Friday, October 12, 2012

Unvirtuous Circle: The Private Equity Club

Unvirtuous Circle:  The Private Equity Club

The front page of the business page of the New York Times on October 11, 2012 carried an eye-catching headline: “E-Mails Hint at Collusion Among the Largest Equity Firms.”  The e-mails in question are contained in a legal complaint filed in Federal District Court.  The lawsuit alleges that 11 of the largest private equity firms colluded to depress the price of a series of large acquisitions in violation of the anti-trust laws. While I don’t have an opinion on the legal issues raised in the complaint, I do know that there is a cozy club among the elite ranks of private equity firms.  This club is not good for its investors or you, but it is powerful and connected, and therefore highly successful.  In this post I want to discuss the two great benefits of membership: joint hunting rights and pass the parcel privileges.  Before we look at these benefits, let’s meet the players.

Napkin # 20 (1999)

Who are we talking about?  While the list isn’t exhaustive, the defendants and co-conspirators in the lawsuit are a going starting point for identifying card-carrying members.  The 11 defendant firms are: Apollo, Bain, Blackstone, Carlyle, KKR, Provident Equity Partners, Silver Lake Technologies, TPG, and Thomas H Lee.  Together they manage about $250 billion in private equity.  The law suit also names six more co-conspirators: Clayton Dublier and Rice, JP Morgan Partners, Merrill Lynch Global Private Equity, Permeira, Warburg Pinkus, and Hellman & Friedman, who probably have another $100 billion.  Truth be told, I’ve met senior people from almost every one of these firms.

As a member of this private club, you get “joint hunting rights,” which means that you get to search for and acquire companies as part of a pack.  Four or five private equity firms will join together in performing due diligence and bidding on a target company.  So instead of nine or ten private equity firms circling their prey, there may only be two or three packs of private equity consortia competing to take down a deal.  Owners of the target company may, therefore, not get the best price for the sale of their company since there is limited competition; this explains why the plaintiffs are suing.

Private equity investors are also losers.  They thought they were hiring two or three private equity firms to independently go out and find deals.  Instead they discover that all three firms have joined together, so they own the same company in three separate funds – so much for diversification of risk.

When it comes time to sell a company, private equity has traditionally relied on an initial public offering (IPO) or a sale to another company (known as a trade sale) to exit the investment.  However, there’s a third option, which is extremely convenient, known as “pass the parcel;” it is a special benefit of membership in the club.   The private equity firm or firms simply sell the portfolio company to another private equity firm or group of firms; hence the term, “pass the parcel.”  In other words, PE firms A, B and C pass the parcel (company X) to PE firms D, E and F.

Who are the winners in a “pass the parcel” deal?  PE firms A, B and C are winners because they get to book a gain on the sale and return capital to their investors from an existing set of private equity finds.  They may earn carried interest (profit sharing) and prepare the way for raising their next fund (more management fees).  PE firms D, E and F are winners because they’ve been able to deploy capital in their new private equity funds to acquire company X, which helps to justify their fees.  The banks are huge winners because they get investment banking fees on the sale and subsequent purchase, plus fees for arranging the financing for the deal.  Now we’re talking about Goldman Sachs, JP Morgan, Bank of America, Barclays, Credit Suisse, or Morgan Stanley (named as defendants or co-conspirators in the law suit).

And the losers are?  You guessed it: investors.  True, the investors gets back some capital back from A, B, and C, but the proceeds are likely to go right back out the door to fund the acquisition by D, E, and F.  The investor still owns an interest in company X.  Instead of A, B, and C managing the investment, it’s D, E, and F at the controls, and because of the transaction, 5 or 6% of the investor’s capital has been eaten up by fees of various kinds.  This is not a good outcome.

We’ll see if the plaintiff can show the type of collusion necessary to win this case.  In any event, we know that these private equity folks and their bankers have more in common with each other than with their investors or you.   They went to business school together, previously worked at the same investment bank, serve on the same university and charitable boards, show up at the same political fundraisers, and have each others numbers on speed dial. If the Yankees remain in the playoffs, they can also meet behind home plate at the stadium.  If the Yankees fall, there’s always golf.

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