The preamble pointed out that most GPs strongly believe they’re top-quartile performers and that their funds will deliver 3x or 4x cash returns. It goes on to suggest they can’t all be top-quartile funds and that a 3x return is very rare, hence unlikely.

The article then suggested we, as an industry, change the performance fee equation to,

30% carry if the GP achieves above 2x cash, but only a 10% carry for below 2x

This idea plays to the outward confidence of GPs while securing better terms for LPs.

It’s a novel suggestion, but unfortunately for LPs, it would never fly. You see, the LPs are the gamblers in this relationship, not the GPs.

GPs are champions of ratchets, earn-outs, stock options and vendor financing; they’re masters of reducing risk first and maximising return second. That’s their business and they’re unlikely to change course at the behest of the LPs who agreed to the 2/20 terms in the first place. It would go against the grain of the private equity methodology to take on a likely risk for an unlikely return.

With that said, it would sure make for interesting conversation at a GP investor meeting. I think the culture of the LP industry instils fear of confrontation with GPs, when in reality, what do LPs have to fear? A little LP activism would probably do them some good.

Of course I support good people doing good things, but I just can’t compute the UNPRI. There are no concrete rules, there’s no stewardship, there’s no recourse, nothing. If we boil it down, it’s a vague guide that suggests I shouldn’t use child labour, or slave labour, or ruin the environment, etc.

Here’s a thought, WHY DO I NEED SOMEONE TO TELL ME NOT TO USE SLAVES? Should I pinch myself; am I really in 2010? Do I need someone to tell me not to be a monster? Obviously the signatories think so.

I’m not questioning the efforts of the UNPRI team; I’ll assume they have good intentions. What is suspicious, are firms that need to tell the world they aren’t morally corrupt. (And you know what they say about people that harp on about their own integrity.) If you ask any one of them, they’ll say they’re supporting the cause and doing it for the children, but you and I both know they’re doing it to display a UNPRI logo on their website and, in the process, condemning others as irresponsible.

It’s truly disgusting in the context of these issues. If they really want to make a difference, they’ll donate a % of their carry to these causes (Ha, best joke of the year). My suggestion: do a little more due diligence on PE firms that are signatories to the UNPRI.

This won’t be a popular view, but it’s my view. And it goes for similar treaties or protocols; stop signing pieces of paper and start acting responsibly on a global scale.

Learning Curve

• We’re not dealing with rocket science here, so the learning curve isn’t particularly steep for private equity; once you’re through the door (i.e. you get hired), it becomes more about your resourcefulness
• For larger funds, the focus is firmly on becoming a confident and polished dealmaker; this means developing great communication skills and fitting in with the culture at the big end of town (sounds easier than it is)
• For smaller funds, the focus is on becoming an amiable dealmaker and an articulate consultant; this means personally connecting with business owners (often ‘moms and dads’) and learning how to deliver pragmatic advice with confidence (which can be a challenge for some people)
• The other difference relates to structuring; larger deals are more likely to use complicated instruments, whereas smaller deals often stick to pref equity and senior debt; but, none of this is too difficult if you apply yourself

Compensation

• Make no mistake, in a large firm you will earn multiples of what your smaller firm counterparts make, and the gap only increases from the day you start
• Smaller firms will attempt to bridge the gap by offering carry (albeit, a small %), but don’t become blinkered by this; it takes a long time for your carry to fully vest (10 years+) and there’s a lot of fine print that will mean you get much less than your initial calculations (see this post on my real-world carry calculations, Part 1, Part 2)
• With that said, carry is the holy grail for private equiteers, but you need a relatively large fund to make it meaningful (or great performance, but don’t count on that); of course there are many other variables, but you know what they say about a bird in the hand (base salary)…

Quality of Life

• Private equity isn’t investment banking, we work pretty reasonable hours
• If anything, smaller firms will work you a little harder as they often have fewer people working on more deals
• Irrespective of firm size, before accepting a position at a PE firm, make sure it doesn’t have a PowerPoint culture; this can indicate they work 80+ hours a week pumping out decks, which as we know, is what most investment bankers do
• You can do the sums to work out the management fee income to work out if they’re running on fumes or flush with cash; there’s a lot to be said for frugality, but it can be downright dispiriting having to pay for your own gas to drive out to investees (trust me, it happens, especially in single-owner firms)
• Above all, you need to be inspired by the people you work with and you need to feel that you’re a part of something big; great teams will make 90-hour weeks enjoyable, and uninspiring teams will make 35-hour weeks painful

Hierarchy

• You operate much more autonomously at smaller firms and get experience across a wide range of domains; this is implicit in having fewer people and working on smaller deals
• At larger firms, you’re more likely to have a set of duties that complement the overall team
• If you pick the right mid-market firm, you can grow very quickly, simply by having complete autonomy to close deals, manage investees and effect exits; you’ll never enter a mega-sized fund as a junior with this level of autonomy
• With that said, you’ll quickly feel under-compensated if you’re closing all the deals as a junior and being paid a janitor’s salary; you need a different mindset regarding compensation and duties going into larger vs. smaller firms

Clearly my experience with mega vs. mid-market firms is limited to a sample that’s nowhere near the entire population of private equity firms. So I’d be interested to hear thoughts, disagreements, questions, etc.

In the last couple of weeks a lot of deal activity has spiked up that was painfully absent for most of the year: both at the larger mid market (eg Apax buying Marken, Carlyle bidding for Shanks, Permira & Just Retirment) and down among the smaller houses (eg Matrix and Inflexion both did multiple deals in December).

… how do you read this and care to make some predictions for 2010?

The significance of size and location (of private equity firms) became clearer and clearer as activity increased in late 2009. We saw many micro firms in resilient economies at full-steam, but also larger global firms reeling from negative press. This isn’t to suggest anything about the quality of nations, or firms, or people, or decisions; it’s just the way the cookie crumbled (if you’ll let me take the easy way out).

Irrespective of size and location, most of us paid too much pre-GFC. I’ve heard many smaller players chastise larger players and congratulate themselves on exhibiting more restraint. But we ALL paid too much at a point, and if nothing else, we should be a little humble after such a display of ineptitude. Sure, there’s no point living in the past, but there’s no point celebrating losses either.

With this in mind, I think the defining characteristic for 2010 will change from size and location to the composition of existing funds. The same way firms couldn’t escape their genetic make-up in 2009, they won’t be able to escape the overhang of under-performing assets in 2010. It may sound somewhat sombre, but 2010 will be the beginning of the end for firms with net negative equity. It will take much more than an uptick in a few economic indicators to restore value, even if just to original purchase prices.

For everyone else, this overhang will still clearly define their deal-making activities going into 2010, but to different degrees. For new funds, I see 2010 as a time of unprecedented opportunity, which will warrant furious deal-making efforts. But the reality is that most of us will be finely balancing our fiduciary duties to existing investees with our determination to capitalise on seemingly unprecedented opportunities.

Above all else though, I think the ingenuity of private equiteers will reign supreme once again. We’ll see countless casualties in terms of companies, shareholders and even private equity firms, but we all know life in a capitalist world is a roller-coaster: ups and downs.

Image: Life is a roller-coaster in a capitalist society [source: Shutterstock]

However, that’s not the point I was making. Of course LPs time their cash flows across their portfolios, which is probably the reason why so many have defaulted on capital calls recently. If anything, this supports my argument rather than refutes it. So let me make my points a little clearer (I concede my last post was a little rushed):

If you hold all of the committed capital in cash from day 1, then you are exposed to the normal risk of a private equity investment. However, the return of the investment must take into account the risk-free rate on the cash for the entire period it is held in cash (before it is called).

If you do NOT hold all of the committed capital in cash from day 1, then you increase the risk of the investment. If you default on a call, you destroy massive amounts of value (except in rare cases). Therefore, the risk you are exposed to is not just the risk of the private equity investment and hence the return should be considered in light of the higher overall risk. Even then, any loses or gains from activities designed to meet capital calls should be accounted for in the overall return.

I’m certainly not suggesting private equiteers are misleading LPs, but more that we all mislead ourselves through blinkered analysis. Investment returns must be risk-weighted to mean anything and to be compared like-for-like. It’s convenient for most of us to forget the risk of default, even in the wake of the GFC when such ludicrous assumptions led to cataclysmic outcomes.

• Committed capital: this is money “committed” to the fund, but not necessarily paid. So when you hear about a firm raising a $1b fund, it doesn’t mean they’re in receipt of $1b in cash, it means that investors have contractually promised to invest $1b as (and if) needed. Be aware that management fees take a big bite out of the $1b. At a 2% p.a. fee, you’re looking at a minimum of $100m (equalling 10% of committed capital over the life of the fund) and a maximum of $200m (it would be less than $200m in practice as investors don’t pay fees on distributed capital).
• Called capital: this is money “called” from investors to fund investments in companies. A fund only calls money from investors when it’s ready to invest that money. It typically takes a fund five years to “call” most of its capital (not including the cash required to pay management fees). This is a primary difference between a mutual fund and a private equity fund. (You commit and invest all capital simultaneously in most mutual funds.)

So, what does this have to do with anything? Well, most sane investors put aside the entire committed amount from day 1, because it would be very risky to commit more capital than you currently have. Why? Because if you default on a “call notice”, you could lose your entire investment without reimbursement, or at best, have it sold at a heavy discount to a secondary buyer.

And, how does this result in misleading returns? Well, private equity funds use the internal rate of return (IRR) on cash inflows and outflows as their return metric. The implication is that the return doesn’t account for you having to hold cash. A fund may not even call a dime until year nine, then return double your money in year 10, and then quote a 100% return for the fund. The fact is, you held that cash for nine years at a negligible rate, and achieved an overall return of only a few percent on the commitment (certainly not 100%).

This issue isn’t so black and white because,

1. no one is forcing you to hold that money at low rates of return
2. no one is forcing you to hold the money at all since the fund only needs it when it needs it

However, you really do need to hold the cash if you want to limit your risk to the risk of the investment itself. And you really do need to hold it in a risk free investment, again, if you want to limit your risk to that of the private equity investment. Ipso facto, the return from the risk free investment should be included in the overall return.

So what effect does this have in economic terms? Well, most private equity firms look to return 2x the original cash investment. But remember, 2x cash is a 100% return, not a 200% return. Now, if my math from many years ago serves me well, that’s a ~7% return for a 10 year investment. Of course, that’s too conservative as you receive distributions well before the 10 years is up. So let’s take an average of five and 10 years. That equates to about 10-11% p.a. Certainly not what most private equiteers espouse.

Sure, my methodology and math isn’t going to win any prizes, but I’m sure you get my point.

It’s also important to note that these stages overlap and that funds even overlap. As you raise a new fund, you may be managing and exiting investments from a previous fund. And, while you may hire new private equiteers to manage the new fund, invariably there’s a labour overlap and old funds create a hindrance.

1. Raising capital and building the team (1 to 2+ years) - it can be very difficult to source capital, which is why most funds don’t even get off the ground in the first place. Private equiteers may spend upwards of two years creating hype and luring investors until they reach their funding target. If and when the final funding round closes, the managing company must then build the team to invest in and manage the portfolio businesses. This is a defining moment because the lifespan of a private equity fund is longer than many marriages and hence, the fund’s success firmly relies on the people chosen at this point (and specifically their resourcefulness, aptitude and ability to get along with others).
2. Sourcing deals (2 to 5+ years) - most mid-market firms source deals themselves, though they may entertain bankers and advisers on the odd occasion. This stage requires a dedicated team willing to sell themselves to C-level executives while broaching the concept of private equity. It can be tough, it can be dispiriting, but we’re private equiteers, so it’s part and parcel. A motivated team can invest an entire fund in a couple of years, while slower funds may take 5+ years.
3. Managing and improving the portfolio (3 to 7 years per investee) – once a team makes an investment, it needs to work quickly to create a record of exceptional performance. A team can’t just wait until before an exit to make a difference because potential buyers look at medium-term historic performance when conducting their valuations. This can be a stressful time in difficult economic conditions or a blissful times during strong economic growth.
4. Exiting the investments (varied time frames) - an exit can occur 6 months after your investment if the right strategic buyers and economic conditions present. However, an exit may drag out for 7+ years if the investment underperforms, the economy teeters, and buyers don’t present. The longer an investment remains in a portfolio, the higher the required exit price to meet target IRRs. If investments remain at the end of the official ten year term of the fund, there are a range of options: a) the investment may be sold to a secondary fund, b) the fund may be extended for anything from 1 to 3+ years, or c) the fund can hold a fire sale.  The best exits are with many potential buyers and when you’re not forced to sell, so private equiteers certainly don’t want to hold fire sales. And, since the team likely raised another fund, extending this fund will only hinder the new fund.

Keeping in mind that the average fund has a real life of 12+ years, most private equiteers will likely have left the firm before seeing a whole fund through. Food for thought, especially when calculating your likely carry.

Images: The private equity fund life-cycle [source: Shutterstock]

Image: Venture capital and private equity = ying and yang [source: Shutterstock]

However, when I refer to private equity, I’m referring to a business model of investment. A few characteristics of this strategy include the following:

1. The business is privately owned, not traded on a public stock exchange
2. The investor is active in the strategy and management of the business
3. The investor is a professional investor employing a pool of funds over a portfolio of businesses
4. The investment is mostly structured as equity, which gives the investor upside exposure
5. The investment is in an established business with existing customers and positive maintainable cash flow

This definition differentiates private equity from family investments at points 2, 3 and 5. It also differentiates against venture capital at point 5. The implication of this point 5 is that while venture capital is often linked to research, commercialisation and monetisation, private equity is more closely linked to expansion, succession, buyouts and recaps.

More simply, to me, VC is about building a business, whereas PE is about expanding a business. The difference may sound subtle, but it completely changes the model in terms of risk versus reward (see more here).

Vivek, if you’re reading, let me tell you, you’re officially a marked man by the industry. Not so much for insulting everything VCs believe they bring to innovation, but for doing it with more than just a modicum of truth. (However, I also think you went a bit far with “VCs at best have little to no impact on these companies and at worst have a negative impact.”)

First up, I agree with Vivek that it’s important to make the distinction between Vinod Khosla et al., who can draw upon their own operational experience, and the rest, who can only draw on their experience investing in and servicing operational companies.

The fact is, experience matters. We all know this, but many of us rationalise it away. Would you go with the guy who founded Sun Microsystems or the guy who negotiates tough liquidation preference terms? Enough said, at least in my book.

So, to focus the discussion a little more, I suspect Vivek has issue with the latter group, the group that signs checks, loves to draft legal agreements, and doesn’t understand the difference between a bit and a byte.  On this, Vivek says:

My VC friends complain over drinks about a new breed of VCs who are crowding out the really smart and experienced. These gold digger VCs bear MBAs and have no real operational experience but plenty of taste for IPOs. (Interestingly, if they don’t have an MBA, they have a law degree. Go figure.)

My point in bringing up Vivek’s article is that I see a similar trend in private equity: lawyers, consultants, bankers, MBAs, etc.,  taking over the industry with financial engineering and very little operational or strategic value-add. They will quote years of experience servicing businesses, but to me, that’s like a bookmaker advising a horse trainer on strategy. Sure, they may have a few tidbits of good info, but I’d hardly call a bookmaker an experienced horse trainer.

So, back to my previous argument: experience matters. If you haven’t ever founded a startup, are you absolutely the best person to be advising a startup? Likewise with private equity, if you’ve never run a business, are you absolutely the best person to be advising a mature business?

A midway solution is to hire a financial controller at the private equity fund level to oversee and improve financial management across the entire portfolio.  The advantages of this are manifold:

• A single overseer of financial performance can provide the private equity team with consistent data across all investees (same template, same metrics, same formulas, same processes, same assumptions, etc.)
• It is much cheaper;  hiring a great (opposed to good) financial controller for each and every investee is very expensive at the mid-market level
• In many cases, you’re spared firing a good financial manager (in exchange for a great one), who likely has years of experience in the business and is therefore a wealth of investee-specific knowledge
• It frees up the investment team from having to deal with minor financial compliance issues

The largest disadvantage of hiring a firm-wide financial controller is that if you hire a dud, they could potentially create issues across your entire portfolio. Other than that, it’s a good idea for firms looking to have more time for strategic value-add. You can even charge the controller’s salary to each of the investees, rather than have him/her erode your management fees. Win, win.

Private equity firms must have a deep and thorough understanding of deal-making, financial instruments, legal structure, business strategy, and of course, debt management. It’s hard for a single private equiteer to have a deep understanding in all of these areas, which is why it pays to have a range of senior parnters/owners whom do in aggregate. Conversely, most single-owner firms are bottom-heavy and don’t have this diversity and therefore contain much more risk for every stakeholder in the firm.

In addition, here are a number of other important considerations regarding single-owner firms:

1. They’re a textbook example of a dictatorship – one person, with all of their emotions, persuasions and biases has carte blanche over every major decision; decisions such as selecting investees, hiring new staff and leading due diligence. In private equity, two, three and four heads are definitely better than one.
2. Key-man risk is a repellent - investors (limited partners), investees, staff, media, bankers and advisers tend to steer clear of single-owner firms for various reasons. LPs will give a wide berth because there’s increased risk borne by having only one decision maker. Investees will do the same because there is often less value-add from a less experienced team. And staff, if they know better, will steer clear because a dictatorship is not the best place to learn.
3. There is fundamental risk to the fund – as previously noted, most of these single-owner firms are bottom-heavy. If something unpleasant affects the owner, the fund is left with a phalanx of fledglings whom may be versed in the daily ruminations of the firm, but lack the critical relationships to run the fund.
4. They circumvent necessary checks and balances - even otherworldly businesspeople need checks and balances in cases where they aren’t thinking straight, aren’t completely objective, aren’t available or are simply too stubborn or clueless. Companies have boards of directors, Presidents have senior advisers, but single-owner private equity firms only have LPs, whom most of the time are oblivious to what’s really going on (sorry LPs, but it’s true at mid-market level due to a lack of transparency).
5. The arrangement is often a sign of the owner’s character – in most cases private equity firms benefit from multiple owners with complementary qualities. My experience is that single-owner firms are single-owner for a reason: the owner finds it hard to compromise and deal (closely) with other people. Additionally, it gives LPs and others comfort to know three or four top equiteers can work productively (even if at times with tension) using their complementary skills for the greater good.
6. Management fees are squandered to profit the owner - with a single owner, there is a real conflict regarding management fees. “Do I spend $x on business tools or tell staff to make do and save the money for dividend time?” Of course this could happen in multi-owner firms, but chances are they’ll keep each other honest. And, having multiple people with a financial interest in the management company will increase the chances that fees are put to good use.

To reiterate, I think it’s industrious and quite brave for a private equiteer to open up their own PE shop. But especially in private equity, it’s best to have a number of owners/partners with complementary contacts, skills, personas and experience. Multiple-owner firms are generally better investors, have better contacts, are better places to learn, are more enjoyable to work within and have more overall success.

You may be thinking that people like Buffett and Branson didn’t need others when they started their ventures, but we’re talking about PE firms run by relatively average earthlings (plus think of Gates and Jobs… and how Buffett fared with Munger). So, whether we talk about investment performance, esprit de corps (team morale), or access to capital, I really believe that multi-owner funds reign supreme.

By way of its namesake, private equity should be “private” and involve “equity”. But, what does that mean? The word “private” could refer to the source of capital, the ownership of the investment or the publishing of financial reports. If you put the words “private” and “equity” together, then you’d imagine that the “private” refers to equity from private sources. However, that would rule out listed private equity (LPE) as genuine private equity, which I don’t agree with (see this post for my LPE discussion).

I’ve previously said that I prefer to think of private equity as a methodology rather than a class of capital. So, this makes me think of the “private” in private equity as referring to privately held investees (or very soon to be private, in the case of Public-to-Private buyouts). Of course, this rules out PIPES (Private Investments into Public EquitieS), but I’m okay with that because PIPES don’t adhere to my idea of the private equity methodology.

But, private equity is more than just an investment into a private company; we’re still left with the word “equity”. Well, I’m a big believer in private equity being about investments as equity or any instrument with unlimited upside potential. Sure, some funds invest through mezzanine debt and preferred stock with liquidation caps, but for me, real private equity has full access to the upside. That’s not to say I think firms shouldn’t have any other exposure, just that most of it should be via real equity with real upside.

Just to summarise, I believe genuine private equity refers to equity investments into private companies. However, that’s still too broad; any old investment fund or wealthy individual could fit into that definition. To wrap up my definition of private equity, the investor has to be active in the business and add strategic value to the business; they must be professional investors and business people. They must act as directors, managers, staff, investors, stakeholders, and value creators. For me, this is the essence of private equity.

As for what I think doesn’t qualify as private equity; any minority investment into a public company, any investment as a passive investor, or any investment that doesn’t give the investor enough influence to make a difference. I certainly don’t buy the idea that you’re only private equity if you’re registered with your local PE or VC association; if anything, it’s more nobel to be an active, long-term, private portfolio investor without the penchant to be called “private equity” (think Buffett and Branson… before they listed).

I’m receiving many reports from roadshows that say LPs are becoming quite annoyed and distressed at the obvious sugar-coating that’s taking place. Apparently general partners (GPs) are talking about future earnings that are multiples of current earnings and then applying outrageous pre-2008 multiples to those with the explanation that by the time they exit they’ll receive those multiples and hence they should use those multiples now. Please.

When the chickens come home to roost, LPs will only give thought to what was done to combat the downturn and what the result is via the exit. Only negative thought will be given to fictitious earnings and multiples, so why bother? Please show some humility, talk about what actions are being taken, and leave the excuses at home. Like many other firms, my firm has spent an inordinate amount of time on investor relations (weekly updates, roadshows, etc.), but none of that matters if you’re not honest and genuine; they’re not brainless, they can see right through it.