Thursday, August 30, 2012

Changing Of The Old Private Equity Guard?

Greg Roth of Reuters reports, Wisconsin jettisons stakes in Blackstone, Carlyle, KKR:

The $83 billion State of Wisconsin Investment Board last month sold $1 billion worth of funds, at least three of them managed by publicly listed private equity firms, in part because those firms could no longer demonstrate that the pension fund's interests came first.

The pension fund joins a wave of limited partners that are selling interests in funds, including the New York City pension system and the California Public Employees' Retirement System. Many cite a desire to shrink their private equity portfolios to make them more manageable. Wisconsin may be the first to publicly cite a misalignment of interests with public firms as a reason to sell.

Wisconsin's private equity adviser, StepStone Group, advised the pension that "select mega buyout firms have embarked on initiatives that reduce the alignment of interests between GPs and LPs, including: asset aggregation and going public or selling stakes to third parties." Implied is that publicly traded buyout firms, in serving the interests of public shareholders, may not always act in the best interest of their limited partners.

If other pension funds were to follow Wisconsin's lead, it would almost certainly cause private equity firms that were considering IPOs, or selling stakes to third parties, to reevaluate those plans. Wisconsin's secondary sale included positions in 12 funds managed by six private equity firms, including The Blackstone Group (BX), Kohlberg Kravis Roberts & Co. (KKR) and The Carlyle Group (CG), according to Wisconsin spokeswoman Vicki Hearing.

Meantime, the $122 billion New York City pension system just completed a secondary sale of nearly $1 billion in private equity stakes in 11 funds managed by nine different firms.

"We clearly have too many relationships," said Barry Miller, the private equity chief for the New York City pension system. "We want to write larger checks to fewer managers," he said, adding that the ideal number of GP relationships was in the "50 to 70 range."

New York City's secondary sale helped reduce the number of relationships to 99 from 108, a drop of nearly 10 percent. It also helped to raise money that can now be allocated to New York City's current stable of managers.

The city's pension system has been trying to shrink its roster of GP relationships ever since Lawrence Schloss became the system's chief investment officer. Among the positions discarded in the sale were commitments of $215 million to two funds from Clayton, Dubilier & Rice; $227 million to two funds from Silver Lake Partners; $75 million to a fund from Thomas H. Lee Partners, and stakes in funds from AEA Investors, Ethos Private Equity, HM Equity Management, New Spring Ventures,Tailwind Capital and Vitruvian Partners.

The $240 billion California Public Employees' Retirement System also has been eager to shrink its stable of private equity relationships. But the motivation of Joe Dear, CalPERS' chief investment officer, isn't just to make things more manageable for the pension's staff. Having too many relationships and too many funds "drives the performance toward the median," said Dear in an August interview. "We want to have a more concentrated, selective portfolio that produces a higher return," he said.

CalPERS has further to go in culling relationships than most funds, mainly because of its giant size. Even after three recent secondary sales, the pension fund still has more than 350 GP relationships and more than $46 billion in private equity commitments, making it the largest and most diversified private equity program in the nation. Even so, said Dear, as he discussed the restructuring, "we're making good progress."

I haven't spoken to Réal Desrochers in a while but surely he's busy cleaning up CalPERS' private equity portfolio since being named its head last June. When running private equity at CalSTRS, prior to joining CalPERS and a brief stint in the Mideast with another large fund, Réal had a simple philosophy of writing larger cheques to fewer funds.

This is fast becoming the norm in the pension industry as investors realize that too many relationships with GPs are hard to manage and worse still, you end up getting some sort of PE index performance with huge performance dispersion between top decile managers and the rest.

What about Wisconsin Investment Board last month sold $1 billion worth of funds, at least three of them managed by publicly listed private equity firms, in part because those firms could no longer demonstrate that the pension fund's interests came first?

I saw this coming a mile away and will caution anyone else in the alternatives industry thinking of going public, if you don't maintain alignment of interests, you're toast!

Of course, don't shed a tear for the Carlyles, KKRs and Blackstones of this world, they're doing just fine, still raising billions in buyout funds, refocusing their attention on carve-outs.

Carlyle just announced its acquisition of DuPont's auto-paint unit for $4.9 billion, becoming the most active US private-equity buyer this year in part by employing a 25-year-old strategy that helped fuel its growth: taking over unwanted businesses from large companies.

But pension funds are starting to wake up with hedge funds and private equity funds, emphasizing alignment of interests. In private equity, there is a shift from the old guard. PEHUB reported that New York committed $600M to Ares, Trilantic and Palladium:

New York City’s five pension funds made $600 million in fresh commitments to three private equity funds, according to a spokesman for the New York City Comptroller’s Bureau of Asset Management, which manages their assets. As of June 30, 2012, the five pensions had combined assets of $122 billion.

The three new commitments are $300 million to Los Angeles-based Ares Management’s Ares Corporate Opportunities Fund IV LP, $200 million to New York-based Trilantic Capital Partners’s Trilantic Capital Partners V LP, and $100 million to New York-based Palladium Equity Partners’s Palladium Equity Partners IV LP.

Ares Management’s newest fund closed in August, having reached its $4.7 billion hard cap, which was substantially more than its original $4 billion target. The firm needed just six months to reach that mark, and the results from prior funds may explain why.

The previous fund in the series, the 2008 vintage Ares Corporate Opportunities III LP, had garnered a net IRR of 25.5 percent and a 1.7x return multiple, according to New York City pension data from Dec. 2011. Funds I (2003) and II (2006) also performed well, with both of them delivering net IRR’s above 13 percent and return multiples of 1.6x. Fund IV marks the fourth time New York City’s pension system has contributed to Ares.

And the New York City pension system is not alone in its interest in Ares. Other pensions to have committed to Fund IV are the Florida State Board of Administration, which committed $200 million; the New York State Common Retirement Fund, which committed $150 million; the State of Wisconsin Investment Board and the New York State Teachers’ Retirement System, each of which pledged $100 million; and the New Mexico State Investment Council and Indiana Public Retirement System, each of which contributed $75 million.

The New York City pension system’s $200 million pledge to Trilantic’s Fund V is also notable. Trilantic, which was spun out from Lehman Brothers in 2009, is looking to raise $2 billion for its new fund. The vehicle has already gathered $100 million from the Pennsylvania Public School Employees’ Retirement System.

This is the third time the New York City pension system has pledged to a Trilantic fund. The previous fund, the 2007 vintage Fund IV, raised $1.9 billion, and has so far generated a 13.9 percent net IRR and a 1.3x return multiple, according to New York City data from Dec. 2011. Fund III, which closed in 2004, was returning a 13.4 percent net IRR and a 1.5x return multiple, according to the data.

The third and final fund that the New York City pension system committed to was Palladium’s Fund IV. The city’s pension system contributed to Palladium’s prior fund, the 2004 vintage Fund III. That fund was returning a net IRR of 15 percent and a 1.5x return multiple as of Dec. 2011.

Fund IV is looking to raise $800 million, so New York City’s commitment will represent an unusually large 12.5 percent share of the fund’s overall holdings. One other pension known to commit to the latest fund from Palladium was the Los Angeles Fire and Police Pension System, which pledged $10 million to the fund this month.

The five municipal pension funds that are managed by the Bureau of Asset Management are the New York City Employees’ Retirement System, the New York City Teachers’ Retirement System, the New York City Police Pension Fund, the New York City Fire Department Pension Fund, and the New York City Board of Education Retirement System.

New York City’s municipal pension system has 6.8 percent, or $8.4 billion, invested in private equity. The system’s private equity target is 6.5 percent, and the system’s managers say they need to commit $2.5 billion to private equity each year just to maintain the program’s current size.

I can tell you Ares, Trilantic and Palladium are not the big brand names of the past but they're delivering strong, if not exceptional, performance and managing the size of their funds carefully, aligning their interests with their pension fund investors.

In Canada, earlier this month, the Public Sector Pension Investment Board (PSP Investments) announced that it's returning to the secondary market to shop about $1.5 billion in private-equity fund stakes:

The portfolio for sale is made up of concentrated positions in large buyout funds managed by private investment firms including Apollo Global Management LLC (APO) and Apax Partners LLP, according to the people, who asked not to be identified because the information isn’t public.

Cogent Partners, an advisory firm based in New York, is managing the sale. Mark Boutet, a spokesman for Montreal-based PSP Investments, declined to comment.

Again, these too are well known funds up for sale in the secondary market, which goes to show you even brand name funds get shunned by big investors when they don't perform up to snuff.

In the case of PSP, the secondary sale is also part of an effort to bring more assets internally to invest directly in private equity, lowering fees and having more control over investments (just like CPPIB, PSP typically co-invests with funds).

One private equity expert shared these thoughts with me:

It's not alignment of interest issues driving this, it's lack of performance, and/or as likely expected portfolio problems during the immense refinancing to come in 2013 to 2015. The great myth is that these name brands have delivered, in fact most of their performance is highly transient and cyclical, and based on the logarithmic growth in the industry performance remains mostly reliant on the valuation of unrealized portfolios of huge scale.

If investors focused on life IRR net of fees and F/X costs the picture would be more straightforward, not necessarily bad but just more obvious as to the risks and full cycle reality. Also, private equity programs need to be measured with the portion of life IRR identifying realized vs. unrealized returns. It's not hard to do this. Valuation is imprecise, and that's ok, just don't declare victory on unrealized performance.

Low transparency and annual or even shorter term score cards for long term investors has led to epic capital market distortions, the outcome simply favouring the short term trading model of investing, and current short term yield at the expense of capital preservation - which approaches may indeed have huge investing merit for the times, so its not really bad for investors, but it is bad for companies and economies which have long term needs that are not being consistently served, especially smaller companies.

It's also usually very costly to vend to the secondaries markets, institutions who are reversing decisions in illiquids are not long term investing, and probably washing out much of their historical net life IRR with these sales. Irresponsible or brave and wise decisions? Depends on the philosophy driving the decisions.

Private equity as an activity remains viable, but only at a regional or specialized boutique scale, or if at larger scale in highly flexible and/or low transaction volume mandates (which would not fit into typical allocator benchmark frameworks and/or diversification preferences). This is how the industry was born, and original track records of appeal were created.

The idea of writing large cheques to fewer firms is a step in the right direction but in effect contains/sustains the problem, and is not the solution. It's simply hard to do private equity well, at any scale and especially at large scale, and requires sustained resources and high efforts. Large cheques to large firms appear to be decisions of expedience and convenience, rarely the qualities behind good investing decisions.

Large private equity funds and firms are in effect awkward conglomerates without synergies among holdings, and no liquidity and huge frictional costs associated with buy and sell/IPO of holdings. Remember what happened to the 1960's conglomerates? Bad business model.

The good news is the industry will fade and right size (just as large scale venture investing died slowly over a long time) along with the timeline of the larger than life personalities behind it, hopefully some younger and/or less fashionable minded people will create new and flexible boutiques under the radar and allow for transformation to a more useful scale and style of investing.

The private equity renaissance will be quietly supported by high net worth people, and smaller institutions with open minded ways of solving for the timeless investment conundrum. And, some secondaries investors will do really well, if the underlying franchises can transform/survive, or at least liquidate with necessary patience.
Great insight. Below, Cristina Alesci discusses private equity groups that are involved with government contractors. She speaks with Pimm Fox on Bloomberg Television's "Taking Stock."As you can see, big government means big business for big PE funds. Oh, the irony!

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