Split in Private Equity Funding?

Gregory Zuckerman of the WSJ reports, Split in Private Equity Funding:

The private-equity industry is dividing between haves and have-nots.

As investors become pickier and more closely scrutinize recent performance, some big names are finding it hard to raise as much money as they would like.

But other buyout specialists are seeing a surprising surge of interest, helping them raise big, new buyout funds.

"There's polarization" in the private-equity business, said André Bourbonnais, who oversees the Canada Pension Plan Investment Board's private-equity investments. "It's a tough environment for fundraising for many funds," but those with stellar recent returns are tapping a gusher of cash, he said.

Among those dealing with some investor indifference: Wilbur Ross Jr., the billionaire specialist in distressed assets. Mr. Ross's WL Ross & Co. recently closed a $2.2 billion fund, well below its original $4 billion target, despite two years of marketing. "The environment has been difficult," said Mr. Ross. "Strangely enough, smaller funds will likely produce higher returns by being invested more rapidly."

Providence Equity Partners LLC, a high-profile buyout group focused on media companies, is raising a new fund that is expected to be much smaller than its last after recent mediocre performance. Providence declined to comment.

Some firms are even throwing in the towel on fundraising. Charterhouse Group Inc., a 39-year-old New York firm, for example, has stopped fundraising for its latest fund, after two years of marketing. "As the market has evolved, we are returning to investing on behalf of" a small group of investors, rather than raising money from institutions, said Thomas Dircks, Charterhouse's managing partner. Charterhouse's decision was reported earlier in industry publication PEHub.com

Despite the challenges, Ares Management LLC, a Los Angeles-based firm managing $54 billion, last week closed a $4.7 billion new fund, Ares Corporate Opportunities Fund IV LP. Ares raised $3.5 billion for its last fund. Ares is run by run by Tony Ressler, one of the last bidders for the Los Angeles Dodgers last year, though he lost out to a group including former basketball star Magic Johnson. He also is the husband of actress Jami Gertz and brother-in-law of Apollo Global Management LLC founder Leon Black.

Another big Los Angeles firm, Leonard Green & Partners, LP, a consumer-products specialist with stakes in Whole Foods Market Inc., J. Crew Group and Petco Animal Supplies Inc., recently closed a $6.25 billion fund, topping its last $5 billion fund, investors said.

Two months ago, American Securities LLC, raised $3.6 billion for a new U.S. buyout and investment fund, up from a $2.3 billion fund in 2008 and above a $3 billion target.Some are hitting fund targets in record time. Earlier this year, Centerbridge Partners LP, one of the fastest-growing firms in private equity, raised $2 billion in 10 weeks for a new distressed-debt fund.

A disparity in recent returns is part of the reason why some funds are fighting off investors while others search high and low for them.

Ares, which specializes in buyouts and debt investments, has scored annualized returns of about 26% from a fund launched in 2008 and 13% for funds launched in 2003 and 2006, after fees, according to its investors. Ares has seen big profits from GNC Holdings Inc., GNC +1.66% the parent of retailer General Nutrition Centers, which managed to increase revenue and profit throughout the economic downturn.

By contrast, Providence has seen annualized gains of about 4% and 6% for funds launched in 2005 and 2007, after fees, investors said. That is well below returns of as much as 78% in the 1990s. Providence has seen losses from investments in broadcaster Univision Communications Inc. and Spanish cable-TV operator ONO, though it has winners in online video service Hulu and New Asurion Corp., a provider of wireless subscriber services and extended service contracts.

Providence has raised about $4.5 billion for its latest big fund, well below the $12 billion size of a fund raised in 2007 though more than its $4.2 billion from 2005, according to people close to the matter.

"You have to be blemish-free" and have exited investments over the last two years "to be successful in this market," said Tim Kelly, who invests in private equity for Adams Street Partners. That's true for "even for the strongest brand names."

Pension plans, sovereign-wealth funds and other investors remain keen on private equity, which survived the economic downturn better than most investment alternatives. Some firms are seeing expanding pools of cash from sovereign wealth funds and other sources, they said

But investors complain that too many private-equity firms continue to sit on investments made years ago. And some private-equity firms made big buyouts just before the downturn, and have turned in disappointing returns.

More investors are narrowing the private-equity funds they are willing to work with, causing a scramble by funds for cash. Some investors are proving slow to sign up for new funds because they know they don't have to rush to write checks to these firms, since there are so many looking for investors. Others are just not as enamored with large funds as they once were.

That is partly why KKR& Co. and Apollo are expected to see new, key funds that are substantially smaller than their last, investors say. Their funds likely will be larger than most in their history, despite the new challenges. Firms like KKR and Apollo may be raising smaller private-equity funds, but they are seeing more interest in other kinds of funds they manage, such a credit funds.

KKR and Apollo declined to comment.

"One of the challenges with the big firms is that investors have the luxury of time to make a decision since there's no chance of getting shut out," says John Morris, a managing director at Harbourvest Partners LLC, which invests in LBO funds. He says firms are taking longer to close big funds, encouraging investors to take their time writing a check, as they asses a firm's performance and weigh rival funds. "We all know that big funds are not the flavor of the day they once were," he says.

"Many groups are test marketing to existing investors," Mr. Morris says. "If they are getting negative feedback, then they are simply delaying officially coming to market" to avoid striking out with new funds, something that could force the firms to shutter.

Mr. Morris says a number of firms are foregoing new funds after getting negative reaction from investors.

I remember a time when Providence didn't have to bat an eyelash to raise multi-billions for a new buyout fund. Those days are over. PE giants are adapting to the new normal but it's a very tough environment to raise funds.

The split in private equity funding shouldn't surprise anyone. In fact, it's a trend that began after the 2008 financial crisis and will continue as large investors retrench, focusing on fewer and fewer funds. The same thing is happening in hedge funds where the top 25 funds account for the bulk of the assets under management.

The main difference between hedge funds and private equity is liquidity. In private equity, in order to receive carried interest, the manager must first return all capital contributed by the investors, and, in certain cases, the fund must also return a previously agreed-upon rate of return (the "hurdle rate" or "preferred return") to investors. The customary hurdle rate in private equity is 7-8% per annum.

Private equity funds only distribute carried interest to the manager upon successfully exiting an investment, which may take years. Hedge funds typically invest in liquid investments, enabling them to pay carried interest ( "performance fee") annually, if the fund has generated a profit for its investors.

What hedge funds and private equity funds have in common is that they typically charge 2% management and 20% performance fee on their assets. The 2% management fee is usually paid in quarterly installments regardless of whether the fund has made any investments (PE funds) or whether the fund is underperforming (hedge funds). When you have billions in a fund, this adds up to a significant chunk of change.

This is why large, sophisticated investors will often co-invest along private equity funds to lower fees by half (1 and 10) and enter separate managed accounts with hedge funds to do the same. The larger you are, the more influence you have over fees.

Unfortunately, most US state pension funds are paying high fees and getting low profits as they run out of alternatives, piling into these investments. Indeed, investing in hedge funds and to a lesser extent private equity, increasingly looks like a loser's game.

Finally, there are succession issues in all these alternative investment funds. Reuters reports that Blackstone is grooming six executives for Schwarzman’s job:

When Blackstone Group LP (BX.N) named a new global head of private equity last month, Chief Executive Stephen Schwarzman was looking for more than just a business unit chief.

Even though the buyout king has no plans to retire, the appointment of Joe Baratta, a 41-year-old dealmaker credited with building up the firm's European buyouts practice, was the latest step in a wider succession plan, Blackstone insiders said.

Baratta joins five other senior Blackstone executives from whose ranks the successor to Schwarzman, 65, will eventually emerge, the sources said. The others are Jonathan Gray, 42, real estate chief; Bennett Goodman, 54, co-founder of the credit business; Tom Hill, 63, who runs the hedge fund team; Laurence Tosi, 44, the chief financial officer; and Joan Solotar, 47, who spearheads investor relations, the sources said.

Blackstone declined to comment on succession planning and on behalf of the executives.

Blackstone's arrangements, as revealed by these sources, bring into sharper focus how and whom it will choose to lead the world's largest alternative asset management house.

They also highlight the succession issue confronting other private equity firms launched in the leveraged buyout revolution of the 1980s and 1990s, whose larger-than-life leaders are now close to or past retirement age.

Those include Henry Kravis, 68, and George Roberts, 68 at KKR & Co LP (KKR.N); and David Rubenstein, 63, William Conway, 63, and Daniel D' Aniello, 65, at Carlyle Group LP (CG.O).

To be sure, the selection of a CEO is not as important as in the firm's early years, given the growth in headcount and resources at Blackstone, which now employs close to 1,600 professionals.

With equity and bond markets uncertain and many of the world's major pension funds underfunded, investors are more concerned about solid returns than an affable personality in the firm's leader.

"We pay out about $64 million every month to over 35,000 retirees," said George Hopkins, an executive director of the Arkansas Teachers Retirement System, a Blackstone investor, when asked about the succession.

"We are not interested in people who are good conversationalists and good company; we are out for people who make us money," he added.

Exactly, "show us the money" and leave your colorful personalities and ultra egos checked at the door. This reminds me, time for many of you to show me the money by contributing to my blog at the top right-hand side (tip or better yet, subscribe!).

Below, as private-equity investors become pickier and more closely scrutinize recent performance, some big names are finding it hard to raise as much money as they would like. Greg Zuckerman has details on Markets Hub.