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Best Bet for Alignment?

Private equity has always thought of itself as the sober end of asset management. In a perfect world, this is how all companies would be managed – lean decision-making bodies focused on well-defined objectives, perfectly aligning capital with business management, away from the short-termism of public markets.

Then there was the credit boom. The magic of cheap leverage raised the ceiling for the biggest buyouts. Suddenly, household names like the UK’s Premier Foods and Boots, the Netherlands’ Multikabel and Germany’s Hoechst were targets. The infamous “private equity put-option” pushed small-cap valuations up to unsustainable and often indiscriminate levels – and private equity found itself very visible, and under suspicion.

Much of the trust that needs to be rebuilt across financial services was knocked down by the ravages of systemic risk, and one could be forgiven for thinking that where leverage exists, systemic risk will follow. The European commission, drafting its recent proposal for a directive regulating alternative investment managers, certainly did. It took a tremendous tussle from private equity lobbyists to get last-minute acceptance from the commission that their industry did not present systemic risk, and even now the draft directive still appears to lump them in with hedge funds, many of which arguably do present such risks.   

It is not often observed that public companies can be even more highly geared than private ones. And while there are, no doubt, quite a few non-performing loans associated with leveraged buyouts (LBOs) on banks’ balance sheets, they pale into insignificance next to the mountain of other toxic assets that drove them to the brink last autumn. According to Jonathan Russell, managing partner with 3i Group and chairman of the European Private Equity and Venture Capital Association (EVCA), the total amount of European debt associated with the industry is less than 1% of the total European bank balance sheet.

“I think there is trust to be re-built,” he concedes. “But the reality is that private equity does not hold the risk of many of the other components of the financial industry, and that needs to be recognised. And in the context of what’s going on in the world, private equity is part of the solution, not part of the problem.”

A Voluntary Code

Private equity had a head-start on the investment banks and asset managers who have only been pelted with rocks since the credit crisis unfolded – almost five years ago in the case of Franz Muntefering’s “locusts” speech, and two years ago in the case of the humiliating appearances before Parliamentary Select Committees in the UK in the build-up to the Walker Report and Guidelines on disclosure and transparency in the industry.

The voluntary guidelines from Sir David Walker’s working group have enjoyed broad support and compliance, and have been emulated in other European markets (AlpInvest, owned by APG and PGGM – investing in private equity funds for ABP and PFZW – is just one of their most influential supporters on the continent). The guidelines recommend that private equity firms should publish a description of their own structures and of the UK companies they own, and a categorisation of their limited partners (LPs) by geography and type, on a “comply or explain” basis. When reporting to LPs, it was recommended that they “commit to follow established guidelines in the valuation of their assets” and provide data to the British Private Equity and Venture Capital Association (BVCA) so that it could begin to construct a database aimed at better returns attribution.

Further, portfolio companies themselves are expected to reveal the identity, senior management and board composition of their private equity owners in annual accounts, while their business reviews should conform to parts of the Companies Act 2006 that previously applied only to public companies. The guidelines also call for “timely and effective communication with [portfolio companies’] employees”.

The process was clearly aimed at improving disclosure, not only to the broader market, but to society as a whole. For George Anson, managing director with private equity fund of funds HarbourVest Partners, this is all the more important for Continental Europe, where only a relatively small proportion of the economy is represented by public markets.

“If a larger buyout firm buys the largest employer in a French province, which in turn happens to have a large catchment of a political party’s voters, you can see why politicians are interested in the firm’s intentions,” says Anson. “It is reasonable for buyout groups to think beyond returns and consider their message to the stakeholder community, otherwise they lay themselves open to the not-irrational assumption that secrecy is bad and they must have something to hide. However, when it comes to taking those responsibilities to broader stakeholders seriously, compared with the public equity and bond markets – forget about the hedge fund market – private equity can go to the head of the class.”

This is all relevant to LPs which abide by environmental, social and governance (ESG) principles, of course. But do they feel they get suitable transparency themselves? Apparently so, to judge by such comments from them as “investors can basically get as much information as they want”, “experience a high degree of proactive communication from our general partners” and “they are more transparent and open than a lot of public companies, quite frankly”.

Leverage Has Limits

This trust has yet to be seriously tested. And the effect of the credit crisis on all that leverage might just end up separating those who provide real service from those who provide lip service.

“There are certainly managers who have put too much debt into some deals that won’t be able to sustain it, and that could undermine confidence in the whole private equity model,” says Jane Welsh, senior investment consultant and head of private equity at Watson Wyatt.

The best managers have more in their toolbox than leverage, of course, and they will focus less on financial engineering for their returns and more on the traditional operational improvements to their portfolio companies. The less able might respond to the unavailability of credit by “going off-piste”, as Welsh puts it. When LPs start seeing activity that does not look like what they originally signed up for – minority stakes, deals in public companies, investments in private equity debt itself – they might worry, legitimately, that their GP has not demonstrated the appropriate skills or experience in those areas.  

But the real hit will come further down the line, as debt taken on at the height of the boom has to be refinanced with stricken banks which, if they do not turn private equity-owned firms away entirely, are certainly going to demand bigger slugs of equity.

“We’ve already seen signs of some firms which don’t have enough capital in their fund to increase the equity portion or whatever is required going back to their LPs for extra money,” says Welsh.

“The last six months have seen many more questions from our investors about the outlook for drawdowns,” says David Currie, private equity fund of funds CEO with Standard Life Investments. “It’s eased a little, but initially people were worried about having to crystallise losses from public equities to fund private equity commitments. It’s about having that ongoing dialogue and trying to avoid things coming as a surprise to people.”

It remains early days, but so far IPE has seen little evidence that these cash-calls have come as a surprise to LPs, let alone that they might have to default on their commitments. LP agreements provide some structural regulation of the possibility of unexpected cash-calls, but if any of those limits are going to be requested to be broken, “the earlier the discussion begins, the better”, as Andrew Lebus, managing partner with fund of funds Pantheon Ventures, puts it. Are expectations well-managed by GPs?

Allocating via funds of funds helps because they smooth cash flows via diversification. Circumstances do change, but most firms will provide a clear picture of expected cash flows over the coming three, six and 12-month periods. Some will even attempt to model further out. Underlying GPs will also brief their advisory boards (on which their fund of funds LPs will often have a seat) on which companies might have covenant issues and how well-positioned they are to deal with them.

“We have a diverse set of models at hand which enable us to model cash flows of the portfolios, even under extreme scenarios, which we run regularly for the majority of our clients,” says Katharina Lichtner, managing director and head of research with Capital Dynamics. “That gives both us and them very good transparency into what to expect in terms of funding requirements or distributions under different economic stress scenarios – we cover not only the median but also the twenty-fifth, seventy-fifth and ninety-fifth percentile case – over the next few years, which they can then use to discuss how to best manage the portfolio with the various constituencies. “With respect to the net cash flows we are at the extreme ranges of the model at the moment, but we are still within the ranges, which gives us and our clients comfort that the models are sufficiently robust and allows clients to better manage through the dislocations we have seen over recent months.”

LPs also have to take some responsibility.

“We’ve certainly discovered that there can be a price for illiquidity in terms of meeting capital-calls,” admitted CalPERS’ chief investment officer Joseph Dear at the recent Milken Institute Global Conference. “What do we do about that? Well, we are getting a whole lot more disciplined and detailed about our cash forecasts and what our requirements are.”

But if the credit crisis has shown us anything, it is that models are just models, and if anything, private equity investors should rely on them least of all. After all, you would not want your GP to invest in any old deal just to meet some modelled cash flow.

“You shouldn’t expect things to pan out as your pretty little model suggests,” says Welsh, “I’d say that just about everyone’s models would have been stressed over the last 12 months or so. Previously they were stressed because cash was coming back much more quickly than the models assumed, and now they have gone the other way and everything has really slowed down.”

As covenant breaches increase, new questions and issues of trust and transparency arise that differ from the initial proposal – “I trust you to go out with my money and pick the best investment prospects from scratch”. Any decision to revisit the capital structure of a portfolio company has to involve an honest assessment of risk and return. And then there is the decision about how to source extra equity. Because deal flow has slowed so drastically, many newly-raised funds are swimming in undeployable capital. The temptation may be to recycle that back into previous vintages where companies are refinancing – which may or may not be good for LPs.

Similarly, top-up funds could be raised – should participation be voluntary or mandatory – if voluntary, should participants get preferential returns, and should the proceeds be available for opportunities like cheap acquisitions? All these solutions throw up issues of dilution for existing LPs.

“We have seen one or two top-up funds in the US,” observes Currie. “They’re not very attractive. One in particular looks like a rights issue at deep discount. The limited partner has to look at the existing portfolio and decide what they think it’s worth and what this round of dilution will mean to them.”

All of these focus down on the vexed question of whom you can trust to provide valuations, particularly with US GPs who may use discounted cash-flow valuation models rather than marking-to-market, as is the norm in Europe. That question also becomes acute if you need to divest into the secondary market – especially in an environment like today’s where buyers and sellers are engaged in a standoff. Can you – should you – trust your GP’s valuations?

“Often the interest of a GP lies with those that are most likely to commit to their next fund,” says Lichtner. “That’s why more and more stapled transactions are seen. There are also instances where valuations of portfolios tend to creep up when a GP is preparing a fundraising in the near future. So a GP might not always be the best source of information. Of course this can never be prescriptive and it all depends on the quality of the relationship and the LP’s motives for selling. Where the GP might be conflicted, it’s best for the LP to tender the interest or possibly seek support from a sell-side adviser.”

Feeding a Fee Machine?

Fees are the major flashpoint between GPs and LPs. “We are feeding a fee machine,” lamented Ewen Marion Kauffman Foundation’s CIO, Harold Bradley, at the Milken conference. This is also an issue of trust, because the amount a LP will be charged is not necessarily clear up-front. There are the basics – a 2% management fee (usually on a sliding scale as cash is drawn and distributed) and the 20% carried interest (the share of profits taken by the GP, usually at the end of the fund’s life, but sometimes deal-by-deal for US funds). But GPs will also charge transaction fees for (usually unspecified) advisory services each time a deal goes through, often up to 1.5% of the deal size. In the US, the GP often gets to keep 50% of this fee, while crediting the rest against the management fee. In Europe, the standard seems to be for GPs to keep 20%. But LPs feel justified in asking for a 100% offset. If deals fall through, legal, accounting, consultancy, due diligence and travel expenses are still charged to the fund – and most LPs now expect those charges to be met by the GP’s 20% or 50% of the fees for other transactions before they share any more. GPs can also pick up directors’ fees, as well as monitoring fees, which are charged to the portfolio companies for ongoing oversight of the business.

“In Europe, by-and-large, the fees are fairly well-controlled,” says Currie. “In the US, however, some managers get up to pretty outrageous things and frankly, we wonder what their management fee is for.”

Capital Dynamics’ Lichtner agrees, “General partners get a sufficient management fee to cover due diligence and the running of the firm, and a carry if they do well,” she says. “But that should be it. Many credit all or a substantial part of any other fees received back against the management fees, in which case that’s fine but when it’s in addition to the management fees and it’s not transparent, it becomes a trust issue as it weakens alignment between LP and GP. Unfortunately, there continues to be little transparency in this area. At times when funds earn substantial amounts of carry these extra income streams pose less of a problem. However, when returns and carry tighten this increasingly becomes an issue.”

Standards for reporting additional fees vary. Some GPs offer none at all, very few offer resource-specific reporting and most report only to the fund’s advisory board – where funds of funds may have seats but not often asset owners.

Like many GP-LP trust issues, these things are usually resolved over time, as solid relationships are built. Indeed, that is one of the reasons why trust is so important in private equity – it is the foundation upon which flexibility is built.

“We view ourselves as building long-term relationships,” as Anson puts it, “so we have to believe in GPs’ business model and they have to be comfortable that we’re not trying to screw them into the ground. If they can convince you that they are best suited to manage your capital, you’ll find a set of terms that is fair. Let’s not negotiate terms up-front before you’ve even convinced me that there’s an exploitable investment opportunity.”

This inevitably becomes an issue of trust between LPs too. As Dear at CalPERS observed, individual institutional investors can be tempted to accept “crummy terms” from the best managers if their net returns are still likely to handsome.

“Can limited partners stick together in enough numbers to ensure that there is enough control of the capital coming in that general partners have to respond?” he asks.

It is complex because each investor and manager has their own idea of what is reasonable. It will prove difficult to get consensus between LPs with established relationships and the newcomers, and in the past a focus on headline fees has had unintended consequences. Currie points to the “perverse mindset” of some US institutional investors that have focused taking reduced management fees back to their boards, without acknowledging that GPs will claw that back through transaction and monitoring fees.

“If GPs start to rely on transaction and monitoring fees to run their business, that’s really poor alignment,” says Watson Wyatt’s Welsh. “If those fees dry up because there are no transactions, what happens to the business? The industry does need to sort these issues out.”

The industry, sure – but the industry’ growing client base also needs to take responsibility and engender trust. That could take several forms – from supporting private equity against harmful legislation, taking a robust approach to liquidity risk management, investing the appropriate resources in developing deeper relationships, or using appropriate intermediation where that is not feasible. In many ways private equity represents the best alignment of interest in financial services – now is a great opportunity to make it even better.

Pension Funds’ Views on Private Equity

In April, 46 European pension funds responded to IPE’s monthly Off the Record survey, coinciding with a Special Report on private equity. Here are the responses to some of the questions we asked.


Are you likely to default on a
cash drawdown this year?


Has the credit crunch affected your
private equity investment?


Is 2009 a good time to start
committing to private equity?


This article first appeared in “Rebuilding Investor Trust”, a special supplement of Investment & Pensions Europe (page 15, July/August 2009 issue).