Carried Interest

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. 

A deal, a deal, my kingdom for a deal

Australian private equity dealflow remains . . . dead. 

I'm confident this will change over the next two quarters as business owners come to terms with lower valuations and boards make tough decisions to address their crumbling balance sheets.  Public to privates will also emerge as an important part of the 2009-2010 market.

In the meantime, other than the Archer + HarbourVest buyout of MYOB, I'm scratching my head to think of a single Australian private equity deal completed this year. 

Am I forgetting any?  [No credit for bolt-ons or follow-on rounds]

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?

ABN AMRO Capital Sleeps With The Fish

Some readers will remember me predicting that ABN AMRO's team wouldn't last long.  I got comment heat from JP Kauymer's family, which was silly, because all I was suggesting was that a spinout was on the cards. 

The ABN AMRO team was indeed heading in that direction, but unfortunately they never made it to the finish line.  Two months ago ABN AMRO Capital became the first Australian private equity manager in memory to get fired by its limited partners.  (See article in Super Review).

So the list of failed or spun-out Australian private equity captives just gets longer and longer:

ABN AMRO Capital (fund transferred to Allegro)

ANZ Private Equity (being closed down)

Mainridge (spinning out of Hastings/Westpac)

Tasman Capital (spinning out of Nikko/Citigroup)

Colonial (closed down)

Propel (The DB Capital guys)

Accede (More DB Capital guys)

Accretion (The old NM Rothschild Arrrow Dev portfolio)

Catalyst (spun out from PPM)

GS Equity (Archer)

Gresham Private Equity (Ironbridge)

Macquarie Direct (Next Capital)

Westpac (Quadrant Private Equity).

My next pick?  AMP Capital.  I can't see them raising another fund in this environment.

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.

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.