Carried Interest

Fundraising Watch - #3

According to Private Equity Online CHAMP has declared a first closing for their new Fund III at $400m.  I heard the same thing from one of CHAMP's primary advisors, so I'm pretty confident the rumour is true. 

The good news is that they finally got there.  The bad news is that they aren't even close to their $1.5 billion target.  I suspect it will still be a respectable fund raising though.  In this market many LPs are reluctant to participate in a first close, but may well be willing to open their cheque books for a final close in 2010.

CHAMP holds A$400m first close

Siddharth Poddar

Australia- and New Zealand-focused buyout firm CHAMP Private Equity has raised A$400 million ($341 million; €238 million) for the first close of CHAMP III Funds, four sources have confirmed with PEO.

The firm is targeting commitments of A$1.5 billion for the final close of its fund, which is likely to be held in the first part of 2010, a source close to the firm said, adding that the fund has seen strong interest from existing investors.

CHAMP Private Equity declined to comment.

CHAMP III will continue to invest in mid-markets in Australasia, Bill Ferris, executive chairman and co-founder of CHAMP Private Equity, told sister publication PEI Asia in an interview in January. He said the firm's investment focus will be on Australia and New Zealand, but it will have the ability to consider transactions in Southeast Asia, a market where the firm has made investments in the past for its portfolio companies.

CHAMP will look to make about 12 investments from its third buyout fund, Ferris said at the time. In terms of sectors, the fund will focus on health, education, financial services, food and in companies providing services to the minerals sector.

Its predecessor fund, CHAMP Funds II, closed on A$950 million in September 2005. The firm's first buyout fund was an A$500 million vehicle that closed in mid-2000.

The New Private Equity Normal

 

Credit: Marc Johns

Every meeting I attend includes a mandatory conversation about green shoots, share market rallies, the IPO window, and whether banks are open for business again.

I think it's worth stepping back and considering what the "New Normal" means for private equity. Can we identify any fundamental shifts in the model, changes that will last for 3-5 years, not 3-5 months?

I'm confident that The New Private Equity Normal includes:

Fewer firms:  As I've written before, 30%-50% of private equity firms will disappear in the coming years.  Which is good.

Tougher fund terms:  Predictions about the end of the 2/20 model are nonsense, but at the margin we will see a swing in favour of the LPs, particularly for new funds which are still building a track record.  Expect to see movement in areas like the treatment of transaction/monitoring fees, the distribution waterfall and advisory board powers.

Longer hold periods:  private equity is supposed to be patient long-term capital.  This was forgotten during the equity boom.  5-7 year holds are back, a 3 year hold is the new quick flip.

Much less debt:  50/50 debt to equity is going to be the standard for the foreseeable future.  Not a big change for the mid-market, but it redefines the buyout sector.

Continued development of GP operating skills:  Leverage and multiple expansion are no longer available to drive easy returns.  GPs are going to have to build value through earnings growth . . . and that means (really) helping improve portfolio company performance.  McKinsey predicted this trend years ago, but the credit boom and strong equity markets allowed many PE managers to cheat, to rely purely on financial engineering.  The future?  Look at firms like KKR.  They have a team of 40 consultants called Capstone whose sole focus is on building value within the KKR portfolio.

......................................................

What do you think defines the New Private Equity Normal?

(btw, if you're shy you don't have to leave an email address to make a comment)

The Waterfall

 

Photo: Arnar Valdimarsson

A reader has just been hired by a fund-of-funds and asks:  "what does my boss mean when he talks about a European distribution waterfall?"

Simply, the waterfall refers to the sequence in which proceeds from the sale of a portfolio company are distributed.  European private equity funds don't usually pay carry to the fund manager until all capital that has been drawn down has first been returned to the investors. 

European Waterfall

- All drawn down capital is repaid to the LPs (cash that was called for realised and unrealised investments, management fees, other expenses of the fund), then

- The investors are paid a preferred return on all drawn down capital.  This hurdle rate is typically an 8% IRR.  And only then,

- The manager starts to get a 20% share of the remaining proceeds (usually with a catch up). 

An American waterfall is more GP friendly.  Most American private equity managers begin to receive a share of the profits (carry) as soon as they have returned the drawn down capital and paid a preferred return on the fund's realised investments.  They don't have to return capital on investments that still remain unrealised within the fund . . . this difference can bring forward carry payments by many years.

Hope this helps. Enjoy your new job!

Questions Continue about Gresham Model

In a recent post I mentioned that Gresham Private Equity is still trying to raise a new $600m fund.  One reader commented on Gresham's unusual relationship with corporate giant, Wesfarmers:

Gresham model is not sustainable. Wesfarmers are under serious pressure from equity analysts to stop backing the PE fund (or ideally divest the entire Gresham asset) . . . Gresham may not like it, but the PE team may have to spin out to survive.

It looks like he knew what he was talking about.   Wesfarmers reported their financial results yesterday and this is what Merrill Lynch analyst David Errington had to say:

The one aspect of Wesfarmers that we find totally unacceptable is its foray into private equity investments via Gresham Partners.  This year Wesfarmers lost $57m via its investments in Gresham . . . .

Why a large and respected company like Wesfarmers, that not long ago paid $19bn for the underperforming Coles businesses, is still undertaking investments in private equity ventures is totally beyond us.

We just don't understand it . . . and disagree with the strategy to continue investments.  The sooner Wesfarmers exits from private equity investments in partnership with Gresham Partners, the better we believe it will be for shareholders. 

Ouch.

Can Australian Private Equity Still Sell-Down?

Lead managers and underwriters for the hotly anticipated IPOs of Myer and Kathmandu should be appointed within the next week or two.  It's important that these two listings are well received by the market because they will set the tone for a long list of upcoming Australian private equity IPOs.

I'm curious to see what sell-down the market accepts.  Historically Australia has been unusually tolerant of private equity owners that cashed in their equity chips at IPO.  Sell-downs of 70%-100% were the local norm. 

By contrast, in the United States a private equity sell-down of 20%-50% of the fund's shareholding would be more typical and in Hong Kong the sell-down is usually limited to less than 40%.  The balance of the PE fund's shareholding is escrowed for 6-12 months or for the prospectus forecast period.

Fund Raising Watch - #2

Still no first closing announcement from CHAMP or any of the other Aussie fund raising hopefuls.

I understand that NAVIS (Malaysian based but with an office in Sydney) has finally reached a first closing of US$400 million.  They were originally targeting US$2 billion for their Fund VI, but cut the target back to $1.25 billion when the GFC hit.  Frankly, with a first closing at $400m you have to question whether they will even come close.

Speaking of NAVIS, here's an interesting interview with Nick Bloy, one of the firm's two managing partners.

It's a Buyer's Market

  

Credit: Natalie Maynor

I had lunch yesterday with one of the top M&A lawyers in Sydney.  We talked about the dramatic decline in prices being offered for assets, and he commented on an equally clear shift he has observed in the deal terms that private equity firms are demanding before they'll invest.

Some of these "buyer's market" changes include:

Earn-outs are becoming more common in PE deals.  This slightly surprised me because earn-outs (where the total purchase price paid depends on the future performance of the company) are notoriously painful to negotiate and their enforcement can do more damage than good.

Escrow of sale proceeds:  PE firms are increasingly insisting that a portion of the sale proceeds be placed in escrow to provide security for potential warranty claims.

Seller liability caps on warranties are increasing, with caps of 50% or more of the purchase price now common.

Warranty and indemnity time periods have lengthened . . . 2-3 years is the new 12 months.  Warranties are also more likely to be given at both signing and completion, and the de-minimis levels for warranty claims have come down.

Material Adverse Change (MAC) clauses are being included in most transactions to protect against a negative event between the time of entering into a purchase agreement and closing the deal.

Non-compete provisions are extending . . . though uncertainty and debate still remains about their enforceability.

Lesson Learned #6 - Great Trade Exits

Great trade sales happen when someone wants to buy your business, not when you want to sell it.  The best trades sales happen when someone needs to buy your business. 

When you think about potential buyers for a portfolio company, an important question to ask is this:  who has an existing revenue-generating relationship that they want to preserve or extend?

For example:  we owned an importer and distributor of an industrial product.  Our business had almost 70% market share in Australia and New Zealand.  The raw material was supplied by one offshore company under an exclusive contract. 

The CEO of our business mentioned that his shareholders were considering an exit . . . and just seven weeks later the offshore supplier owned our company.  They simply weren't willing to take the risk that one of their global competitors might snap it up and lock the market away forever.

Ready to Jump - IPO Watch

 

Photo: DefenceTalk.com

IPO markets around the world began to gently reopen in Q2, and a number of listings were successfully completed in North American and Asia.  Australian equity managers have shown no appetite for IPOs since late 2007, but they certainly haven't been sitting on their hands.  Our equity markets have experienced extraordinary levels of activity driven by de-gearing and de-risking of ASX companies.  In fact, Australian equity issuance represented 18% of global issuance in Q1. . . pretty incredible for a country of just 22 million people.

The Australian recap process is now largely complete, our banks are in good shape, the ASX has been experiencing a sustained rally, and consumer confidence is surprisingly strong.  Many of our superannuation funds and small cap managers missed the recent rally and urgently need to rebalance cash-heavy portfolios. 

It all adds up to a private equity led Aussie IPO boom in Q4.

There's a backlog of IPO quality companies sitting in Aussie PE portfolios and it's been a long time since most of the teams banked a carry cheque.  Is that fresh prospectus ink I smell wafting from office buildings across Sydney?

IPO watch candidates include:

Myer (Australia's largest department store family, TPG Capital)

NDA Group (Stainless steel fabricator, RMB Capital Partners)

Ascendia Retail (Sports stores, Archer)

iNova Pharmaceuticals (old 3m Asian pharma business, Archer)

Healthcare Australia (CHAMP)

Kathmandu (Outdoor clothing and equipment stores, Quadrant and GSJBW)

Link Market Services (Share registry, Pacific Equity Partners)

And in the medium term:  Device Technologies (Medical device distributor, RMB Capital Partners), Mastermyne (Coal mining services, CHAMP Ventures), Hoyts (Cinemas, Pacific Equity Partners), ATF (temporary fencing, Quadrant)

Equity Buyouts (EBO)

Here's an interesting video from The Deal.com.  Brette Simon, a partner at Jones Day, discusses new transaction structures that have emerged since the banks cut back on private equity lending.

Australian Survivor . . . Fundraising Watch

Nine members of the Australian PE tribe are currently raising a fund.  The Poor Buggers.  My guess is that 3-4 of them will achieve a final closing this year.

1.  CHAMP:  is an Australian private equity pioneer.  The firm is 50% owned by the local team with the balance held by the American PE house, Castle Harlan.  I understand that Castle Harlan's stake will fall to 25% when the new fund is raised. 

Despite a few high profile stumbles (Sheridan, Australian Discount Retail) CHAMP remains the bluest of Australian PE blue chips, and I've no doubt that even in this brutal environment they will raise another fund.  The only question is, how big?  They're officially targetting $1.5 billion, but a first closing still hasn't been announced . . . rumour is they will come in lower than hoped.

2. Direct Capital:  New Zealand's most successful PE firm.  They've just announced a successful first closing for their latest fund at NZ$200m.  Their success is deserved.  Direct have delivered strong returns to LPs over the past 15 years, are genuinely differentiated by virtue of their location, and have maintained team continuity.  What more could an LP want?

3.  Gresham Private Equity:  Not to be confused with the UK firm that shares their name. In Australia Gresham is a well established boutique investment bank.  Unusually, the firm is partly owned by a large conglomerate, Wesfarmers, who has also served as an anchor investor for their PE funds. 

The Gresham PE business has a checkered past:  in 2003 virtually the entire team resigned after a stoush over carry, and together formed Ironbridge.  A number of Australia's leading LPs were caught up in the collapse, and as a result Gresham is unlikely to ever raise local institutional capital . . . at least while the PE business remains captive.

Gresham was targeting a $600m fund, but in this market they will do well to match the $325m raised from Wesfarmers and retail investors back in 2004.  I've heard that they are targetting international money (particularly Middle East) to top up another generous contribution from Wesfarmers.

4.  Tasman Capital Partners: the team left DB Capital Partners a few years ago to form the Australian arm of Nikko Private Equity.  Unfortunately Nikko got acquired by Citi, so last September they formed Tasman.  No first closing yet.

5.  Mainridge Capital:  another spinout story.  Mainridge is the old PE team from Hastings Funds Management.  Hastings was acquired by Westpac, who wanted to get their hands on the infrastructure business.  The PE team negotiated a friendly spinout, but unfortunately this process took so long that they ran head-first into the GFC. 

Last I heard Mainridge were supposed to have raised funds by 30 June or the spinout deal was off.  I believe this deadline has now been extended until year end.  No first closing yet.

6.  Propel Investments: was founded in June 2007 when Deutsche Bank divested DB Capital (fundraising gets confusing when you have both Propel and Tasman claiming the same deal track record!).  Propel intended to raise a $250m - $350m fund this year, but have now withdrawn their IM from the market.

7. Harbert Australia:  is the new Australian subsidiary of Harbert Management Corporation, a $2.5 billion investment group based in Alabama.  The local team is led by Jeremy Steele, who used to run the now disbanded ANZ Private Equity.  The American parent has provided seed capital of $40m, and the Aussie team is trying to raise a futher $100m from local and overseas investors.

8.  Pinnacle Private Equity:  was launched in January by two former AMP Capital Investors executives, Bill Cook and Peter Ludemann.  They are targetting a new $300 million mid-market fund.  No first closing yet .

9.  AMP Capital Investors:  announced last year that they would raise Fund IV, a $350 million mid-market fund.  The team is still led by Greg Smith but in recent years has suffered from considerable turnover (see related post).  No first closing yet. 

Cold Reception

  

Photo credit: Jaxxon

A reader based in Moscow (!) asks:  is the private equity or VC fund raising situation in Australia any better than the cold reception we face in Europe?

I suspect the climate is slightly warmer in this part of the world (titter, titter.  Sorry, couldn't help myself). 

More seriously:

1.  The larger superannuation funds have continued to support local private equity.  Since 1992 all Australian workers have been required to contribute 9% of their income into retirement funds (which we call superannuation funds).  As a result Australia has built an extraordinary pool of retirement savings-- over $1.2 trillion.  In fact, per capita, Australians now have more money invested in managed funds than any other nation.

2.  Sentiment is not quite as bleak here as in the UK and USA.  Our banks are healthy and amazingly our economy has not yet gone into a recession-- though it feels like one to me.

3.  There are relatively few local PE and VC funds (only about 40) chasing the big pot of superannuation honey, and Australia is too far away to make it an attractive fund raising destination for most overseas private equity firms.

4.  At least half the Australian PE funds still have significant levels of uncalled capital and can therefore postpone fundraising.

To be clear, I'm not claiming that fund raising is easy here.  It's hard.  And I'm very, very glad my firm isn't out there this year. 

Perhaps for my next post I'll summarise the current crop of Aussie/NZ fund raisers and how each one is progressing . . . that will get tongues wagging.

Dentsu's Ten Rules of the Demon

 

I've had this list of rules on my desk for about 15 years.  It was given to me by my first really great boss.

A Japanese visitor recently noticed it and was amazed to see a copy translated into English . . . sitting in Sydney, Australia.  He told me that in Japan the list is known as the Ten Spartan Rules— I like that.

1.  Create work for yourself; don't wait for work to be assigned to you.

2.  Take an active role in all your endeavours, not a passive one.

3.  Seek out large and complex jobs.  Trivial tasks debase you.

4.  Welcome difficult assignments.  Choose them.  Progress lies in accomplishing difficult work.

5.  Once you begin a task, complete it.  Never give up.

6.  Lead your fellow workers.  Be an example for them to follow.

7.  Set goals for yourself to ensure a constant sense of purpose.  This will give you perseverance and hope for the future.

8.  Move with confidence.  Confidence gives your work force, focus and substance.

9.  Find new solutions.  This is the way we ensure satisfactory service.

10.  When conflict is necessary don't shy away from it or be afraid.  Conflict is the mother of progress and the source of aggressive enterprise.  If you fear conflict, you will become timid and servile.

Lesson Learned #5 - There's No Place Like Home

  

There's an old myth that a Silicon Valley VC won't back any start-up based more than 30 minutes drive from Sand Hill Road.

I'm not quite that lazy.  In fact I'm posting this from the Qantas lounge in Auckland.  But I've learned the hard way that distance is not a friend in private equity, and these days I expect potential investments based more than a couple of hours away from Sydney to clear a higher hurdle.

Distance is a minor nuisance when a portfolio company is performing well.  You get on the phone, send emails, fly to the factory for monthly board meetings and management offsites-- no drama. 

But when the wheels come off, or just wobble a little, distance can become a big problem for a PE investor.  When a company underperforms it's not always obvious exactly what's going wrong.  You can feel the momentum slipping away, but without spending plenty of time with the team, without "living the business", it's hard to quickly get to root causes and make correct decisions.

Was the rework problem in May really a one-off?  Who's telling the truth about quality issues, the Sales Manager or the Plant Manager?  Why is the CEO suddenly slow to return calls?  Is there a good headhunter in Kalgoorlie?

These issues are even more acute when you start investing internationally and barriers like language emerge.  It's dangerous to delude yourself that you can project the capabilities of a small PE team into another market. 

A thought: I'm normally skeptical about the mega-buyout firms and the scale benefits they claim to enjoy.  But their size does allow them to deploy locally recruited teams in many geographies (like 3i did in the UK).  Perhaps that's a genuine advantage they have?

Leason Learned #4 - Always Include Grey Hair in Your Due Diligence

Photo credit:  AFP/Getty Images/Thomas Lohnes

Private equity due diligence has become more sophisticated over the past decade.  These days the information package that gets handed to the banking syndicate may include:

1. Market and strategy analysis by a consulting firm to test and validate the commercial thesis behind the investment  (In Australia, active players are LEK, HUB Consulting, BCG, Crescendo)
2. Financial and tax review by an accounting firm (The Big-4, Grant Thornton)
3. Legal review (Freehills, Corrs, Clutz, etc)
4. Insurance analysis  (Aon, WSP)
5. Environmental risk assessment (ERM, SKM Consulting)
6. Management team background checks and capability review by an HR consultant.

When you're paying for all this big city "brain power" it's easy to forget the single most valuable source of business wisdom:  a grey-haired industry veteran. 

McKinsey may do a great job of mapping out the market structure, analysing segment profitability, testing growth assumptions, and so on.  But there's nothing like having a recently retired CEO by your side when you tour the factory, interview customers, or hold question and answer sessions with management. 

He'll be the person who notices that the overhead cranes in the workshop belong in a museum and need to be replaced immediately.  Or warns you that a major supplier has been bought by the competition and will probably cut off distribution.  Or remembers that this particular company always had a problem keeping good sales reps.

Is Private Equity the Next F!cked Company? (Part 2)

 

Coller Capital just released the latest edition of their twice-yearly Limited Partner survey.  The LPs believe that 23% of buyout firms will be unable to raise a new fund in the next seven years-- in other words they will go out of business.

That's not surprising when 84% say they have declined to re-invest with one or more of their existing GPs over the last 12 months (in Summer 2005 the figure was just 45%).

It's depressing stuff, but still a lot less gloomy than the doomsday industry meltdown that BCG was predicting last year.

Green Shoots?

 

Is the fund raising environment thawing?  Funds of funds certainly appear able to get new commitments from their LPs.

According to TheDeal.com, over the past two months fund-of-funds managers have closed on roughly $5.1 billion in fresh capital to invest in private equity, venture capital and real estate vehicles.

No surprise to see that much of the money is heading towards distressed asset or special situation PE funds!

Lessons Learned #3 - When In Doubt, (Quickly) Throw Him Out

Like most private equity investors I am far too slow to make tough decisions about portfolio company managers.  I procrastinate.  I blame market conditions,  I blame wet weather,  bad luck . . . anything to avoid the painful conclusion that THIS GUY MUST GO NOW.

My advice to a new general partner would be this:  the second time you find yourself questioning whether you have the right manager in the chair, start the search process.  And never make an investment where the shareholder agreement limits your ability to replace the CEO.

Lessons Learned #2 - Don't Be Greedy

It's usually a mistake to reject an attractive exit opportunity because you believe that "in a couple of years we'll get far more for the business." 

In a couple of years the share market could have collapsed, a new competitor may have launched, the CEO could have died, the price of oil could have doubled . . . risk is real.

If someone offers you 2x after two years . . . take it.  41% IRR and the profit is banked.

Lessons Learned #1 - The Exiting Founder

A new series which documents some of the more painful lessons I've learned over a decade or so spent in private equity.

Lesson 1:  Avoid investments that include an Exiting Founder

For my firm, without exception, these have been disasters.  Let's face it, the wily old bugger who has built a business over thirty plus years knows exactly when to sell.  The situation is particularly dangerous in a small business, where the processes, customer relationships and commercial judgment tend to sit in the founder's head.

I'll still consider investments with a transition plan that allows a founder to exit over a period of time, particularly if the deal includes some form of earn-out or retained equity stake.