Private Equity Titans Cashing Out?

Tom Metcalf and Gillian Tan of Bloomberg News report that private equity titans have quietly discovered how to get even richer:
Robert Smith built Vista Equity Partners into a money machine.

The private equity firm has racked up more than $120 billion of deals since its 2000 inception, mostly in technology companies, and produced some of the highest returns in the industry.

That has made Smith one of the world’s richest people with a $6 billion fortune. But like many private equity tycoons his wealth is largely illiquid, with the bulk of it locked up in Vista’s investment funds.

Smith, 56, pioneered an increasingly popular way to free up some of that treasure. He sold about 30% of the company he co-founded, helping him to become one of the most prominent philanthropists in the U.S. and buy at least $100 million of real estate, while also adding $500 million to the firm’s balance sheet.

Since cutting his first deal with Dyal Capital Partners in 2015, Smith has stepped up his philanthropy, signing Warren Buffett’s Giving Pledge in 2017. In May, he went viral with a promise to wipe out the student debt of an entire college class. He also reportedly bought two homes in Malibu, California, for about $40 million and plunked down almost $60 million on a three-story Manhattan penthouse.

Vista’s 2015 deal helped popularize sales of minority stakes, upending the conventional wisdom that only weaker businesses would sell a piece of themselves and at a time when more money than ever was pouring into private equity.

“It’s ironic that the industry has been one of the last to take private equity money,” said Daniel Adamson, senior managing director of Wafra, which was among the first to buy minority stakes in buyout firms. “It’s like a shoemaker’s family going barefoot.”

They’re making up for lost time. At least 39 buyout shops sold minority stakes from 2014 through 2018, according to a February report by Bain & Co. That’s more than triple the number from the previous five years as bulk buyers including Dyal, Goldman Sachs Group Inc. and Blackstone Group Inc. jostle for deals for established firms like Tom Gores’s Platinum Equity, Barry Sternlicht’s Starwood Capital Group and Steven Klinsky’s New Mountain Capital.

Funds targeting equity stakes raised $17 billion from 2012 through 2018 and are currently raising $17 billion more, according to Bain. Dyal’s fourth fund had raised more than $8 billion by September and already allocated most of that capital.

Meanwhile, the industry’s biggest names have been tapping some of that newfound liquidity for a variety of uses.

In 2016, Vista co-founder Brian Sheth reportedly dropped $38 million on a Los Angeles mansion and two years later spent $16 million on a neighboring property. He also has become a leading wildlife conservationist with his foundation committing $60 million largely to environmental initiatives, according to its website. He pledged more than $13 million to a youth club in Austin, Texas. David Miller, co-founder of Houston-based EnCap Investments, donated $19 million to his foundation in 2016, months after Dyal acquired 20% of his firm.

Owners and buyers stress that such deals are more about providing capital to bolster investing lines, helping general partners meet their commitments in funds they’re raising and enabling succession planning -- and typically have little to do with rewarding founders.

Typically more than 75% of the money from these investments goes back into the firms, according to a person familiar with the transactions. Vista’s Dyal deal helped it scale and boost its fund offerings without going public while Platinum Equity is using proceeds from its 2017 sale to build out a credit platform and grow its operational capabilities.

Still, the practice can generate uneasiness.

“Investors are now bracing for this kind of news,” said Andrea Auerbach, head of private investments at Cambridge Associates, which manages portfolios for endowments, foundations, pensions and family offices. “The capital can be used for lots of different things -- monetizing wealth, opening new lines of business -- and the concern is that can also take focus away from existing funds.”

Lofty Valuations

A 2018 Dyal investor presentation obtained by Bloomberg shows that seven of the 10 deals featured as case studies included some proportion of secondary sales.

No matter where the proceeds of such deals flow, the lofty valuations they bestow upon buyout shops reveal a fresh cohort of billionaires in an industry where such riches have accrued most visibly to the founders of publicly traded firms like Blackstone, KKR & Co. and Carlyle Group LP. They include Vista’s Smith and Sheth, and Starwood’s Sternlicht, according to calculations by Bloomberg.

Some scoff at such paper valuations.

“I don’t care what our firm is theoretically worth -- if I’m not going to sell the rest of it, it isn’t worth anything,” Kimmelman said in an interview. “It was an effective way to give us a balance sheet and strengthen the financial aspects of our firm.”

Rich Returns

Those acquiring stakes have reaped rich returns thus far. Dyal’s $5.3 billion third fund has posted annualized returns of 26% as of June 30, according to a report by the Minnesota State Board of Investment, which committed $175 million in 2016. The deals offer prized access to the economics of buyout firms at a time when private equity is steadily infiltrating just about every corner of the economy. From 24 Hour Fitness to Cinnabon to Vivid Seats, more than 20 million people are employed by the 15,000 companies backed by private equity.

“I cannot replace this kind of cash flow, predictability and downside protection,” said Christopher Zook, chairman and chief investment officer of CAZ Investments who has invested in some of Dyal’s funds. “I’ve told my wife and son that if I get hit by a bus they’re never allowed to sell this investment.”

Such optimism is well-founded. Vista’s assets have grown by more than a third to $56 billion since the second Dyal investment, making it one of the world’s biggest buyout firms. Miami-based H.I.G. Capital has added about $10 billion of assets since Dyal first invested in 2016.

Still, the market may have peaked. There’s a finite supply of top-tier firms even as the money chasing stakes in these entities grows with recent entrants including Stonyrock Partners, backed by an arm of Jefferies Financial Group Inc., and Investcorp.

“The first generation of these funds have done nicely,” Bain’s Elton said. “They were bought well during a good period for private equity. At the time, value drivers were pointing in the right direction, but now they may no longer be doing so.”

For now, it’s giving the latest generation of private equity owners the resources that are traditionally the preserve of more liquid fortunes. That was on dramatic display earlier this year when Smith stunned students at Morehouse College’s graduation ceremony with his promise to pay off the student loans of every member of the Class of 2019, a $34 million act of largesse.

“On behalf of the eight generations of my family that have been in this country, we’re gonna put a little fuel in your bus,” he told the graduates.
Mr. Smith's generous donation to the entire 2019 graduating class at Morehouse College, donating $34 million to the historically black men's school in Atlanta, is well-known by now.

Ten years ago, I wrote about another private equity titan, Pete Peterson who co-founded Blackstone along with Stephen Schwarzman. Peterson knew the meaning of enough which is why he walked away and started giving away most of his fortune before he died.

Now, the article above presents a very balanced view of why some private equity titans are cashing out of their business, selling an equity stake to entities like Dyal Capital Partners.

Of course, the initial thing that goes through everyone's mind is they're cashing out at the top but this isn't true. Sure, as I stated last Friday, there are bubbles everywhere including private equity where performance is deteriorating, secondaries are no longer selling at a discount and volatility is often underestimated even if the alpha is there over the long run.

So, now is as good as it gets in private equity, and probably a great time to cash out, especially if Elizabeth Warren or Bernie Sanders get elected and implement a huge wealth tax.

But as the article states, typically more than 75% of the money from these investments goes back into the firms to expand operations, so it's hard to draw any negative conclusions from these deals.

One thing is for sure, investors in Dyal Capital Partners are reaping huge gains which is why most of them want to continue investing in these deals, for now.

The private equity landscape is changing but investors like CalPERS and others are still clamoring to get into the very best private equity funds to make their target rate-of-return.

I recently wrote about how private equity is booming while hedge funds are waning and I don't see this trend ending any time soon. A serious crisis might temporarily impact the industry but it won't curb investor demand for more private assets over the long run.

Having said this, private equity is attracting ever more scrutiny. Harvard Business Review recently looked at the role of private equity in driving up healthcare prices (not everyone agrees) and I keep reading about how private equity firms have caused painful job losses and more are coming.

The private equity industry continues to have a serious image problem, and to be brutally honest, it's entirely because the people running it are incapable of explaining their industry properly and they typically shy away from the press.

What else? New research indicates that the performance of buyout funds largely comes down to the individual portfolio managers making the deals, not the overall private equity firm:
The preliminary working paper, which analyzed the performance persistence of buyout firms and individual portfolio managers, found evidence that individuals were “about four times as important as the organization” in explaining buyout fund returns over time. The paper was authored by Reiner Braun and Nils Dorau of the Technical University of Munich alongside University of Oxford professor Tim Jenkinson and Daniel Urban from Erasmus University Rotterdam.

“In absence of alternatives, many buyout fund investors put an emphasis on individual manager’s track record when making investment calls,” the authors wrote. “Our research indicates they may be right in doing so.”

The four researchers looked at the performance of nearly 4,000 individual portfolio managers from about 800 different private equity firms between 1970 and 2017. They found that an individual manager who was previously responsible for a top-tercile deal was “substantially” more likely to land another top-tercile deal than to deliver performance in the middle or bottom third of buyouts. Managers whose previous deals were middle- or bottom-tercile were similarly likely to continue in the same performance bracket.

According to the study, these individual differences in skill were not tied to age or industry experience, whether managers attended an Ivy League university, or if they have obtained an MBA degree.

The individual managers also continued to display performance persistence after the authors controlled for where they worked. In fact, they found that performance persistence had declined at the firm-level over the last several years, while continuing to exist at the individual level.

“Even in the face of increased competition for deals and standardization of processes and terms, some individuals seem to exhibit repeatable investment skill,” the authors wrote.
Very interesting findings which should make everyone think long and hard about where they are investing and why.

Lastly, Alicia McElhaney of Institutional Investor reports that private equity contracts are expensive and complex and the ILPA wants to change that:
In a bid to reduce the complexity and costs involved in agreements between private equity firms and their investors, the Institutional Limited Partners Association has released a new set of guidelines for limited partnership agreements.

The industry association that represents private equity investors, called limited partners or LPs, announced Wednesday that its model limited partnership agreement is now available for general partners (GPs) and LPs to use as a guide for their own contracts.

At present, most GP-LP agreements are bespoke — law firms draw up the contracts, which are then rarely shared between firms, according to Chris Hayes, the senior policy counsel at ILPA.

“It's hard to get a copy of a draft model LP agreement,” Hayes said. “They’re all secret. It’ll be the first-ever document that’s out there and public.”

ILPA worked with roughly 20 lawyers over about a year to create the model agreement, Hayes said by phone.

The model letter includes provisions for the LP advisory committee to be allowed to meet without the GP or its affiliates present and to approve all affiliate transactions.

It also gives the LPs the right to vote to terminate or suspend the commitment period and to communicate with one another about the fund, the letter shows. It would require GPs to give LPs a list of their fellow LPs on a quarterly basis so that they can know who their peers are and communicate with them about governance. 

“We think it’s important for the GP to make sure the LP understands the treatment they should expect,” Hayes said. “They should have a list of the other LPs in the fund. It can help LPs exercise governance rights.”

The model letter includes several provisions to protect both LPs and GPs against overpayment, including an optional escrow provision, a GP clawback (the return of past performance fees to investors if the fund’s investments later underperform), and an LP giveback (when investors have to return money to the fund, for example to pay a claim against the fund), among other provisions.

The letter also specifies how a co-investor with a private equity firm should handle fees, expenses, and liabilities of the portfolio in a way that is fair to other LPs in the fund. 

“By putting it out there, it adds value to the private equity industry itself,” Hayes said. “I think this hopefully democratizes access to what a typical limited and fair limited partnership agreement looks like.”

But not everyone is keen on implementing the new model contract just yet.

“I don’t expect the biggest GPs to just get rid of their contract and use ours,” Hayes said. “Some GP counsel said they didn’t believe in the standardization, but we’re hoping that they’ll take a look at this.”

He added that he hopes the document will be useful especially for emerging managers, as the use of an ILPA-approved model could add credence to their process.
I commend the ILPA for doing this as it will mostly help emerging managers which is a good thing. My readers can obtain more information here.

Below, Vista Equity Partners' Robert Smith is one of the world’s richest people with a $6 billion fortune. He sold about 30% of the company he founded. His first deal with Dyal Capital Partners in 2015 helped popularize sales of minority stakes, upending the conventional wisdom that only weaker businesses would sell a piece of themselves. Bloomberg's Tom Metcalf and Lisa Abramowicz discuss this trend.