Wednesday, September 23, 2009

Private Equity on the Cusp of Golden Age?

A senior private equity manager sent me an article from Andrew Ross Sorkin of the NYT, A Financier Peels Back the Curtain:

“We all had too much money. It was just too easy.”

That’s the unvarnished appraisal of the private equity business by Guy Hands, perhaps best known for his unfortunate $4.73 billion purchase of the record company EMI in March 2007, the peak of the buyout boom — a bet that will almost certainly lose his investors and his firm, Terra Firma, a fortune.

That ill-timed acquisition aside, Mr. Hands’s surprisingly candid assessment of the private equity industry is worth sharing. He was in the midst of the industry’s growth to dizzying heights during the debt-fueled boom, and he is now having to deal with the aftermath of its shopping spree. Like others, he is desperately trying to keep businesses afloat and pay off the equivalent of huge monthly mortgage payments to the banks that financed them.

Mr. Hands, a large man with unruly hair who is a name-brand financier in his hometown, London, was in New York last week to meet with investors and speak at a conference. A longtime investor who started his career at Goldman Sachs, he made his reputation investing for Nomura. His net worth is estimated at more than $400 million.

Over afternoon tea at the Jumeirah Essex House hotel by Central Park, Mr. Hands, who now lives on the island of Guernsey to escape British taxes, offered the most frank assessment of the private equity world — including his mistakes — I had ever heard from anyone still gainfully employed in the business.

He had prepared remarks for a conference that morning, but didn’t get to air many of them. Some of his most provocative thoughts were in his notes, which he shared with me. Most strikingly, he grabbed the third rail of the private equity world: the fee structure that gave the firms 2 percent of assets under management, plus 20 percent of profits.

The problem, he said, was that the funds had grown so big that the 2 percent became just as important as the 20 percent.

“Clearly a large number of P.E. firms were totally overpaid at the peak of the market,” he said. “The fees were an entirely unwarranted windfall, as the managers did not use the excess fees to invest in resources to grow the skill base of their funds.”

He estimated that the private equity firms’ “net earnings will decline a minimum of 80 percent from the peak in 2007.”

Success had less to do with performance or risk management, he said, and more to do with bulking up. “It is time for investors to see through the elaborate marketing machines created by the industry,” he said.

Between sips of his mint tea, he said that during the boom, investors had thrown so much money at so many private equity firms — some of which formed consortiums to buy businesses from one another — that they were “really investing in the same thing so their capital was competing against itself, driving up prices.”

He also argued that private equity firms formed consortiums not to spread risk, but because, ultimately, it was easier than going “through the pain of gaining internal consensus to do something contrarian.” The big firms would counter that consortiums allowed them to buy bigger companies and to spread the risk.

With banks still holding back on loans, some on Wall Street have suggested that the private equity industry is dead. Others argue that the biggest firms — the Blackstone Group, Fortress Investments, Kohlberg Kravis Roberts & Company, which is planning to go public — will survive, albeit in a different form. Last year, Stephen A. Schwarzman, the co-founder of Blackstone, said, “The people rooting for the collapse of private equity are going to be disappointed.”

Mr. Hands is not rooting for the industry’s demise, but he is predicting it will wither. The firms still have funds big enough to last them at least a decade, as they provide steady fees. “Right now, the big firms have a tower of fees,” he said. “But the tower starts to collapse over time.”

As the funds dry up, Mr. Hands expects the firms will struggle to raise enough new money to support the hundreds of employees they now employ. His prediction has a precedent — that’s what happened to venture capital after the late 1990s. The industry shrank sharply after it became clear that too much money was chasing too few deals.

But the pattern may play out in slower motion for private equity. “Neither the banks nor P.E. want to come clean about mistakes,” he wrote in his notes. “Hence companies will live as zombies unable to grow their businesses or make long-term commitments. Meanwhile banks will try to suck out as much money as they can in fees and postpone recognizing the full extent of the losses of their underwriting decisions.”

In the end, he said, “Many P.E. firms are hoping that daylight doesn’t shine on the corpses of their companies, so they are reluctant to restructure too quickly.”

Of course, it’s possible that some firms will make terrific bets now, in the depressed economy, and will come out even stronger when things improve.

Mr. Hands is quite open that he made an awful mistake with EMI, which desperately needs to be restructured or sold (most likely to Warner Music, eventually).

His timing was off, he says, but not by much. If, by chance, he had waited several weeks, the deal probably wouldn’t have happened. The securitization market was about to seize up, which would have pushed him into a higher interest rate, making it impossible to sell some of the business to co-investors.

“If the EMI auction started two weeks later, it wouldn’t have occurred,” he said. “We wouldn’t have bought it. We’d have 90 percent of our funds still to invest and we’d look like geniuses.”

The good news for Mr. Hands is that most analysts, and even his own investors, give him high marks for operating the business very well, squeezing out every last efficiency.

The bad news is that he has been unable to invest in the company’s future and any additional cash goes only to one place: Citigroup, which provided the financing for the deal.

The bank has become Mr. Hands’s de facto boss now that there is more debt on the books than equity. “Negotiations with one’s bankers, when the debt is so large in relation to the earnings, are always difficult,” he said.
I can't say that I am shocked with Mr. Hands's comments because I saw this coming back in 2005. A bunch of large private equity firms with slick marketing presentations gathering obscene amounts, collecting 2% management fee and 20% performance fee as they leveraged their way from one deal to the next. A big fat financial orgy that came to a grinding halt after the 2008 credit crisis.

The problem is that over the last several years, public pension funds were funding this nonsense and now that it's curtains for private markets and the end of the great pension con job, the chicken has come home to roost.

And the nonsense continues as public pension funds continue to plow billions into private equity, betting that the worst is behind us. Maybe the worst is behind us, but I wouldn't want to make any outsize bets in illiquid asset classes.

In the environment we're heading into, I prefer liquid asset classes over illiquid ones and I certainly would pick and choose my private equity and real estate funds more carefully instead of writing big cheques to every large buyout fund. I'd make sure that my private equity managers are not glorified financial engineers who came from an investment banking background, but guys and gals with solid hands on experience restructuring companies from the bottom-up.

Is the PE tower collapsing? It depends on who you listen to. Reuters reports that private equity may be on cusp of "golden age":
The near collapse of the global financial system, which wiped out trillions in corporate value and personal savings, may be giving way to a new "golden age" for private equity investment, Silver Lake Co-CEO Glenn Hutchins said in an interview on Tuesday.

Private equity firms suffered badly when debt markets seized up as a result of the crisis and banks did not want to lend increasingly scarce capital. Only just recently have credit markets started to unfreeze.

"The financial markets may be on the cusp of a new 'golden age' for private equity," Hutchins, who is also a co-founder of the firm, told Reuters on the sidelines of the International Economic Alliance Symposium.

Hutchins, the co-founder of the $13 billion private investment firm, cautioned that while there has been a significant stock market rally, the economy is showing stable, though not robust, growth.

"This recent stock market rally is a little troubling because it seems to me not to be supported by underlying economic fundamentals," Hutchins said.

"But that aside, we have gotten down to levels that are pretty attractive and the banks seem to be recovering enough to provide modest levels of financing, which is all we need. We feel pretty optimistic," he added.

The major concern, he said, is how long will investors have to be prepared to withstand low levels of economic activity.


But for the moment, Hutchins said, investors are once again finding risk premiums at attractive levels versus the low premiums before the asset bubble burst in December 2008.

"Now that the sort of panic of '08 is over and capital markets seem to be returning to some degree of normality ... companies will be able to access debt and equity markets like they have in the past. And that is no surprise," Hutchins said.

But he added that investors needed to be mindful that valuations in 2007 should not be defined as normal. They were an "overshoot in another way," he said.

The average investment grade corporate bond now yields 232 basis points over U.S. Treasuries, down from the all-time high of 656 basis points on December 5, 2008. By comparison, in May 2007, before the credit crisis started, spreads narrowed to 92 basis points, according to the Merrill Lynch indexes.

"Now risk premiums are at attractive levels. Investors are being paid to take risk again. That means when you look back on this, when you get back to economic recovery, this will have been a good time to invest," Hutchins said.

Silver Lake makes only a few acquisitions a year and is more inclined to use financing for working capital rather than purchases, Hutchins said.

"If you need financial engineering to enter a deal and multiple expansion to exit a deal, then your business is fundamentally challenged," Hutchins said.

The firm, along with other investors, agreed to a deal earlier this month to pay $1.9 billion to buy a 65 percent stake in online telephony unit Skype from Internet auction and services company eBay Inc (EBAY.O).

Ebay agreed to sell the stake in Skype for $1.9 billion to a consortium including Netscape founder Marc Andreessen's Andreessen Horowitz, venture firm Index Ventures, Silver Lake, and the Canada Pension Plan Investment Board.

Asked what he thought about the Skype sale and lawsuits filed by Skype's founders, Hutchins responded: "No comment."

I am not as worried about guys like Glenn Hutchins and David Bonderman of Texas Pacific Group who has $30 billion to invest:

One of the world's largest private equity funds TPG [TPG.UL] currently has about $30 billion in uninvested capital and is looking for opportunities, its founding partner said on Friday.

"We have about $60 billion of capital, half of it is uninvested and we are looking for opportunities," David Bonderman told Sochi Investment Forum.

Bonderman said the fund saw growth capacity in Russia's consumer sector and was "cautiously optimistic" about Russia.

Mr. Bonderman should go back to read his 2004 interview with The Harbus:

Harbus: Where do you see the private equity sector going in the next 5 to 10 years in terms of players in the industry and the overall potential for attaining the level of returns that private equity funds have achieved historically?

DB: I think the right way to look at private equity is as an illiquid equity investment which ought to be competing in the investors' minds with the public markets. As a result, the private equity firms should deliver returns significantly higher than what the public markets do.

You can argue about whether that return should be 500 basis points or 1,000 basis points higher, but somewhere in that range at least. And if they can't, they probably shouldn't be in business because, given the liquidity penalties and so forth, that's what private equity ought to deliver.

What you think of the private equity sector depends on what the markets are likely to be doing going forward. We've obviously had a roaring market in 2003, but if you believe that over the long-term public markets should be yielding 10%-11% in real terms, then the private equity firms should be yielding 16%-25%, or they shouldn't be in business. As the market comes to realize that, what is going to happen - and you've seen some of that already - is that the players who are successful and continue to be successful will not have a lot of trouble attracting capital.

The people who can't do that will fall by the wayside. You had one or two big firms already lose their way in that regard. At the end of the day, you will see a collection of larger firms, and you'll see some midsize firms and you'll see some niche firms. But over time, you probably will have less than the 85 or so firms at the moment who have $1 billion dollars in capital or more. Probably some of those guys will go away over time.


Harbus: What do you think makes a good private equity investor?

DB: Being a good private equity investor is more complicated than it seems. I would say that there are a few characteristics that are important. If you look at the skill set that you need to ultimately be a successful private equity investor, at least at the senior level, you have to be, in this business, a good investor. You have to be able to help companies perform and you have to have judgment around exiting investments. If you look at the skill sets there, they include some things you can teach and some that you can't.

One of them, of course, is being a person who has good judgment about businesses. A second is someone who's pretty analytical and understands how to deal with numbers. A third one is personality, because in the private equity business, there's no deal unless you can persuade somebody to sell you their company. And as you say, there are many competitive situations here. So if many of us are all out there competing, and people like you and they don't like me, they're probably going to be interested in selling their company to you, and not me. So, you have to have a mix of those talents.

In addition, a very important characteristic is having a nose for value. That's why some of the very best private equity people, in my experience, are people who start out as stock pickers - people who really understood value, how to take a company's financials apart and couple that with good judgment about businesses, macro trends, and where things are going.

It's a complicated skill set, and probably no one is perfect at all of them.

The more you start out with the right kind of personality, the right kind of smarts and the better the training you get, the more successful you're likely to be.

Harbus: Mr. Bonderman, you've obviously had a very successful career in private equity. What do you enjoy most about your job? What has been the most challenging aspect of your career path?

DB: Let me answer those in different ways. For me, one of the highlights of being in the private equity world is that you need to learn a lot and very quickly about different businesses. So it's always a continuing learning experience where you can apply what you know, of course, by way of judgment and by way of numerical analysis. You're always investing in new businesses, which is a learning experience in itself. I think that is a wonderful thing and I think it makes for intellectual challenge and for continued personal growth. That, for me, is the highlight of this job.

You have a challenge every day in figuring out what's happening in the markets, where your next deal is coming from and so forth. So there is always a continuing challenge - but this is a financial services business, it's not brain surgery. The challenges are all about getting it right, but in the scheme of things, there is plenty of latitude to get it wrong.

Given the uncertain economic landscape, there is plenty of latitude to get it wrong, but guys like David Bonderman didn't get to where they are by being stupid with their money. The management fees that TPG charges its investors can attract some pretty smart people to help them uncover value. They'll need all the brains and brawn they've got to face the challenges that lie ahead.

***UPDATE: Comment from an informed reader***

Please read this comment carefully:

PE has been a good idea for hundreds of years, but best executed by family offices with long term time horizons and fewer “agency” problems. The current mega LP led/investment banker enabled business model is dysfunctional, and I fear some limited partners will harden their approaches at the expense of the general partners (rather than seeing themselves as the root of the problem), with the usual unintended consequences of poorly thought through alignment of interests creating more dysfunction going forward.

I think the golden age references imply that current tough markets are transient, and opportunistic, distress style deals will work out well. In my view, most GP’s are poorly equipped for distress investing, and those who on the whole are strange, mean people who aren’t really cut out to be fiduciaries.

Given my personal extreme bearish view on broader economic fronts, I can’t see a golden age emerging. I see this as a tough business that will get tougher.

My solution, as always, is to contain PE activities within portfolios to a relatively minor scale.

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