Wednesday, March 6, 2013

Private Equity: When Things Don’t Go As Planned

Private Equity: When Things Don’t Go As Planned

A recent podcast on Bloomberg News[1] prompted me to write about this question. What happens when a private equity manager can’t immediately raise another fund?  The short answer is: investors perspire.  If a manager isn’t able to raise a new fund, it probably means that the existing fund hasn’t done too well.  Obviously, investors aren’t favorably disposed toward subpar performance.  However, harvesting the remaining companies in the existing fund at favorable prices has to be investors’ biggest worry. 

As the size of the existing fund shrinks, the management fee diminishes.  Of course, the prospect of carried interest has long disappeared.  As a result, investors have to wonder about who will stick around to manage and sell the remaining assets, and get them back as much money as possible.  Without the prospects of another fund or the lure of carried interest, key professionals might decide that their future is with another firm.  Without key employees, a poor performing fund might turn into an extremely ugly fund.
Changing the Asset Allocation (2003)

My former client Terra Firma has come up with at least one answer.  The firm’s founder, Guy Hands, has decided that he has to fund the bonus pool because the management fee is no longer big enough to cover all the expenses of the management company.  He talked about this in the podcast.  Without that extra compensation to hold together the investment team, he might be forced into a fire sale of the remaining assets in Terra Firma’s two funds.  Before you decide to put Mr. Hands up for private equity sainthood, consider two additional factors.

First, Mr. Hands is a large investor in those funds.  Thus, he has a big interest in extracting as much value as possible as his team winds down the investments.  There’s an investment lesson here.  The best, albeit imperfect, form of alignment is when the general partner has a lot of its own money tied up in the fund.  The corollary to this lesson is that carried interest is a weak form of alignment.  Carry only aligns the GP and LP in winning situations, much like stock options in a company.  Capital invested in the fund creates a powerful reason for the manager to try to keep his investment team together when things don’t go well.

Second, while the management fee at Terra Firma has declined in recent years, we can’t feel too sorry for Mr. Hands.  Not all too long ago, Terra Firma’s two general funds and its German real estate fund were probably pretty lucrative for Mr. Hands.  So in effect, he’s simply putting some of the profit back into the company in order to keep it together.  While Mr. Hands might have done it anyway, it’s good that he’s also a major investor in the funds.  Without that inducement, he might have just let the remaining investment crumble.

As investors, we tend to focus on our potential returns when we first commit to a manager.  The investors in Terra Firma’s funds certainly had reason to concentrate on the prospects of success, as the firm had a good track record.  Conversely, we don’t think about the possibility that things might not go as planned.  Before making a commitment, investors would be well served to focus some of their due diligence on the manager’s capacity to deal with adversity.


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