Going Dutch on Private Equity?

Simon Clark of the Wall Street Journal reports, Dutch Pension Fund Demands Full Fee Disclosure From Private-Equity Firms:

A Dutch pension fund running €186.6 billion ($204 billion) is to cease investing in outside money managers, including private-equity firms, that don’t fully disclose their fees, a move that echoes concerns raised by a host of U.S. investors.

In a document seen by The Wall Street Journal, Dutch fund PGGM sets out for the first time what it deems to be acceptable compensation for money managers. It is worried that the pensions of its clients—social workers and nurses—are being undermined by high fees.

“The interests of our beneficiaries and the interests of the asset management industry are not always aligned,” Ruulke Bagijn, PGGM’s chief investment officer for private markets, said in an interview. “We are on the side of pension funds and we no longer want to turn a blind eye on difficult subjects like fees and compensation.”

Ms. Bagijn oversees investments including private equity, which accounts for a high proportion of the fees PGGM pays to managers, especially when compared with the amount invested in the asset class. Most of the money that PGGM manages is on behalf of the PFZW pension fund. More than half of PFZW’s €811 million fee bill in 2014 went to private equity. Yet private equity only accounts for 5.6% of PFZW’s €162 billion of assets.

PGGM’s determination to reduce fees coincides with a Securities and Exchange Commission investigation into the private equity industry which has focused on expenses. The SEC has been helpful in highlighting the issue, Ms. Bagijn said. In addition to annual management fees and keeping a share of profits, private-equity firms sometimes charge less-visible administration and transaction fees. In July, a group of U.S. state and city officials wrote to urge the SEC to require private-equity firms to make better disclosure of expenses.

PGGM will gradually introduce its new rules and will stop investing in funds that don’t disclose all fees by 2020, according to the document. It will also stop investing in funds whose fees are deemed to be “considerably higher than costs.” PGGM expects remuneration to be based mainly on the performance of managers’ funds, and it is monitoring how much of each manager’s own money is invested in their funds.

“Writing what we find acceptable and what we don’t find acceptable is new,” Ms. Bagijn said.

She wouldn’t disclose the share of fees from PFZW that PGGM keeps. The fees which PGGM retains for itself, rather than passing on to asset managers, are “a very small part of the overall fees that PFZW is reporting,” Ms. Bagijn said.

PGGM sold its private equity investment unit in 2011. It continues to invest in private equity despite higher costs because of the relatively high returns. Private equity returns over a 40 year period add almost 5% to PFZW pensions, according to PGGM. The fund faces the dilemma of reducing costs at the same time as maintaining high performance.

To reduce its fee bill, PGGM stopped investing in infrastructure funds and started investing directly in infrastructure assets a few years ago. As a result, annual infrastructure fees have declined from more than 2% of assets to less than 1% and PGGM expects them to decline further. PFZW paid €36 million in infrastructure fees in 2014 and had €4.3 billion in the asset class last year.

In private equity, the pension fund has started to invest directly in takeovers, such as the €3.7 billion purchase of car leasing company LeasePlan Corporation NV in July. It is also backing the creation of new private-equity firms in exchange for better terms on fees. Last year, PGGM supported the spinout of Nordian Capital Partners, formerly the private equity unit of Rabobank. The fund is also committing larger amounts to some managers to gain more favorable terms.

“We are able to make progress because we are going more direct,” Ms. Bagijn said. “That is already resulting in lower costs for our clients and further cost reduction will be substantial going forward.”

Kudos to Ruulke Bagijn, she's definitely on the right track pushing hard against powerful private equity interests who basically want to continue charging exorbitant fees and steal from clients by not disclosing lucrative arrangements they have with third-party providers.

And it's not just PGGM that's hopping mad about private equity fees. Sophia Greene of the Financial Times reports, An outburst of outrage about private equity fees:

It turns out the biggest US pension funds, which have large allocations to private equity, have no idea what profits their private equity managers have made off those allocations.

Every time FTfm publishes more details of this ridiculous situation, there is an outburst of outrage on social media, where a small faction believes we are conducting a campaign against private equity. Either investors should not care about the private equity managers’ earnings, because they only exist if the returns are positive, or investors should stop complaining because they knew the deal when they handed their money over.

This is wrong on pretty much all counts.

First, just to be clear, we have nothing against private equity. It is a perfectly valid asset class and many managers add significant value to their investments and the wider economy through their judicious capital allocation and the support they give their investee companies. This does not excuse poor performance, bad practice or overcharging.

The other two ideas need rather more careful consideration. Does it make a difference what your manager makes on the back of your investment? Private equity managers charge a pro rata management fee, which is agreed upfront and about which there is no mystery. However, they also get to hold on to a share of whatever profits they make for a client. No profit, no share for the manager.

Provided the net returns are acceptable, should it matter to the pension fund what their manager is getting? Of course it should. Without transparency, how can they know if they are getting value for money? How can they negotiate the best deal for themselves, or rather for their members? This is key. Pension funds have a fiduciary duty to their members and it is hard to see how derogating all responsibility for a chunk of that money is meeting that duty.

Collectively it is also important that private equity fees are clearer, because this is supposed to be a competitive market. Managers would no doubt claim the competitive differences lie in their skill rather than their fees, but investors might like to take account of how much it costs as well.

Look at Calpers, the Californian pension fund that is only just about to start finding out how much its private equity managers are charging in total. This will be useful to it in its current review of private equity, which aims to cut the number of managers in half. How would they be expected to go about choosing the better half without knowing how much they are paying for these services?

The other argument put forward to imply this is all a storm in a teacup might be described as victim blaming. The pension funds are big enough and ugly enough to look after themselves, to read the contracts and decide if the deal offered is worth it.

There may well be an element of truth in that — the pension funds certainly should have acted more in line with their description of being “sophisticated investors”, but it does not mean private equity managers have come out of this looking squeaky clean.

Considering the terms and conditions of private equity contracts, it is apparently standard practice to include a clause saying that not only will the managers not reveal the fees they pay themselves out of the funds, but they will feel free to charge all sorts of expenses (including travel expenses “without limit”) to the portfolio companies, which will then be reimbursed from the fund. Any such reimbursements will of course not be disclosed, despite the acknowledged conflict of interest.

Investors should have known better than to accept such terms, but it looks as though these deals may no longer be sustainable. Private equity managers may be about to find out whether their business models are viable without being shrouded in secrecy.

It's about time the SEC and investors scrutinize private equity fees and expenses. I happen to think that CalPERS and other large investors that don't know (or publicly disclose) all the fees they pay out to their private equity funds are in serious breach of of their fiduciary duties.

Long gone are the good old days where private equity giants received huge cheques and charged investors whatever fees they felt like charging. The era of deflation means fee compression and investor scrutinization are here to stay.

Of course, private equity firms aren't stupid. They know they're cooked and are adapting by emulating the Oracle of Omaha's approach, namely, collecting more assets for a longer investment horizon from their "coalition of the willing." This way what they lose in fee compression they gain by gathering ever more assets for a longer period even if this typically means lower returns.

But one thing is for sure, private equity's 'Golden Age' is finally coming to an end and it's pretty much the end of private equity superheroes as we've known them. The old pioneers and mavericks are being replaced by a new generation of bureaucrats.

This isn't necessarily a bad thing. In fact, smart private equity funds are shunning the mega deals of the past and focusing more on being nimble and focused investors. Joseph Cotterill of the Financial Times reports, Private equity picks at smaller morsels:

Anyone looking for the shades of 2006 in this year’s sky-high, credit-infused markets will have noticed one big missing piece: the large leveraged buyout.

Buyouts are certainly back. In Europe and the UK alone, private equity deals worth £100m and over are being signed at rates that would bring volumes close to levels last seen in 2006, if the pace is sustained throughout this year, according to Canaccord Genuity.

That would be about €190bn and £65bn, respectively. Yet the single deal valued at more than $10bn, a common sight in 2006, is nowhere close to reappearing partly because investors do not like the big exposure.

In the first half of the year — one of the busiest six months on record for dealmakers — only six cents in every dollar of M&A came from buyouts, according to Thomson Reuters data.

This even though private equity groups are sitting on $1tn of “dry powder” — money committed but not yet invested in deals. Although they are flush with capital — and using buoyant public markets to realise even more cash on selling assets — private equity groups are scrambling to avoid paying high prices for a shrinking pool of large investments that might threaten future returns.

“It is a big issue,” says Harry Hampson, the head of financial sponsors for JPMorgan in Europe. “If you think of the money that has been raised, they really need to deploy capital.”

Instead they are increasingly buying smaller assets, often then expanding them through an acquisition spree. This sounds simple, but is a profound change in how private equity has aimed to make money historically.

One way private equity, which uses debt to buy companies, traditionally drove returns was simply to exit an investment with its value at a higher multiple of earnings than when it was bought. That has become increasingly untenable in the post-crisis era.

At the end of 2014 the average target was already valued at nearly 10 times its earnings, before interest, tax, depreciation and amortisation, at the end of 2014, going by S&P Capital IQ figures. That figure has since edged over 10, beating records set in 2007.

Private equity have at least taken advantage of such valuations as sellers of investments, exiting at an impressive pace recently.

In the 12 months to the end of the second quarter, Apollo, KKR, Carlyle, and Blackstone, four US titans of the industry, alone realised more than $90bn on listing or selling investments, including real estate.

There are more exits to come. KKR’s First Data, a leveraged buyout when bought for $30bn in 2006, has filed to list this year after ebullient credit markets refinanced its heavy debt.

For some investors in buyouts recycling this cash into new funds, avoiding mega-sized deals may be a blessing in disguise.

Entering an investment at a multiple that is hard to grow further presents a problem for private equity’s traditional promise to more than double an investors’ money over the years capital is locked in a fund.

Rising market multiples are also directly feeding the competition: listed corporate acquirers. They can bid for assets with a lower cost of capital, by using their stock as acquisition currency, or through issuing cheap debt.

Both factors seem to be leading European groups off the beaten path and into closer involvement with portfolio companies’ expansion plans.

So far this year CVC, one of the largest of the European buyout houses, has snapped up assets as diverse as the energy unit of Poland’s state railway, a Mamma Mia!-producing Dutch theatre group, and a New Jersey generic drugmaker.

Similarly Permira, a rival to CVC, has done tech-focused deals including Informatica, one of the year’s largest leveraged buyouts, and acquiring eBay’s enterprise unit. Such businesses may have potential for international expansion or lie in a sector where growth is fast, enough to justify seemingly big multiples.

Another option is to go empire-building: the “buy-and-build” strategy. After completing a buyout, private equity can use the freshly-acquired company to acquire similar businesses — given the excess capital in the industry, groups are likely to have the firepower for further deals.

This allows them to find smaller assets at more attractive investments and combine their revenues to accelerate growth, before selling or floating the bulked up company.

Credit markets at the moment are ideal for this model, with few covenants or hefty repayment demands in new loans to limit an acquisition spree. It is also a way around investors’ phobia of large leveraged deals after the 2006 blow-ups. Building a bigger business also gives private equity more options when the comes time to exit, such as a stock market listing.

Cinven, the London-based private equity group, has used buy-and-builds in the past to roll up assets ranging from life insurance to generic drugs. Now it is betting medical diagnostics laboratories in Europe, key to its health services cutting costs by focusing on prevention, are fragmented and ripe for consolidation.

In May Cinven bought French medical diagnostics company Labco for €1.2bn and one month later it bolted on Germany’s Synlab. Combined, the two had a respectably-sized €2.9bn enterprise value.

The risk of buy-and-build strategies is being tempted to overpay for assets, with the hope of finding acquisitions to fill the gap later.

“A disciplined investor should not be paying synergistic multiples on the first deal,” says Stuart McAlpine, a Cinven partner. “You’re 15-love down before you’ve started.”

In this environment, it's increasingly difficult to be a disciplined investor. Strategics are flush with cash and overvalued shares and private equity funds are all chasing the same deals. No wonder multiples being paid on deals keep creeping up, decreasing potential future returns and increasing risk for investors.

And while the FT article above makes it sound like private equity funds are doing more deals, even if they're smaller deals, there has been a substantial drop in big deals and it's impacting investment banking revenues.

Lastly, Robert Milburn of Barron's reports, Beware of Private Equity Zombie Funds:

An army of “zombie funds” are stalking the Street. Zombie funds are private equity vehicles that deployed investor’s capital at peak valuations, often just before the market tanked during the recession, and then were forced to hang onto their assets much longer than the norm, looking for a way out. After years of economic recovery they are still unable to sell off their assets at a profit, even during our current good times, which is resulting in yet more such private equity funds turning into ghouls.

At the end of July, the number of private equity zombie funds, originally formed between 2003 and 2008, rose 12.5% to 1,180 versus this time last year, according to industry tracker Preqin. In the past two years, assets held by zombies ballooned by 45% to $126.6 billion, as yet more funds formed in 2008 have joined the ranks of the undead.

That’s a sobering thought and seven years into the bull market it’s worth extracting some lessons from the excesses of the previous boom and bust, particularly as private equity valuations are again sky-high and reminiscent of the previous pre-recession gorge-fest.

First, some number crunching: Zombie funds formed in 2004 had a median distribution of 37.4% versus 94.4% for the overall industry. Faring even worse were the zombie funds launched in 2007, which have paid out just 21.6% to date. While they sit on their underwater deals, the zombies feed off their management fees. According to Preqin, the average zombie fund charged investors the industry-typical 2% annual management fee – and they continue to plague wealth investors’ portfolios to this day.

Why does all this matter today? “In North America and Europe, we’re seeing peak pricing yet again,” warns Dan O’Donnell, Citi Private Bank’s head of private equity and real estate. Private equity deals in both of those regions are currently valued at roughly 10 times EBITDA (earnings before interest, taxes, depreciation and amortization) on average versus about 7 times in 2002, he says. That means investors today are buying in at historically-elevated valuations and, as is typical in private equity, are then locked in for five to ten years. That makes O’Donnell nervous. At current pricing, it’s hard to justify that illiquidity, he says, since “you have to price in some level of contraction over the next five to seven years.”

But it’s not all bad even in this environment, O’Donnell says, if you know where to look. He continues to believe in an earlier bet Citi made on behalf of clients: investing in European non-performing loans—those in which borrowers have not made payments for at least 90 days— which are being sold off in an effort to recapitalize the continent’s struggling banks. According to a PwC estimate, the value of Europe’s bad loans at the end of 2014 was €1.9 trillion ($2.1 trillion), up from €1 trillion just two years ago. KKR, Blackstone Group, Cerberus, PIMCO and Apollo Global Management have all launched funds to snap up these distressed loans.

As Penta noted in a previous story, banks were selling these NPLs at such steep discounts, in the 30-to-50 cents range, helping investors to realize returns, net of fees, in the mid-to-high teens over the next five years. Citi’s early bet already appears to be paying off. Citi Private Bank has invested in two PIMCO Bravo funds on behalf of it’s wealthy clients. The first fund was launched more than three years ago and has realized annual returns of 19%, net of fees. With continued turmoil in Europe, O’Donnell still sees “attractive discounts” in European NPLs today, especially for American investors who are buying up these assets with stronger dollars. The dollar is up 18% in the past year versus the euro.

In essence, investors need to dig a little deeper to find deals in today’s heady private equity market. If zombie funds can teach us anything, it’s that when buying into a maturing bull market, investors need to be hyper wary of overpaying for investments that look good on paper – but are, in fact, already the walking dead.

Below, Warren Buffett speaks to "Squawk Box" about Berkshire Hathaway buying Precision Castparts (PCP) for $235 per share in cash. Also, Bloomberg’s Michael Moore reports on Berkshire courting Precision Castparts. He speaks on Bloomberg Television’s “Bloomberg Surveillance.”

Even though he admits paying a high price for his latest acquisition, when it comes to buying, holding and building on companies, the Oracle of Omaha can teach private equity a thing or two.