For Private Equity Investors, The Work Is Just Beginning
Dow Jones Daily Bankruptcy Review January 7, 2009
Over the past 18 months, we have seen the investment stars of the credit decade fall out of the sky – mortgages, commodities, hedge funds. Whispers are growing that private equity will soon join them. Certainly, the pace of private equity investing was just as accelerated in the bubble days of 2006 and 2007 as it was for all those other now-discredited investment categories.
Investors seduced by the rapid return of private equity money deployed in 2004 and 2005 doubled down on their previous bets in the hopes that private equity would deliver the excess returns of the future, allowing them to sock their money away for 10 years and pull it out when their rainy day needs came calling. And it wasn’t just novices drawn to the private equity flame. Calpers, among the most seasoned of all private equity investors, committed $25 billion to private equity in 2006 and 2007 – as much as it had invested in the category over the previous 15 years. Some might say Calpers’ bet is paying off.
Year-to-date through October, private equity was virtually the only positive number in a sea of red ink for the pension giant. And many in the business, noting the rather large amounts of uninvested private-equity capital sitting on the sidelines, sagely point out that it is in times like these that spectacular fortunes are made.
But there are other signs that bode less well for private equity: A cascade of spectacular blow-ups, many involving marquee sponsors, a rash of studies evidencing plummeting prices across a broad spectrum of PE debt (one recent report analyzed credit spreads on more than 300 PE companies and found 60% of their debt trading at distressed levels) and now a swelling Greek chorus of industry pundits warning that when year-end results are pounded down by auditors’ mark-to-market hammers, PE portfolios will show declines of 30%, 40% or more. No doubt, investors will be waiting for those audited numbers with churning stomachs. And once they get them, the work will really begin. Bad returns, for sure, will trigger some tough conversations between investor and sponsor.
Investors will not only have to evaluate each and every one of their funds to determine which might be dragged under by the weight of recent bad deals, but they will also have to analyze the entirety of a sponsor’s activities. In a sobering new development for the PE industry, concerns that whole firms might collapse because of improvident investments are taking hold, largely on the back of a rather bleak study predicting the demise of 20% to 40% of all PE firms.
It’s not enough anymore to be happy with your particular investment; now you have to make sure the sponsor will stay together long enough to manage you out of it.
For some investors, the challenge of managing liquidity to meet future capital calls, now that distributions from early deals can’t be counted on to fund the later ones, will be the straw that breaks the camel’s back. They will join other unhappy investors who choose to cut their PE losses through a fast, unhappy sale in the beaten-down secondary sales market. But what if (sigh of relief), the valuations are relatively good? One must ask, in a world of mark-to-Madoff reporting, if the numbers can be trusted.
After all, private equity is largely a Level III game, highly dependent on management assumptions and models, hence implicitly subjective.
Blackstone, for example, uses “long-term exit multiples” to determine the current value of its deals. I’m not sure exactly what that means, but I’m willing to bet those multiples are
more favorable than what we’d see in the market this very day.
Maybe Blackstone’s interpretation will prove to be accurate, but investors can’t blindly accept valuations if for no other reason than the interests of general partners and limited partners are considerably misaligned.
Consider how private equity firms make their money. Perhaps it once was from carried interest; sponsors did well when their investors did well.
But as fund sizes grew bigger and the range of fees charged by PE sponsors to their investors and portfolio companies grew more extensive, the importance of the carry declined. Today, non-carry fees provide the real money, as much as 2/3 of PE compensation, according to some studies, and a strong incentive to keep the game going, however bad the final returns might look.
There is, in fact, substantial evidence that some private equity firms string out positive valuations to nonsensical lengths. The “living dead” of the PE world are the zombie companies that haven’t delivered any cash for years but are carried as a big chunk of a fund’s residual, unrealized value – generating fees for their sponsors year after year and, at the end of the run, a huge write-off for their trusting investors. How much?
By some analysts’ estimates, as many as seven points of PE returns will ultimately be written off, a big number in the context of the low return environment we may now find ourselves in, a number that should make an investor think twice before swallowing rosy projections of unrealized value. But let’s say investors ramp up their due diligence efforts on their current PE funds and still like what they see: No deals or valuations that make them question the sponsor’s (or accountant’s) judgment, skill or ethics; a plan for making money in the compressed multiple, credit-short, low demand world in which we now live; appropriate staffing across the full gamut of a sponsor’s funds to handle whatever workout challenges it might have. What then?
First, recognizing the conflicts that current compensation arrangements present, PE investors must stay on top of what’s happening with portfolio companies and their expected returns. There can be no more sitting around wishing and hoping that returns roll in as they’ve been promised. Second, they should push (and regulators may help them) for more independence in valuation. Third, they should use every opportunity to realign incentives so that private equity firms profit when they do.
Obviously, the standard two and 20 is something to look at (really, who wants to pay that much for a return that may struggle to get out of single digits in the next decade?), but there are other practices, from how the carry is calculated to what kind of fees are charged to portfolio companies, that can significantly depress investor returns and that until now seemed to have escaped much scrutiny.
Finally, this extra level of activity on the part of investors goes double for any new investments. The old excuse that investors couldn’t argue with what they were presented lest they be shut out of a hot fund seems feeble in today’s environment.