living can take a lot away from Berkshire Hathaway and Warren and his partner Charlie.

Five Star Service

A couple of readers have asked why I've added star ratings at the bottom of these posts. 

What I'm hoping is that the Carried Interest community will rate the posts as you read them and then, once we've been doing this for a couple of weeks, I'll add a Most Popular Posts widget that will automatically update based on your feedback.

Thanks!

PS:  Be nice.

Easy Target?

 

It's Private Equity Abuse Week in Australia.  The Financial Review (our WSJ) ran a two page spread entitled "How Lo Can Private Equity Go?"  Not to be left out, the Sydney Morning Herald responded this morning with "Vultures Go Hungry."

I know I won't get any sympathy if I try and defend the PE industry.  Let's face it, the prices paid and debt multiples on many of the large buyout transactions were utterly irresponsible.

But I do wish that the journalists could get some of the basic facts right.  For example, they never distinguish between the irrational exuberance of the global buyout giants and the very different behaviour of the dozens of conservatively operated mid-market private equity firms. 

Ingrid Mansell wrote this beauty in the Weekend AFR:

"Private equity firms typically buy underperforming companies, strip out costs, boost profitability and sell the assets after three to five years."

What a load of ignorant nonsense.  Unless they're distressed asset specialists private equity firms almost never buy underperforming companies.  In fact they spend millions of dollars in due diligence costs to ensure that the businesses they buy are performing strongly and will grow.