Carried Interest

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.

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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)

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!

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.

 

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. 

The Cheque is in The Mail (Part II)

Last year I wrote about a worrying possibility:  limited partners not meeting capital calls.  Here's an video interview from Bloomberg that comments on this very live issue.

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 . . . .

When Good Companies Go Bad (Part III)

  

"It's Dr. Evil, I didn't spend six years in Evil Medical School to be called "mister," thank you very much."

It's D-Day.  Your bank manager has just broken the uncomfortable news that he will no longer be your point of contact and you should expect a phone call from a Mr G Reaper of the Asset Restructuring division.  Congratulations . . . you're in the Bad Bank.

As usual, the answer to what you should expect next is— it depends.  Here are some of the variables and possibilities:

1.  The Bad Bank will almost certainly appoint (at your cost) an investigating accountant.  This firm will spend a few weeks completing a mini-due diligence on the business and will then make  recommendations to the bank.

2.  Perversely, if your company is a real basket-case it could strengthen your hand.  Let's say that the business has few tangible assets that could be sold (such as real estate or valuable factory equipment) and is only just breaking even each month.  In this situation it's unlikely that liquidation will recover much of the bank's money, so they may instead let the company trade on and hope for better times.  They'll be patient and supportive.  The Bad Bank might even agree to write off or suspend part of the loan to help return the struggling business to a more solid footing.

3.  The most dangerous situation for a PE investor is a portfolio company in the Bad Bank with valuable assets and a reasonable bottom line.  In these circumstances there's a risk that the lender will sell off the business (or its assets) and try to recover their loan.  Needless to say, the equity holders will probably be washed out.

The Economist recently raised the alarm about cash-strapped banks rushing to this solution as a way of freeing up funds and improving their liquidity position. 

Worryingly, however, a large number of profitable companies that are still paying down their loans may go bust through no fault of their own. Simon Walker of the BVCA, an industry group, frets that British banks in particular are forcing sound firms into early liquidation over minor breaches of their loan agreements in order to reduce the size of their loan books.

4.  Sometimes the Bad Bank will adopt a watchful waiting approach.  They may conclude that the business has stumbled but is not at serious risk, or that a turnaround plan looks promising.  In this situation they'll agree to let the company continue trading but will renegotiate the terms of the loan to reflect the higer risk involved.  Examples of typical Bad Bank loan amendments include: 

• Adding penalty interest to reprice the loan
• Cutting back undrawn loan facilities such as working capital and capex
• Changing the loan amortisation schedule so the debt gets paid back faster
• Charging the company a painful one-off amendment fee
• Increasing the frequency of reporting dates and covenant tests.

5.  Finally, the approach the Bad Bank chooses will depend on the broader banking relationship.  Bad Bank execs pride themselves on not being relationship managers—their game is recovering cash, not making friends.  Having said this, over the past decade banks have become more sophisticated at managing their problems loans.  During the 1990's they learned the hard way that carelessly rushing companies into liquidation wasn't a smart way of recovering maximum value and destroyed valuable business relationships.  Nowadays they will at least pause and think about the bigger picture before pulling the trigger. 

For example, I know one very high-net-worth individual whose company has run into serious problems.  It's in the Bad Bank but they're being incredibly gentle and tolerant. Why?  Another division of this banking group also manages his (large) private assets  . . . that's called having leverage.

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!!!

When Good Companies Go Bad (Part II)

 

"I ate his kidneys with some fava beans and a nice chianti."

Performance at the portfolio company continues to slip.  It has breached bank covenants three quarters straight . . . what happens next?

Banks hate including an equity cure provision in their loan documents, but ironically the first thing they always ask for when things go off the rails is . . . an equity cure.  During the boom an equity cure meant plugging a gap in quarterly EBITDA to bring the covenant calcs back into line, but sadly those days are well and truly gone. 

Today what happens is this:  your loan officer calls and assertively says "I think it's time we sat down and discussed the situation at Buggered Markets Pty Ltd."   He appears firm and confident, but the truth is he's feeling pretty nervous.  He underwrote that ridiculously large loan, and if it goes into default he has lots of explaining to do.

You discuss the weather and New Zealand's rugby prowess for twenty minutes, and then finally, "we feel it would be appropriate if the shareholders injected some capital to reflect the current performance of the business."  By this he means: please, please, please pay down some of the senior debt so I don't get fired for lending money to your crappy company. 

The key insight here is that the financial sponsors lending team is totally aligned with the private equity investor, not with the bank that employs them.  If a loan defaults, they're in trouble too.  And it's impossible for them to play the tough guy because their job is to sell more debt to the PE firm.  They're worried about missing out on the next deal.  No new loans, no big bonus.  No big bonus, no sprawling holiday house in Noosa Beach.

The lending team will bend over backwards to cooperate with the PE firm and keep the evil credit guys at bay.  The corruption varies from bank to bank, but I have watched lending officers turn a blind eye to outrageous profit normalisations and approve gymnastic variations to covenant calcs . . . anything to avoid a visit to the bad bank.

Next time:  The Bad Bank.  The PE firm just won't play ball.  The General Partners have decided that this could be a case of throwing good money after bad, and refuse to inject any capital. What happens now?

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."

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.