Bottom line: institutions have over-committed to private equity funds and now the chickens are coming home to roost. Staying with the chicken theme, it seems all of those celebrations for closing those billion dollar funds were somewhat chicken before the egg. OK, no more chicken clichés, but it is a little worrying for private equity firms, mine included. I was dismissing this latest news as a big fund phenomenon, but then I hear WaMu defaulted on a $30,000 capital call.  

The implication of this is not as serious as the media are making out, at least not for recent vintage funds and not as long as the defaults are limited to a small portion of committed capital. In practice, it would mean calling extra cash from other investors and maybe scaling down the fund and reducing future investments. It doesn’t look good making subsequent calls due to defaulting investors, but it’s certainly not the end of the world unless there’s a dire need. What really concerns teams is what they’re always concerned about… the carry.  I’ve written about the 2/20 rule and the significance of carry before.

More worrying than all of this though, are reports that limited partners are wearing the pants and demanding that general partners don’t make capital calls until otherwise advised. According to the Carried Interest blog, some limited partners are threatening not to invest in future funds if calls are made without their approval. This is going to be a real saving face battle as private equity firms and listed partners fight for power. Unfortunately, for private equity funds, it’s a buyers’ market and listed partners, more than ever, already have the power.

Private equity is an illiquid, medium-term investment for a number of reasons. Firstly, it takes time to turnaround, grow and develop businesses. Secondly, this process, by its very nature, requires cash up front and then delivers cash much later in the game; income along the way is just cream.

The term “J-Curve” is the net cumulative cash position of a private equity investment over the life of the fund. That is, net cash flows are negative in the formative years and become highly positive in later years, and the net cumulative position looks like the letter “J” on a chart.

The J-Curve effect intensifies because funds are much more likely to write assets down than write them up. This is more to do with accounting standards than conservatism. In most instances, the lower of cost or market value is used in valuations. On the other hand, an asset’s value is rarely written up unless there is a cash inflow event. This means that unrealised gains could be accruing, but until the investment is exited, they won’t be declared or reported.

Tereza Tykvová penned a paper, almost two years ago, entitled “How Do Investment Patterns of Independent and Captive Private Equity Funds Differ? Evidence from Germany”. It presents and discusses empirical evidence of performance differentiation between independent and captive funds (in Germany). A captive fund, according to Alt Assets, is:

A private equity firm that is tied to a larger organisation, typically a bank, insurance company or corporate.

There’s been a long-standing debate about the viability, attractiveness, performance and conflicts of captive funds. In theory, they’re setup like traditional private equity funds, but in practice, they lack the je ne sais quoi that gives private equity its mystique and appeal. It’s a similar argument to whether listed private equity defeats the purpose (and circumvents the value-add) of traditional private equity. 

Anyway, Tykvová postulated and confirmed that independent funds perform better. In the broad strokes, his thesis is that the peculiarities of captive funds directly suppress performance. That is, the principal-agent problem is more at work than in a traditional fund. I’ve written previously about the principal-agent problem and specifically that private equity goes a long way to circumvent the problem. Well, captive funds go some way to undo the circumvention of the principal-agent problem because often the edicts from a captive fund’s parent (often a bank) conflict with the value-add of private equity. Rather than harp on about my biases either way, here’s a list of captive characteristics (as usual though, the list isn’t exhaustive):

1. Capital flow: when a fund invests directly from the balance sheet of a large corporate, it doesn’t have all of the issues associated with raising a new fund. This is particularly attractive to private equity teams when capital is tight, like right now. Most of the time though, the parent will still require some external fund raising to complement its committed investment.
2. Deal flow: if the parent is a bank, accounting firm, advisory firm, etc., then the team has access to deals from within the greater group. This can mean thousands of warm leads into businesses deemed fit by other departments within the greater group. At times, I would give my left… ummm… arm for access to potential investees like that. 
3. Carry: I’ve written previously about how private equity teams are precious about their carry and how various external parties can have a stake in the carry. Well, it’s not unusual for parents to take 5-10% of out-performance, meaning 25-50% of the total carry. Is that worth the additional capital and deal flow? Maybe in times like this, but it still tests the relationship. For the parent, this portion of the carry determines whether the private equity business group is profitable, so it is basically the fund’s life-line. Don’t deliver profits and you’ll have the board barking down the phone and analysts questioning your existence. 
4. Reporting: if there’s anything that goes against private equity, it is reporting on a regular short-term basis (often quarterly) to a manager, a board, or even worse, the public. Exposure to quarterly reporting conflicts directly with the theory of private equity; that is, building great global companies over a medium term. Public markets, public investors and the J-curve definitely don’t mix.
5. Deal competition: this is a pro or a con; personally I see it as a pro. If your parent is a bank or advisory firm, then other banks and advisories won’t bring you deals, unless they’re of inferior quality. If I had to choose between having access to an intra-company database of thousands of potential investees and getting regular calls from pesky investment bankers, I wouldn’t exactly be torn.
6. Interference: private equity teams love autonomy and flexibility; nothing’s going to kill the vibe more than a corporate dictator trying to flex his bureaucratic muscle. Captive funds often have to deal with an executive from the parent on their investment committee who can’t help but toe the company line. This can be a constant distraction. Other edicts from the top may include exiting investments at certain times to satisfy analysts and to bolster quarterly reports.
7. People: private equity is as much an art as a science (cliché police?) and the art is based on people and culture. The private equity culture is the engine of the private equity machine; the flexibility, autonomy, creativity, diversity, energy and opacity make private equity what it is. You add some bad voodoo into the mix (read: bureaucratic bullshit) and all of a sudden you’ve upset the equilibrium. I see this as the biggest problem with captive funds.

Truth is, I don’t think captive funds can compete with independent funds. The empirical work supports this thesis, the industry trends support this thesis (captive fund numbers are on a downward spiral) and the anecdotes support this thesis.

Private equity firms have quite flat management structures, especially at the mid-market level where everyone is responsible for deal origination, negotiations, due diligence, transacting, monitoring and exiting. But, even with this flat structure, there is a subtle hierarchy that tenure (and success with deal origination) drives.

Often senior employees in a private equity firm focus on securing limited partner investments and dealing with high-profile opportunities. The junior employees engross themselves in financial models, make cold calls to potential investees, and deal with the dreaded intermediaries. In aggregate though, great deals and great returns form the basis of incentives.

Without further adieu, the hierarchy of staff from senior to junior is as follows:

1. Founding Director
2. Managing Director
3. Director
4. Associate Director
5. Associate 
6. Investment Manager
7. Investment Analyst

Although this hierarchy may vary across regions, titles usually correlate quite closely to this structure. Employees often enter firms from the bottom up after completing an MBA or other relevant post-graduate study.

The 2/20 rule simply refers to a 2% management fee and a 20% outperformance fee. That is, investors typically pay 2% of committed capital to the management company to manage the fund and 20% of returned funds above the initial capital as an incentive.

I mentioned committed capital, because in most private equity funds, investors commit capital rather than invest capital. Their capital is called as required by new investments. So in practice, a firm may not invest a single dollar for two years, but based on committed capital of say $1b, $20m a year is paid as management fees to… sift through opportunities. This is one of the many beauties of the private equity model (for private equity firms at least).

I once heard a prominent partner of a large New York private equity firm say, “There are three certainties in life: death, taxes and a 20% carry.” Of course the monetary value of the carry isn’t a certainty, but what he was inferring is that the private equity industry will stick by its 20% carry rule irrespective of what anyone else thinks because it is their livelihood.

As for the 2% management fee, it keeps the fund running; it pays the staff, the lease on the office, the electricity bills, and those infamous lunches that introduce new investees to the big time. Since the fee is fixed, employees are rarely paid bonuses in the private equity space; the 20% carry is their incentive. Additionally, distributed funds from exited investments aren’t included when calculating the management fee (even that would be too audacious for a private equity firm); only invested or uncalled capital attracts fees.

The 2/20 rule sounds simple enough, but it really is the lifeblood of the industry. Some of the best strategic thinkers go to private equity because of the combination of small teams, large funds and the 20% carry. Equally, the 2% management fee is vital to facilitate great deals, mainly because the carry is contingent on many variables and often not paid for five or so years into a fund (until exits occur).

I’m hearing it a lot lately; it’s a great time to be buying and an awful time to be selling. This roughly translates to, it’s a great time to be in the embryonic stages of a PE fund, but a not such a great time to be anything else. But, what happened to the dangers of catching falling daggers? 

There aren’t many guarantees in life, but fortuitously, there’s a guarantee that it’s not the top of the cycle for PE firms to be buying. Sure, the economic atrophy can continue, and financial markets currently resemble cosmic black holes, but at least there’s the comfort of not buying at the top. Ipso facto, you could do a lot worse than make investments in this market.

As for making a call, I see the current state of the market as a double-edged sword. The lucky PE firms will find great businesses with owners whom are worried enough to sell at lower multiples. But, I also think we’ll see a spate of rushed deals based mostly on the pretence of low multiples. Of course those multiples may look low now, but if earnings fall… well, let’s just say they won’t be so low anymore.

The other limiting factor of many current deals is the mud-like flow of debt. For smaller deals that don’t require syndication, this certainly isn’t insurmountable. The cautious and prudent move at this stage would be to limit gearing to maybe 2-3 times of earnings, provided cash flow still exists. 

Overall, I think it’s a great time to be looking for deals in mid-market private equity, but certainly a risky time to be rushing into them. Business owners aren’t exactly capitulating, and those that are, probably run businesses that private equity firms would rather stay well clear of. With that said, I’m sure there are a few diamonds in trouble that just need a little extra polishing to reflect their true light.

The formal definition of private equity is vaguely:

… The ownership of equity securities in a business not publicly traded.

As simple and concise as this definition is, it doesn’t differentiate between passive and active investors. This is an important distinction because the private equity offering contains much more strategic value than the offering of most other private investors. In this sense, a private equity investment more closely resembles an investment made by a management team. The primary difference being that the private equity professionals do not constitute staff and hence, they represent an extension of management that isn’t completely engrossed in the daily operations of the business. This allows them some independence and a refreshingly different view of the business from the outside world. Therefore, my expanded definition of private equity is:

… the ownership by a value-add investor of equity securities in a business not publicly traded.

Best regards,

the Private Equiteer