Thursday, September 29, 2016

Private Equity's Misalignment of Interests?

Sebastien Canderle, author of The Debt Trap: How leverage impacts private-equity performance, sent me a guest comment (added emphasis is mine):
It usually takes a financial crisis of the magnitude witnessed in 2008 for glitches within an economic system to come to light.

It has been widely known and reported that private equity dealmakers could at times be ruthless when dealing with their portfolio companies’ management, employees and lenders. But at least these PE fund managers (general partners or GPs) were treating one party with all the respect it deserved. Their institutional investors (the limited partners or LPs) could feel appeased in the belief that the managers’ interests were aligned with their own. According to a report recently issued by research firm Preqin and entitled Investor Outlook: Alternative Assets, H2 2016, 63% of PE investors agree or strongly agree that LP and GP interests are properly aligned.

One of the most prevalent urban legends perpetuated by GPs and their PR machine is that their actions are vindicated by their sole concern to serve their investors’ interests. After all, given the 2% of annual management commissions limited partners pay to cover the GP executives’ salaries and bonuses, this argument of perfect alignment seems to make sense. But it is emphatically not the case.

Let’s review some of the many tricks that financial sponsors use to serve their own interests rather than (often to the detriment of) their LPs’. Note that the following is not meant to be an exhaustive list; just a few pointers that some LPs have come across in the past.

First, just to remind the reader, quick exits and dividend recapitalizations have one key advantage: they boost the internal rate of return (IRR), the key performance yardstick in private equity. You might think that it is a good thing for LPs, since it delivers strong performance. But actually, it is not always ideal. Upon receiving their money back, LPs then need to find a new home for the capital that has been returned to them earlier than expected.

Let me expound. What institutional investors like pension funds and university endowment departments aim to do when they commit capital to the PE sector is to yield a higher return on their money than if it was allocated to lower-risk securities. But another crucial decision criteria is to put money to work for several years (typically 6 to 10 years).

When I state ‘higher return’, there are two ways to look at it: either through the IRR or via a money multiple. The difference is that an IRR is expressed as a percentage whereas cash-on-cash return is shown as a multiple of the original investment. And the difference matters enormously.

If a GP exits after two years (via a quick flip), a 1.5-times return yields a 22.5% IRR. It is massively above the hurdle rate (usually 8%, although many larger GPs do not bother with offering any preferred return to their LPs, or they offer a lower rate). So this 22.5% yield would enable the GP to look forward to carried-interest distribution (assuming of course that the rest of the portfolio does not contain too many underperforming assets and that there is no clawback clause in the LP agreement).

But a similar 1.5-times return after six years only yields an internal rate of return of 7%, which is below the standard hurdle rate, so it will not give right to carry for the GP since it did not give LPs an adequate return for the risk they were exposed to. A six-year holding period represents a higher-risk investment for a GP. Yet, an LP would receive 1.5 times its original capital and would still be satisfied, especially if that capital had delivered lower returns in a low-coupon bond environment like the one witnessed since 2009.

Because GPs know that the time value of money affects the likelihood of their investment performance falling below the hurdle rate, they have every incentive to partially or fully realise (that is, exit) their investment as quickly as possible. Quick flips are therefore preferable to GPs, even if the LP wished to see its capital remain deployed in order to accrue further value. GPs do not care if LPs then struggle to find a new home for the capital returned too early. All a GP cares about is whether its strategy will deliver carried interest, which is why quick flips and dividend recaps are so prevalent. The time value of money explains why GPs do not always serve their LPs’ interests.

Conversely, at times GPs prefer to hold on to investee companies longer than warranted, even when they receive approaches from interested bidders. In some instances fund managers can make more money from the annual fees they charge their LPs than by selling an asset. Imagine that a portfolio company is given a value by third parties that would grant an IRR of less than 8%. It might be totally acceptable to the LP, but because it falls below the hurdle rate, it will not enable the financial sponsor to receive carry. However, if the latter retains the company in portfolio, it will continue to charge annual management fees (of 1% to 2%) on the LPs’ capital invested in that company. You understand now why some LBOs turn into long-term corporate zombies or end up spending a while in bankruptcy. As long as their financial sponsors retain ownership of the companies, they keep charging management commissions to their LPs, but as soon as control is transferred to the creditors, fees stop coming in because the investment is deemed ‘realised’.

This strategy, as old as the industry itself, was adopted by very many GPs in the years following the Credit Crunch; especially GPs who failed to raise a follow-on fund. These PE managers (themselves becoming zombie funds) simply decided to milk the assets the only way advantageous to them, even if it meant extending the life of the fund beyond the typical 10-year period. For the LPs, realising the portfolio would have been clearly preferable in order to reallocate the recovered capital to higher-yielding opportunities. But they had few means to force their fund managers to comply (since they had already refused in most cases to up their commitment in a subsequent vintage). For the GPs, charging these fees enabled the senior managers to make millions in annual bonuses for several more years without having to sell the assets.

There is more. Consider the following practice, which most GPs are guilty of. When a fund is relatively recent (say, less than five years old since its original closing), it contains a fair share of unrealised assets in its portfolio. By this I mean that a lot of acquired companies are still held in portfolio. The implication is that, when valuing the unrealised portion of the portfolio at the end of each quarter, the GP managers need to use estimates. There is a guideline issued by national trade associations to define these estimates, but there is quite a bit of wiggle room here. What prevents a GP from taking out ‘outliers’ that do not show a pretty enough comparable multiple? Many GPs tend to be quite carefree (who wouldn’t be when doing his/her own self-assessment?) by mostly using comparable multiples that grant a high valuation (and therefore a high unrealised IRR) to the portfolio.

Why do GPs bother acting that way? For several reasons, but here is the key one: imagine that the GP wants to raise a subsequent vintage to its current fund. Its existing LPs will certainly be more interested in taking part in the new vehicle if they see a high IRR (even if unrealised) as a likely outcome of the current fund. You might argue that LPs are not that gullible and will not commit further capital unless a significant portion of the portfolio has been exited and has shown good results. Yet in 2008 several funds were raised even though the 2005/06 vintages had not been fully utilised, let alone materially realised. We know what happened to these 2005/06 funds. Their performance was far from stellar.

Recent years have seen a vast number of GPs raise new vintages even though their previous funds had seen no or very few portfolio realisations. North American energy specialist investor Riverstone launched a fresh fundraise in 2014 only one year after closing its previous vehicle (Riverstone Global Energy and Power Fund V) and before having exited any investment from that vintage. Admittedly, the fundraising process lasted more than two years. This month, tech specialist Thoma Bravo closed its latest fundraise at $7.6 billion, exceeding its $7.2 billion hard cap even though it was set at practically twice the size of the $3.65 billion fund raised in 2014. British outfit Cinven raised its sixth vintage in the first half of 2016 - after just four months on the road - when it had only divested one company (out of 15 portfolio companies) from its fifth fund of 2013. Cinven VI was reportedly twice oversubscribed. French mid-market firm Astorg had exited none of the seven companies acquired out of its fund V (raised in 2011) before reaching the hard cap of its fund VI in June 2016. Similarly, Australian shop Quadrant raised its fifth fund in August 2016 (on its first close) only two years after raising the previous vehicle. Quadrant PE No4 had exited none of its five investments. All these GPs had to use interim IRRs in order to raise fresh vintages despite the lack of meaningful exit activity from their previous vehicles. Time will tell whether the reported unrealised IRRs were realistic, but LPs do not seem too bothered by the very high-risk profile of immature vintages.

There is another reason why, traditionally, GPs artificially inflated their unrealised IRRs. In the early days of the sector’s history, PE managers used to be able to raise funds without granting LPs any right to the aforementioned clawback. Clawbacks are ways for institutional investors to recoup previously distributed carry if the GP manager’s performance at the end of the life of the fund falls below the hurdle rate. Nowadays, the vast majority of PE funds’ agreements include a clawback clause, but years ago it wasn’t always so, which explains why GPs tended to ‘tweak’ IRR calculations to their advantage and distribute themselves carried interest on the basis of high unrealised returns. Why not do it if you can get away with it.

Anyone telling you that GPs only care about maximising returns is just a scandalmonger. In truth, GPs care even more about charging fees, primarily because two-thirds of GPs never even perform well enough to receive any carried interest. Thus, I cannot possibly draw a list of LP/GP interest misalignment without raising the issue that has made front-page news (at least in the specialised press) in the years following the financial crisis.

The debate that has been taking place around management and monitoring fees and the double-charging by GP managers is not new, but it looks like even the foremost LPs committing billions of dollars to the sector failed to keep track of how much they were being charged annually by their GPs. Perhaps this is why, according to the aforementioned Preqin report, two-thirds of investors consider that management fees remain the key area for improvement and more than half of respondents are asking for more transparency and for changes in the way performance fees are charged.

In 2015, high flyers KKR and Blackstone were fined by the Securities and Exchange Commission $30 million and $39 million respectively for, allegedly, failing to act in the interest of their LPs in relation to deal expenses and fee allocation. Similarly, following another S.E.C. investigation, in August of this year their peer Apollo was slapped with a $53 million fine for misleading investors on fees. The issue of fee transparency and conflicts of interest is unlikely to be restricted to the mega segment of the industry. So there might be more bad news to come if the regulators choose to pursue the matter further.

Again the foregoing list is not meant to be exhaustive, but it serves to demonstrate that the alignment of interests between private equity GPs and LPs is kind of a myth. It took a financial crisis to remind everyone of this evidence, though based on Preqin’s research, not all investors seem aware of it.
You will recall Sebastien Canderle has already written another guest comment on my blog, A Bad Omen For Private Equity?, which I published in November last year.

Sebastien was kind enough to forward me this comment after he read my last comment on why these are treacherous times for private equity. I sincerely thank him as he is a PE insider who worked for four different GPs during a 12-year stretch, including Candover and Carlyle in London.

In other words, he knows what he's talking about and doesn't mince his words. He raises several important issues in the comment above and while some cynics will dismiss him as wanting to sell his book, I would buy his book, read it carefully and take everything he writes above very seriously.

We talk a lot about risk management in public markets but what about risk management in private markets where too many LPs don't devote enough resources to really take a deep dive and understand what exactly their private equity and real estate partners are doing, what risks they're taking, and whether they really have the best interests of their investors at heart.

I used to invest in hedge funds at the Caisse and saw my fair share of operational screw-ups which could have cost us dearly. When I moved over to PSP, I worked on the business plan to introduce private equity as an asset class and met GPs and funds of private equity funds. I used my due diligence knowledge in hedge funds to create a due diligence questionnaire for private equity GPs. It's obviously not the same thing but there are a lot of issues which they have in common and I really enjoyed meeting private equity GPs.

Unlike hedge fund managers -- and I've met some of the very best of them -- top private equity GPs are all very polished, and when they're good, they can close a deal with any LP. I remember a presentation given by fund managers at Apax Partners at our offices at PSP in Montreal. When they were done, Derek Murphy, the former head of private equity at PSP looked at me and said: "Man, they're good, they covered all the angles. You can tell they've done this plenty of times before."

Interestingly, Derek Murphy is now the principal at Aquaforte Private Equity, a Montreal company he set up to help Limited Partners (LPs) establish "aligned, high-performing, private equity partnerships" with General Partners (GPs). You can read all about what they do here.

I don't mind plugging Derek's new firm. Someone told me he's "too scared" to read my blog which made me chuckle but if you're an LP looking to improve your alignment of interests with private equity GPs, you should definitely contact him here (rumor has it his boxes were packed the minute PSP announced André Bourbonnais was named the new CEO and he quit shortly after knowing their styles would clash).

Anyways, I really hope you enjoyed reading this comment even if it shines a critical light on deceptive practices private equity GPs routinely engage in. Trust me, there are plenty more but Sebastien's comment above gives many of you who don't have a clue about private equity how private equity's alignment of interests with LPs are often totally screwed up.

Those of you who want to learn more on private equity can read Sebastien's books here as well as the links on my blog on the right-hand side. I also recommend you read Guy Fraser-Sampson's book, Private Equity as an Asset Class (first edition is available for free here), as well as other books like Private Equity: History, Governance, and Operations, Inside Private Equity, and one of my favorites, Thomas Meyer's Beyond the J Curve: Managing a Portfolio of Venture Capital and Private Equity Funds. Lastly, Jason Scharfman has written a decent book, Private Equity Operational Due Diligence: Tools to Evaluate Liquidity, Valuation, and Documentation.

The problem these days is too many so-called experts are too busy to read and learn anything new. They think they know a lot but they've only scratched the surface. My philosophy is to never stop reading, learning and sharing. And if you have expert insiders like Sebastien Canderle offering you something worth publishing, you take it and run with it.

Hope you enjoyed reading this comment, please remember to kindly show your financial support for the work that goes into this blog by subscribing or donating via PayPal on the right-hand side under my picture.

Below, Bronwyn Bailey, Vice President at Private Equity Growth Capital Council (now called American Investment Council), outlines why transparency is important for LPs and GPs. This clip was filmed at SuperReturn International 2016.

You can also watch a Privcap discussion on Why Fee Transparency is the New Reality to gain more industry insights on this important topic.

Like I said in my last comment on why these are treacherous times for private equity, even though regulators and investors are putting pressure on the industry, I take all this talk on increased transparency with a shaker, not a grain of salt.

If you want to know what is really going on in private equity, you need to read insights from insiders like Sebastien Canderle who expose some deeply held myths on alignments of interests in the industry.

Update: On fee transparency, Sebastien did send me this follow-up comment: "Getting fee transparency should in principle be straightforward. They simply need to be audited and the audit reports should be handed over to the LPs, with the auditors clearly stating any discrepancy. Not sure why this is not happening. Maybe the GPs can't afford the audit fees...".

I don't know either but it is very disconcerting to say the least that billions are being pumped into private equity funds that are not properly disclosing all the fees they levy on to their investors.

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