Private Equity on the Cusp of Golden Age?

A senior private equity manager sent me an article from Andrew Ross Sorkin of the NYT, A Financier Peels Back the Curtain:

“We all had too much money. It was just too easy.”

That’s
the unvarnished appraisal of the private equity business by Guy Hands,
perhaps best known for his unfortunate $4.73 billion purchase of the
record company EMI in March 2007, the peak of the buyout boom — a bet
that will almost certainly lose his investors and his firm, Terra
Firma, a fortune.

That ill-timed acquisition aside, Mr. Hands’s
surprisingly candid assessment of the private equity industry is worth
sharing. He was in the midst of the industry’s growth to dizzying
heights during the debt-fueled boom, and he is now having to deal with
the aftermath of its shopping spree. Like others, he is desperately
trying to keep businesses afloat and pay off the equivalent of huge
monthly mortgage payments to the banks that financed them.

Mr.
Hands, a large man with unruly hair who is a name-brand financier in
his hometown, London, was in New York last week to meet with investors
and speak at a conference. A longtime investor who started his career
at Goldman Sachs, he made his reputation investing for Nomura. His net
worth is estimated at more than $400 million.

Over
afternoon tea at the Jumeirah Essex House hotel by Central Park, Mr.
Hands, who now lives on the island of Guernsey to escape British taxes,
offered the most frank assessment of the private equity world —
including his mistakes — I had ever heard from anyone still gainfully
employed in the business.

He had prepared remarks for a
conference that morning, but didn’t get to air many of them. Some of
his most provocative thoughts were in his notes, which he shared with
me. Most strikingly, he grabbed the third rail of the private equity
world: the fee structure that gave the firms 2 percent of assets under
management, plus 20 percent of profits.

The problem, he said, was that the funds had grown so big that the 2 percent became just as important as the 20 percent.

“Clearly
a large number of P.E. firms were totally overpaid at the peak of the
market,” he said. “The fees were an entirely unwarranted windfall, as
the managers did not use the excess fees to invest in resources to grow
the skill base of their funds.”

He estimated that the private equity firms’ “net earnings will decline a minimum of 80 percent from the peak in 2007.”

Success
had less to do with performance or risk management, he said, and more
to do with bulking up. “It is time for investors to see through the
elaborate marketing machines created by the industry,” he said.

Between
sips of his mint tea, he said that during the boom, investors had
thrown so much money at so many private equity firms — some of which
formed consortiums to buy businesses from one another — that they were
“really investing in the same thing so their capital was competing
against itself, driving up prices.”

He also argued that private
equity firms formed consortiums not to spread risk, but because,
ultimately, it was easier than going “through the pain of gaining
internal consensus to do something contrarian.” The big firms would
counter that consortiums allowed them to buy bigger companies and to
spread the risk.

With banks still holding back on loans, some on
Wall Street have suggested that the private equity industry is dead.
Others argue that the biggest firms — the Blackstone Group, Fortress
Investments, Kohlberg Kravis Roberts & Company, which is planning
to go public — will survive, albeit in a different form. Last year,
Stephen A. Schwarzman, the co-founder of Blackstone, said, “The people
rooting for the collapse of private equity are going to be
disappointed.”

Mr. Hands is not
rooting for the industry’s demise, but he is predicting it will wither.
The firms still have funds big enough to last them at least a decade,
as they provide steady fees. “Right now, the big firms have a tower of
fees,” he said. “But the tower starts to collapse over time.”

As
the funds dry up, Mr. Hands expects the firms will struggle to raise
enough new money to support the hundreds of employees they now employ.
His prediction has a precedent — that’s what happened to venture
capital after the late 1990s. The industry shrank sharply after it
became clear that too much money was chasing too few deals.

But
the pattern may play out in slower motion for private equity. “Neither
the banks nor P.E. want to come clean about mistakes,” he wrote in his
notes. “Hence companies will live as zombies unable to grow their
businesses or make long-term commitments. Meanwhile banks will try to
suck out as much money as they can in fees and postpone recognizing the
full extent of the losses of their underwriting decisions.”

In
the end, he said, “Many P.E. firms are hoping that daylight doesn’t
shine on the corpses of their companies, so they are reluctant to
restructure too quickly.”

Of course, it’s possible that some
firms will make terrific bets now, in the depressed economy, and will
come out even stronger when things improve.

Mr. Hands is quite
open that he made an awful mistake with EMI, which desperately needs to
be restructured or sold (most likely to Warner Music, eventually).

His
timing was off, he says, but not by much. If, by chance, he had waited
several weeks, the deal probably wouldn’t have happened. The
securitization market was about to seize up, which would have pushed
him into a higher interest rate, making it impossible to sell some of
the business to co-investors.

“If the EMI auction started two
weeks later, it wouldn’t have occurred,” he said. “We wouldn’t have
bought it. We’d have 90 percent of our funds still to invest and we’d
look like geniuses.”

The good news for Mr. Hands is that most
analysts, and even his own investors, give him high marks for operating
the business very well, squeezing out every last efficiency.

The
bad news is that he has been unable to invest in the company’s future
and any additional cash goes only to one place: Citigroup, which
provided the financing for the deal.

The
bank has become Mr. Hands’s de facto boss now that there is more debt
on the books than equity. “Negotiations with one’s bankers, when the
debt is so large in relation to the earnings, are always difficult,” he
said.

I can't say that I am shocked with Mr. Hands's
comments because I saw this coming back in 2005. A bunch of large
private equity firms with slick marketing presentations gathering
obscene amounts, collecting 2% management fee and 20% performance fee
as they leveraged their way from one deal to the next. A big fat
financial orgy that came to a grinding halt after the 2008 credit
crisis.

The problem is that over the last several years, public pension funds were funding this nonsense and now that it's curtains for private markets and the end of the great pension con job, the chicken has come home to roost.

And
the nonsense continues as public pension funds continue to plow
billions into private equity, betting that the worst is behind us.
Maybe the worst is behind us, but I wouldn't want to make any outsize
bets in illiquid asset classes.

In the environment we're
heading into, I prefer liquid asset classes over illiquid ones and I
certainly would pick and choose my private equity and real estate funds
more carefully instead of writing big checks to every large buyout
fund. I'd make sure that my private equity managers are not glorified
financial engineers who came from an investment banking background, but
guys and gals with solid hands on experience restructuring companies
from the bottom-up.

Is the PE tower collapsing? It depends on who you listen to. Reuters reports that private equity may be on cusp of "golden age":

The
near collapse of the global financial system, which wiped out trillions
in corporate value and personal savings, may be giving way to a new
"golden age" for private equity investment, Silver Lake Co-CEO Glenn
Hutchins said in an interview on Tuesday.

Private
equity firms suffered badly when debt markets seized up as a result of
the crisis and banks did not want to lend increasingly scarce capital.
Only just recently have credit markets started to unfreeze.

"The
financial markets may be on the cusp of a new 'golden age' for private
equity," Hutchins, who is also a co-founder of the firm, told Reuters
on the sidelines of the International Economic Alliance Symposium.

Hutchins,
the co-founder of the $13 billion private investment firm, cautioned
that while there has been a significant stock market rally, the economy
is showing stable, though not robust, growth.

"This
recent stock market rally is a little troubling because it seems to me
not to be supported by underlying economic fundamentals," Hutchins said.

"But
that aside, we have gotten down to levels that are pretty attractive
and the banks seem to be recovering enough to provide modest levels of
financing, which is all we need. We feel pretty optimistic," he added.

The major concern, he said, is how long will investors have to be prepared to withstand low levels of economic activity.

'ATTRACTIVE' RISK PREMIUMS

But
for the moment, Hutchins said, investors are once again finding risk
premiums at attractive levels versus the low premiums before the asset
bubble burst in December 2008.

"Now
that the sort of panic of '08 is over and capital markets seem to be
returning to some degree of normality ... companies will be able to
access debt and equity markets like they have in the past. And that is
no surprise," Hutchins said.

But
he added that investors needed to be mindful that valuations in 2007
should not be defined as normal. They were an "overshoot in another
way," he said.

The average
investment grade corporate bond now yields 232 basis points over U.S.
Treasuries, down from the all-time high of 656 basis points on December
5, 2008. By comparison, in May 2007, before the credit crisis started,
spreads narrowed to 92 basis points, according to the Merrill Lynch
indexes.

"Now risk
premiums are at attractive levels. Investors are being paid to take
risk again. That means when you look back on this, when you get back to
economic recovery, this will have been a good time to invest," Hutchins
said.

Silver
Lake makes only a few acquisitions a year and is more inclined to use
financing for working capital rather than purchases, Hutchins said.

"If
you need financial engineering to enter a deal and multiple expansion
to exit a deal, then your business is fundamentally challenged,"
Hutchins said.

The firm,
along with other investors, agreed to a deal earlier this month to pay
$1.9 billion to buy a 65 percent stake in online telephony unit Skype
from Internet auction and services company eBay Inc (EBAY.O).

Ebay
agreed to sell the stake in Skype for $1.9 billion to a consortium
including Netscape founder Marc Andreessen's Andreessen Horowitz,
venture firm Index Ventures, Silver Lake, and the Canada Pension Plan
Investment Board.

Asked what he thought about the Skype sale and lawsuits filed by Skype's founders, Hutchins responded: "No comment."

I am not as worried about guys like Glenn Hutchins and David Bonderman of Texas Pacific Group who has $30 billion to invest:

One
of the world's largest private equity funds TPG [TPG.UL] currently has
about $30 billion in uninvested capital and is looking for
opportunities, its founding partner said on Friday.

"We
have about $60 billion of capital, half of it is uninvested and we are
looking for opportunities," David Bonderman told Sochi Investment
Forum.

Bonderman said the fund saw growth capacity in Russia's consumer sector and was "cautiously optimistic" about Russia.

Mr. Bonderman should go back to read his 2004 interview with The Harbus:

Harbus:
Where do you see the private equity sector going in the next 5 to 10
years in terms of players in the industry and the overall potential for
attaining the level of returns that private equity funds have achieved
historically?

DB: I think the right way to look at private
equity is as an illiquid equity investment which ought to be competing
in the investors' minds with the public markets. As a result, the
private equity firms should deliver returns significantly higher than
what the public markets do.

You
can argue about whether that return should be 500 basis points or 1,000
basis points higher, but somewhere in that range at least. And if they
can't, they probably shouldn't be in business because, given the
liquidity penalties and so forth, that's what private equity ought to
deliver.

What you think of the private equity sector
depends on what the markets are likely to be doing going forward. We've
obviously had a roaring market in 2003, but if you believe that over
the long-term public markets should be yielding 10%-11% in real terms,
then the private equity firms should be yielding 16%-25%, or they
shouldn't be in business. As the market comes to realize that, what is
going to happen - and you've seen some of that already - is that the
players who are successful and continue to be successful will not have
a lot of trouble attracting capital.

The
people who can't do that will fall by the wayside. You had one or two
big firms already lose their way in that regard. At the end of the day,
you will see a collection of larger firms, and you'll see some midsize
firms and you'll see some niche firms. But over time, you probably will
have less than the 85 or so firms at the moment who have $1 billion
dollars in capital or more. Probably some of those guys will go away
over time.

...

Harbus: What do you think makes a good private equity investor?

DB:
Being a good private equity investor is more complicated than it seems.
I would say that there are a few characteristics that are important. If
you look at the skill set that you need to ultimately be a successful
private equity investor, at least at the senior level, you have to be,
in this business, a good investor. You have to be able to help
companies perform and you have to have judgment around exiting
investments. If you look at the skill sets there, they include some
things you can teach and some that you can't.

One of them, of
course, is being a person who has good judgment about businesses. A
second is someone who's pretty analytical and understands how to deal
with numbers. A third one is personality, because in the private equity
business, there's no deal unless you can persuade somebody to sell you
their company. And as you say, there are many competitive situations
here. So if many of us are all out there competing, and people like you
and they don't like me, they're probably going to be interested in
selling their company to you, and not me. So, you have to have a mix of
those talents.

In addition, a very important characteristic is having a nose for value.
That's why some of the very best private equity people, in my
experience, are people who start out as stock pickers - people who
really understood value, how to take a company's financials apart and
couple that with good judgment about businesses, macro trends, and
where things are going.

It's a complicated skill set, and probably no one is perfect at all of them.

The
more you start out with the right kind of personality, the right kind
of smarts and the better the training you get, the more successful
you're likely to be.

Harbus: Mr. Bonderman, you've obviously
had a very successful career in private equity. What do you enjoy most
about your job? What has been the most challenging aspect of your
career path?

DB: Let me answer those in different ways.
For me, one of the highlights of being in the private equity world is
that you need to learn a lot and very quickly about different
businesses. So it's always a continuing learning experience where you
can apply what you know, of course, by way of judgment and by way of
numerical analysis. You're always investing in new businesses, which is
a learning experience in itself. I think that is a wonderful thing and
I think it makes for intellectual challenge and for continued personal
growth. That, for me, is the highlight of this job.

You
have a challenge every day in figuring out what's happening in the
markets, where your next deal is coming from and so forth. So there is
always a continuing challenge - but this is a financial services
business, it's not brain surgery. The challenges are all about getting
it right, but in the scheme of things, there is plenty of latitude to
get it wrong.

Given the uncertain economic landscape, there is plenty of latitude to
get it wrong, but guys like David Bonderman didn't get to where they
are by being stupid with their money. The management fees that TPG
charges its investors can attract some pretty smart people to help them
uncover value. They'll need all the brains and brawn they've got to
face the challenges that lie ahead.

***UPDATE: Comment from an informed reader***

Please read this comment carefully:

PE has been a good idea for hundreds of years, but best
executed by family offices with long term time horizons and fewer “agency”
problems. The current mega LP led/investment banker enabled business model is
dysfunctional, and I fear some limited partners will harden their approaches at
the expense of the general partners (rather than seeing themselves as the root
of the problem), with the usual unintended consequences of poorly thought
through alignment of interests creating more dysfunction going forward.

I think the golden age references imply that current tough
markets are transient, and opportunistic, distress style deals will work out
well.  In my view, most GP’s are poorly equipped for distress investing,
and those who on the whole are strange, mean people who aren’t really cut
out to be fiduciaries.

Given my personal extreme bearish view on broader economic
fronts, I can’t see a golden age emerging.  I see this as a tough business
that will get tougher.

My solution, as always, is to contain PE activities within
portfolios to a relatively minor scale.

Comments

[AR]

Read the article profiling Leon Black (Apollo Partners) in the February 11th, 2009 issue of Portfolio magazine (not defunct).  Essentially, private equity makes money for one group -- their founders and senior principals. Everyone else invested like pensions, insurance, endowments, etc. -- pays exorbinant fees to be part of "their elite game and group."  Is private equity really smarter? Doubt it. This from a study referenced in the article:  European academics, Ludovic Phalippou and Oliver Gottschlag, demonstrated in a paper that the poor performance of private equity firms could be understated. When private equity firms report the value of their funds, they include estimated values of deals before the investments are actually realized through a sale or share offering. Surprise, surprise: Those estimates tend to be biased upward. When the data is cleaned up, Phalippou and Gottschlag found, it becomes clear that the private equity industry tended to underperform the S&P 500 by three percentage points a year after fees.  Also from the artcle:  After fees, private equity firms as a whole don’t beat the market. University of Chicago scholar Steven Kaplan studied the industry’s returns and in a 2005 paper reported that over a period of about three decades, the average private equity firm’s annual return was no better than that of Standard & Poor’s 500-stock index.  As we say around our here:  "Wall Street...the most highly regulated, legally corrupt industry in the world..."

[Leo Kolivakis]

***UPDATE: Comment from an informed reader***

Please read this comment carefully:

PE has been a good idea for hundreds of years, but best executed by family offices with long term time horizons and fewer “agency” problems. The current mega LP led/investment banker enabled business model is dysfunctional, and I fear some limited partners will harden their approaches at the expense of the general partners (rather than seeing themselves as the root of the problem), with the usual unintended consequences of poorly thought through alignment of interests creating more dysfunction going forward.

I think the golden age references imply that current tough markets are transient, and opportunistic, distress style deals will work out well.  In my view, most GP’s are poorly equipped for distress investing, and those who on the whole are strange, mean people who aren’t really cut out to be fiduciaries.

Given my personal extreme bearish view on broader economic fronts, I can’t see a golden age emerging.  I see this as a tough business that will get tougher.

My solution, as always, is to contain PE activities within portfolios to a relatively minor scale.

[Leo Kolivakis]

McGriffen,

All excellent points. I see a lot of PE funds getting wiped out and others are sitting on a pile of dough, collecting 2% management fee and hoping the economy will improve. LPs are becoming increasingly impatient with funds that are collecting 2% and not putting money at work. Only the best funds will survive this next cycle and even they won't find it that easy.

[McGriffen]

Didn't KKR (Kravis) proclaim the golden age was mid-2007?  I want to recall someone powerful & long-standing making that claim.

In addition to that EMI deal, there's got to be a plethora of horribly-timed deals gone wrong during 2007.  Flowers' LBO of SLM was among them...an LBO of a student lender, good grief wish I had followed that signal a lot closer.

Blackstone cashing out with that IPO was another timely signal...