Carried Interest

Jim Rogers Speaks, I Listen

 

Source: Channel 4 News

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.

 

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. 

Should Private Equity Firms Sell Their Equity?

Interesting.  Apax Partners, the massive UK-based private equity group, has sold a 7.7% stake in its management company to a pair of sovereign wealth funds: Singapore's GIC and the Australia Future Fund.

I usually hold my nose when GPs sell off equity in their firm to outsiders.  They always rationalise the move by mumbling about succession planning or locking in anchor LPs, but everyone knows it's bullshit.   These guys are selling out the next generation of employees so they can take advantage of dumb money during a bull market (think Blackstone's IPO).  It's greed at its purest and ugliest, nothing more or less.

But I do think that Apax has a defendable explanation.  All the proceeds of the sale are being kept within the firm (or a related investment vehicle) and will be used to take limited partnership positions in future Apax funds.  That's smart. 

LPs expect private equity execs to have personal skin in the game, typically 1%-2% of the fund's value.  In fact, Apax employees personally committed about £200 million to the European buyout fund they raised last year [note to self:  send CV to Apax].  

In addition to reducing the financial pressure on individual Apax staff, the new pool of capital will also be a powerful selling point during fundraising.  To quote Chief Executive Martin Halusa, "We would like . . . to say we are the biggest investor in our own fund, which would help the next time we go fundraising."

Taxation of Carried Interest

Accepted wisdom in the US private equity industry has been that moves to tax carried interest as income are off the table because Obama has much bigger fish to fry . . . like General Motors, Iraq, Citigroup, health care, the Middle East. 

But according to yesterday's WSJ this is not in fact the case.  We're right near the top of his Christmas list.  Be afraid, be very afraid . . . .

Three More Cracks in the Wall

 

According to Reuters, Bain is going to suspend management fees on some of its older funds.  Despite appearances this is not an act of charity by the kind people at Bain.  These funds are getting long in the tooth, but Bain knows it won't find buyers for the portfolio assets until the economy recovers.  In the meantime all remaining uncalled capital must be hoarded to protect these orphans.  One day, when the sky is blue again and the companies can be sold, Bain will be back for its fee! 

The Financial Times says that Candover is going to to release its LPs from a significant portion of their commitments to the firm's recent €3bn fund.  This is particularly humbling for Candover because the largest LP in the fund was their own listed vehicle, Candover Investments, who have stated that they intend to make "a significant reduction" in their €1bn commitment. 

I've commented recently that an exodus of talent is one of the PE industry's emerging problems, so this quote caught my eye:  "A person with direct knowledge of Candover’s strategy said that its biggest worry was to ensure that its best people are retained in spite of an expected “internal rationalisation”.

Finally, I hear from a reliable source that Merrill Lynch Global Private Equity is closing its doors.  At the height of the boom MLGPE was a gorilla in the PE market with about 70 staff and billions invested.  As the attached MoneyWatch article from 2007 says, "they were everywhere."  MLGPE has a team here in Sydney (they jointly acquired VedaAdvantage with PEP), who I understand will leave their offices in Governor Phillip Tower next week.

Not Guilty!

 

Photo Illustration; Greenspan: Alex Wong / Getty; Getty

I'm trying to start the week on an upbeat note, so here's some good news: 

TIME just published their list of 25 People to Blame for the Financial Crisis and NO private equity executives are featured.

Pop the champagne corks!!!

David Rubenstein at Davos 2009

Carlyle's David Rubenstein talks with Bloomberg about the outlook for private equity in 2009.  Note his comment that (paraphrasing):  "every buyout done in the past couple of years will need some form of debt or equity restructuring."

Money Can't Buy Me Love (or Loyalty)

When newspapers revealed that Capgemeni COO Pierre Danon had interviewed for the role of Chief Executive at Accor Hotels, Mr Danon probably felt angry about the leak and mildly embarrassed.  Imagine his shock when Capgemeni promptly fired him.

I've been pondering whether Accor's reaction was reasonable or a childish temper tantrum.  The market certainly wasn't impressed:  Accor's shares dropped 2% on the news.

Mr Danon was hired less than a year ago, so Capgemeni's fury was perhaps understandable.  But surely naive as well?  Time and time again the "big end of town" has made it clear that employees are disposable assets.  We no longer expect loyalty from a corporate employer, so surely they can't demand loyalty in return.

Let's face it, most ambitious senior executives are constantly on the lookout for the next opportunity.  It would be a rare individual who refused the dream promotion out of corporate loyalty.

An Aussie Police State?

Aung San Suu Kyi of Burma and Deputy Prime Minister Anwar Ibrahim of Malaysia would have plenty to say about the Australian government's new anti-terrorism legislation.  It terrifies me.

History shows that these laws are always abused.  It's just a matter of time.  Politicians are too often corrupt, and the police force is too blunt an instrument, to be trusted with these draconian powers.  I'll say it again:  these laws will be abused.  It's just a matter of time.

The government ("trust us") has kicked off the process by allowing Parliament just one week to review the legislation and by suppressing any publication of the draft act.  We only know what they're planning because the Chief Minister of the ACT has posted the act on his website and is refusing government directives to remove it.

The most infuriating thing is that I don't believe these laws will really make us safer.

My old friend Ben Franklin said it best:

They who would give up an essential liberty for temporary security, deserve neither liberty or security

George Bush Joke of The Day

Donald Rumsfeld is giving the president his daily briefing. He concludes by saying: "Yesterday, three Brazilian soldiers were killed."

"OH NO!" the President exclaims. "That's terrible!"

His staff sit, stunned at this display of emotion, and nervously watch as the President rocks back and forth, head in hands.

Finally, the President looks up and asks, "How many is a brazillion?"