Investors Lukewarm on Private Equity?
It seems a long time ago when private equity was the unacceptable face of capitalism in Britain. But on the eve of the banking crisis, in June 2007, prominent British representatives of the industry were hauled before parliament's Treasury select committee to explain themselves as political and public disquiet over the sector reached a peak.Syder is right, the excesses of the past are long gone and this is a good thing. The credit crisis led to a major shakeout in the industry. Many PE firms have closed shop and the ones that are surviving can no longer rely on financial engineering to produce outsized returns.
"You are effectively filling your boots with debt," said Brooks Newmark, a committee member. The then chair of the committee, John McFall, excoriated witnesses – including executives at Permira, 3i and Carlyle Group – for failing to clean up their public image. "Here is an industry which you tell us is so successful, but there is opprobrium out there. I think you have to do something about it."
A phenomenon of bigger and bigger deals, paid for with escalating debts that produced lightly taxed profits, had given rise to the perception of an unaccountable industry picking off UK companies, stripping them to the core and selling them on with scant regard for the social consequences. The lightning rod was a regime that allowed firms to pay as little as 10% tax on the "carried interest", or profits, that they made on their investments, when the lowest income tax bracket at the time was nearly double that at 22%.
The deal frenzy reached its peak in 2007 when US firm KKR and Axa Private Equity backed the £11.1bn buyout of Alliance Boots. It was the biggest private equity bid for a British business and the first for a FTSE 100 company.
Now there are signs of a tentative re-emergence. Cinven this week agreed to buy Lloyds Banking Group's German life insurance business in a £250m deal and has spent €4bn (£3.4bn) over the past 12 months.
But this is no return to the boom years. The number of private equity deals hit a record 367 in 2007 with a total value of £38bn, according to industry analyst Preqin. That figure would have been £10bn higher if a joint attempt by CVC Capital Partners, TPG and Blackstone to buy Sainsbury's had succeeded.
Then everything changed. As the credit crunch hit, the bank loans that fuelled the buyout boom dried up and many firms' prized acquisitions were burdened by debts they could not pay.
Britain's second biggest buyout – the £4.2bn acquisition of EMI by Guy Hands – met this fate when his Terra Firma defaulted on loans from Citigroup. The bank took control in 2010 and the group that gave the world the Beatles, Coldplay and much else in music was broken up. The number of private equity acquisition s slumped by 2009 to a total value of £5.4bn and firms were left with £78bn in "dry powder", or uninvested cash raised from investors. Some firms went to the wall while others limped on.
The Bank of England warned this year that a legacy from the pre-crunch years could still destabilise the UK economy, as it cautioned that debt-laden private equity deals could unravel with disastrous consequences.
Tim Hames, chief executive of the British Private Equity & Venture Capital Association (BVCA), said the buyout boom should be seen as a blip instead of something the industry wants to repeat. "There was an overwhelming sense that scores of FTSE 100 firms were going to go private but it turned out Boots was the only one. It was a period of crack-house capitalism compared with which almost anything is going to look more modest. But if you take 2006-07 off the graph what we have got is a much more natural continuum."
Private equity firms raise money from pension funds and other investors to buy companies, typically with heavily debt-funded bids, and sell them on after a few years at a profit. The industry says it provides expertise, international contacts and management discipline that can transform a company. A typical investment period of three to five years gives management the time to revolutionise a stuffy private business or a public company away from the sometimes debilitating glare of quarterly reporting.
Critics have accused the industry of loading up healthy companies with dangerous debt, charging investors excessive fees and exploiting tax benefits intended for genuine entrepreneurs.
Nicholas Ferguson, chairman of SVG Capital, said in 2007 that private equity bosses were paying "less tax than a cleaning lady" because they could be taxed at 10% of earnings.
As financial markets returned to health, activity picked up, with acquisition values hitting £17bn in 2010. However, about half these deals were so-called pass-the-parcel transactions as private equity firms sold their debt-laden acquisitions to stronger buyout firms.
There are still 475 UK-based firms looking for funds and deals. But buyers are harder to come by. TPG, one of the world's biggest private equity firms that operates in the UK, recently asked its investors for more time to use $3bn of capital it had not been able to spend. In return it has offered to waive tens of millions of dollars in management fees.
It is also harder to exit investments. Despite booming equity markets, investors are wary of share offerings from private-equity-owned companies returning to the market. And weakened banks are no longer providing loans at the knock-down rates that used to fuel acquisitions such as the Alliance Boots deal.
Tim Syder, deputy managing partner at Electra Partners, said: "Banks providing acquisition debt have drawn in their horns and what debt there is out there is more expensive – banks' margins have more than doubled. In this market, private equity firms have got to be cleverer. The days of simplistic financial engineering – buying a company, loading it up with debt and believing that it will grow in value – have long gone."
Now, he says, deals are about encouraging management teams to get out and find new markets as London-based Electra did with Allflex, a UK animal-tag producer that is now the biggest of its kind, including a significant business in China. After 15 years of ownership, Electra sold Allflex in July for $1.35bn (£830m) but kept a 15% stake.
Investors are also taking a hard line on buyout firms' fundraisings after accepting their claims too readily before the crisis.
Sandra Robertson, who runs Oxford University's £1.5bn investment fund, stunned private equity luminaries at a conference late last year with her attack on sharp practices, impenetrable paperwork and unjustified fees. She said: "Why on earth as a rational investor would I allocate blindly to private equity…? There is no longer an alignment of interests. Entrepreneurs have been replaced by brands and partnerships by organisations."
Bain & Co, the management consultants, has identified three surges in private equity activity: the break-up of unwieldy conglomerates and the rise of junk bonds in the 1980s, economic growth and surging stock markets in the 1990s, and the credit bubble of the 2000s. Economic conditions are improving but there is no sign of a trigger to start a new frenzy. It is steady as she goes.
Syder said: "Compared with past excesses, private equity is going to remain at these reduced levels – and many would argue that is a good thing."
Still, there are concerns going forward. While soaring stock markets have been a boon to funds, the pressure is on private equity to find deals in an increasingly unfavorable investment environment where the world is awash with liquidity and asset prices are being bid up.
And investors are taking notice. Some of the largest pension and sovereign wealth funds in the world are dodging Wall Street, taking control of their assets. Others are lowering their return expectations. Becky Pritchard of Dow Jones Financial News reports that investors into private equity and hedge funds may be gradually lowering their return expectations, but there is still a significant rump who aren’t happy with performance:
A quarter of investors into hedge funds said their investments have fallen short of their expectations over the past year, according to a survey by data provider Preqin.I highly recommend you read Preqin's entire survey on alternatives for H2 2013 (PDF file available here). It contains a wealth of information on investors' attitudes and approaches in all alternative asset classes.
The survey, which is based on interviews with 450 investors in alternative funds, also found that only 14% of private equity investors were not happy with their investments.
However, investors are happier than last year. In the period from June 2011 to June 2012, 41% of hedge fund investors and 21% of private equity investors were dissatisfied with the performance of their investments.
But the survey also revealed that private equity investors have lowered their expectations about the level of returns they will get from their portfolios. Just 49% of respondents said that they expected their private equity portfolios to make returns of 4% above the public markets, this compares to 64% of respondents that expected to make those returns in the previous 12-month period and 70% in the year before that.
This year, a third of investors expected private equity portfolios to deliver returns of 2% to 4% above the public market, while 17% expected private equity to deliver less than 2% above the public market.
For hedge fund investors, CTA and macro funds were the most disappointing over the last year, with 31% and 27% of investors, respectively, saying that these strategies had underperformed. Event driven funds were the best performers over the past 12 months, with 23% of investors stating that they felt these funds had exceeded expectations.
As far as private equity, the survey is mostly positive. While most investors are lowering their return expectations, it is clear that private equity investment is still attractive to LPs, with 92% of investors interviewed intending to maintain or increase their allocation. Furthermore, investors are actively looking to access the asset class through a diverse range of methods. In particular, Preqin’s interviews with investors reveal a growing interest in private debt. "The emergence of this space adds to an exciting layer to a dynamic private equity landscape, along with all others, for investors to contemplate."
Again, read the entire Preqin survey on alternatives for H2 2013. It's clear that investors are increasing their allocations to alternatives but they're also beefing up their due diligence, changing their approach and focusing on alignment of interests. For example, among the key issues in LP and GP relations, the survey states:
Management fees have consistently been at the forefront of investors’ minds as an area within fund terms and conditions which needs improvement; a significant 59% of investors interviewed highlighted management fees as an area of contention at present. Over a third (35%) of LPs cited the amount of capital committed by a GP as an area within fund terms and conditions that needs improvement, while carry structure and rebate of deal-related fees were named by 27% and 16% of investors respectively.The institutionalization of alternative asset classes means there will be increasing pressure on GPs to better align their interests with those of LPs. You already see this with hedge funds, most of which are coming up short, but you will see it in other alternative asset classes too.
In sum, while the landscape in private equity has changed and the excesses of the past are long gone, there is still plenty of interest in the asset class but investors are tempering their return expectations, changing their approach and focusing on alignment of interests.
Below, Blackstone, the world’s biggest private equity firm, is in talks to buy a stake in Goldman Sachs’ European insurance business. And KKR & Co., the private equity firm led by Henry Kravis and George Roberts, created a unit to lend to the maritime industry, including assets such as drilling rigs and shipping vessels. Devin Banerjee reports on Bloomberg Television's "Money Moves."