Monday, March 19, 2007

PE funds – way to go in India II

Just after I’d finished writing my previous post on the subject, there still was this lurk. Have I said it all ? I owe it to the PE fund managers in India to drive home my point - by contrasting it with the US scene, where PE funds had their origin, the mistakes they made and the way they matured. We may still have to tailor it a bit to suit our businesses, the ownership fetish to be addressed, high quality CEO material will have to be nurtured and newer methods of value creation to be learnt.

Let's visit it then and look at the situation there. This will help us avoid the pitfalls if we are intelligent enough to recognize.

To give you a glimpse of the PE canvas, of the record $1.56 trillion spent on mergers and acquisitions in the U.S. last year, PE buyouts accounted for 25% of the action, up from 10% in 2005. PE's firepower has never been greater. Last year firms in the U.S. raised a record $156 billion in new capital. It is believed that the global buyout industry currently has $400 billion available to be invested. With leverage, that $400 billion represents as much as $2 trillion in potential buying power. (To put this in perspective, U.S. mutual funds have more than $10 trillion in assets.)

Private Equity funds, like hedge funds, are classified as "alternative investments," the two are often lumped together. And they do share common ground. Investing in both is limited to those with deep pockets, who can presumably handle the greater risk. Both feature lavish fee structures - variations on the "2 and 20" formula, in which general partners take a 2% fee for simply managing the assets they control and a 20% slice out of any incremental profits they deliver. Both soared in the wake of the 2000-01 market meltdown, which persuaded well-heeled investors that riding the market indexes (Dow 36,000! Nasdaq 10,000!) wasn't automatically going to make them richer.

But here's where they differ. While hedge funds mostly have individuals as investors, PE firms get the bulk of their money from institutions (roughly half from pension funds, another big chunk from banks, insurers, endowments, and foundations, and only 7% or so from individuals). Though so-called activist investors running hedge funds at times noisily pressure public companies into making changes to boost stock prices - think Nelson Peltz or Carl Icahn - most rarely end up owning companies; nor do they want to.

So what does this mean for those of us who don't wear pinstripes or dine where the elephants bump? Are we moving into an era when we have both a public and a private economy in the same way we have a public and a private educational system? Do Blackstone and its peers really take broken companies, mend their wings, and set them free in the public markets? And how big can PE get, anyway?

Cheap debt is the rocket fuel for this, but it's not the only driver. In terms of governance, management focus and strategic decision-making, the PE model is usually superior to that of publicly held companies. Otherwise they’ll end up holding the hot potato. There are only two ways for a PE liquidity event. Flipping the portfolio company to another PE or to take it back Public. On both options, the invariable question they face is “what were you doing with it so far ?”.

They had better show value. Unlike the quick-hit artists at hedge funds, PE is a long-term investor who succeeds only when its companies succeed. That's typically followed by the it's-all-about-the-talent chorus. “Today anyone can raise equity and borrow money," says the Carlyle Group's co-founder David Rubenstein. "What's rare are two things: a deal everyone isn't clamoring to get into, and people who know how to operate the companies we buy. Given a choice between hiring an experienced investor for our firm and landing a guy who's run a leveraged buyout, I'd take the latter."

Amen, adds Michael Milken, whose nearly single-handed creation of the junk-bond market in the 1970s gave rise to the first great LBO wave of the 1980s. "The concepts and financial structures that we introduced back then - and that were rejected as too radical and poorly understood - are now in every introductory textbook," says Milken. "But success then and now mostly depends on finding great people. The difference is, where I only backed strong individuals who wanted to start or buy a business - Steve Wynn in gaming, Len Riggio in books, Craig McCaw in cellular, and Bill McGowan in telecom - the PE industry today has the scale to first buy up assets and then match them up with the right managers."

Another difference between Milken's era and today is that instead of merely bankrolling entrepreneurs, private-equity firms are co-opting CEOs. There are the elder statesmen - Lou Gerstner, Jack Welch, Larry Bossidy, Jim Kilts, John Browne, and many more - who have joined PE firms rather than retire to the golf-and-board-of-directors circuit.

They have learnt it the hard way in US. We have a better template now that needs to be customized to suit local businesses. We must do better since they’ve committed a lot of mistakes before us which we must avoid. We may commit new mistakes, learning newer lessons while on the run. That learning capability should differentiate us. Are our PE fund managers listening ?

If not, watch out for the train wreck ahead. What do you think ?

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