Man Up ! for social values and integrity

Clean tech sure is catching up. I am all glad for that.

Serial entrepreneur Sunil Paul has this brilliant post in Venturebeat on why he’s veered into clean tech – for social values he upholds or for the profit that it might entail. Excerpts.

“We investors and entrepreneurs in the cleantech world have a guilty conscience. People often ask us, “Are you motivated by the money or by the mission?” It’s become unfashionable and a little shameful to say you’re driven by anything but profit, but I’m not afraid to say I’m a clean energy investor because of my values.

The money vs. mission question comes from fear. Environmentalists and energy security hawks fear capitalists will sell out their social goals in favor of profit. Investors fear a venture investor or entrepreneur will subvert their financial return for a social agenda.

Venture capitalists are beholden to their limited partners who are weighing whether to put money into venture capital versus, say, currency arbitrage. Those investors don’t want to hear that the venture capitalist has any motivation other than giving them a great return. That mentality rubs off on venture capitalists, and trickles down to entrepreneurs and management teams.

But it doesn’t have to be a choice between social and economic goals. Clean energy is like the love child of John Muir and Adam Smith. It joins environmentalism with capitalism. Cleantech companies have great value not captured by the price of the good or service. Their entire business model generates excess social return. In addition, the energy market is huge, and is ripe for change – and so the opportunity for profits is tremendous”.

This reminds me of a paper on leadership posted by Jason Drohn on Howard Schultz vision of Starbucks [ you may have to download a 4 page PDF file, but it’s good stuff – it has some exclusive finds ; like the lawyer who organized capital for Starbucks acquisition was Bill Gates’ Father !]. I think all these people are where they are today because of the level of genuine social commitment they carry.

Jason opines – “Schultz has a wonderful degree of integrity. As he was growing up, his father worked mid level jobs to pay the bills, without health coverage or worker’s compensation. So if he got laid off, his employment was simply terminated. If he got hurt on the job, he didn’t have anything to go back to.

In a 60 Minutes interview, Schultz commented on remembering what it was like to walk into his house, with his dad on the couch, cast on his leg. No job, nowhere to go to work, just a stack of bills and nothing to pay them with.

For this reason, Starbucks offers health insurance to anyone who works more than 20 hours a week, even in unmarried, spousal situations. They offer stock options to their employees throughout the whole company. And Schultz said that those benefits were something that would never be reconsidered.

This is the primary reason that coffee is as expensive as it is. Starbucks pays more in health care than they do the coffee beans to make the coffee !

So if you spend $4.10 on coffee, the majority of the cost goes to the health care being consumed by the person across the counter from you (the barista, in Schultzian terms..).

Adding to the integrity of Schultz and his company, he pays the coffee bean growers above market value for their crops. He feels that if he overpays a farmer, more passion and consistency will be given to their coffee beans. His social responsibility also plays a role in the decision as well.”

When you are asked, “are you in this to make money or change the world?” bring yourself to reply like Sunil bravely does. “Of course we wanted to change the world! Making money was just validation that it worked. Virtually every early internet entrepreneur I knew recognized the opportunity to change the world for the better by growing the Net. It wasn’t until many years later that the hordes of profit-only entrepreneurs came to the scene. Indeed, if you want a sign of over-investment in cleantech, look for an invasion of founders and CEOs who are in it only for the money.”

Would you not like to leave a green planet behind for your grandchildren ? This way, you will. You can convince your limited partners – for they too will have grandchildren !

Why buy when smart guys are selling ?

I was reading Roger Ehrenberg’s review of the valuation and rationality of Fortress IPO which was a blockbuster success on Wall Street.

For the uninitiated, Fortress Investment Group LLC, which manages $30 billion, became the first private-equity and hedge-fund manager to sell shares on U.S. markets and promptly emerged as one of the hottest initial public offerings in years. Its shares, issued at $18.50 apiece, opened for trading at $35 amid frenzied demand and closed at $31 -- 68% higher than its IPO price.

With its stock offering, Fortress is essentially inviting the public to share in the fees it earns managing private-equity and hedge-fund assets. At the end of 2005, the company's then-$7.6 billion in hedge fund assets (a hoard that has since grown) ranked it the 36th-largest fund globally.

What took me by surprise was Ehrenberg’s shock (“ Investors, are you stoned ?“ asks the Wall Street veteran) when the public market offered 40x valuation to Fortress’ shares.

I’ve commented my views to the blog post but then I couldn’t elaborate since I am a strict observer of blog ethics ( always be brief with comments ). But then I came across this wonderful piece in LA Times which squarely settles Ehrenberg’s misgivings.

To sum up, Fortress despite being a Hedge Fund manager went public because :-

a) a presence in Public Market gives it a perceived longevity, besides credibility ;

b) having a publicly traded stock allows its employees to turn their stakes in the company into income. In a partnership as Fortress had been, it was difficult to cash out. In a public company, it's a simple matter of selling shares. ;

c) it is a well timed move since hedge funds returned fantastic results in the year that had gone by ( 2006 ) and Fortress in particular enjoyed a great year itself ( earned $88 mm in the first half of 2006 ). Further, If Goldman was letting the public into its business after 130 years as a highly profitable — and secretive — private partnership, the insiders must have known that was as good as it would get.

d) Fortress is essentially inviting the public to share in the fees it earns managing private-equity and hedge-fund assets ; conversely if the following years turn out to be not as good as those gone by, it’s risk gets evenly distributed across a larger investor base.

e) Being publicly traded will increase the odds of gaining "permanence" as an investment manager. It will also attract high quality accredited investors and Board managed Pension and University funds which by their charter are barred from investing directly in lowly regulated vehicles like hedge funds which are not transparent.

f) The hedge fund and private-equity businesses are becoming ever more competitive as the number of players mushrooms. A serious shakeout is inevitable. When it happens, the firms with the deepest pockets will have the best chance of surviving.


But the question remains. Would you buy when these smart guys are selling ?

The Retail kettle rattled ; now it’s Multiplex’s turn to quake.

Even as the Indian retail industry is geared up to meet the impending arrival of global retail chains like Wal-Mart, Carrefour and Tesco, their knee-jerks do betray their internal jitters however best they try to conceal.

And now this. Wal-Mart, the no. 1 retailer in the US, known as the 800-pound gorilla, unveiled a movie and TV download service yesterday and all the major studios have joined the party. Wal-Mart Stores said the download movie service offers more than 3,000 titles from Twentieth Century Fox, The Walt Disney Co., Lions Gate, Metro-Goldwyn-Mayer, MTV Networks, Paramount Pictures, Sony Pictures Entertainment, Universal Studios Home Entertainment, and Warner Bros. It also includes content from television networks Comedy Central, Fox, and Nickelodeon

The entry of foreign retailers has been a contentious issue for many years, with the government unable to convince the political establishment to support the move, given the stiff resistance from the powerful trader lobby who argues foreign players would wipe out the mom-and-pop stores ( called “Kirana stores” in local parlance). Under existing foreign investment norms, international players can own up to 51% stake in companies that sell only one brand through a chain of stores. The commerce & industry ministry is, however, planning to expand the scope of foreign participation to select sectors like electronics and sports goods, where global chains can open retail outlets.

But the truth is that with the emergence of the Indian retail formats like Big Bazaar, Subiksha and others have already begun to impact the fortunes of these kirana stores. Their customers have been deserting kirana stores en masse because of the better shopping experience and apparent discount offers at the neibhorhood mall. In fact, the real threat for Kirana stores are from retail supermarket format itself regardless of the nationality of its owners.

So it is in fact the Indian branded retail lobby which is running scared of the foreign retail chains.

The ruling Indian Congress party President Sonia Gandhi, had written to Prime Minister Dr.Manmohan Singh asking the government to take into account the implications that these transnational giants could have on neighbourhood kirana stores.

Lately the big Indian retailers including Big Bazaar, Ebony, Shoppers' Stop, Landmark, Westside or even Subhiksha are looking to source merchandise at the lowest rates globally. Future Group's Pantaloon Retail India has just set up global sourcing offices in Hong Kong and Mainland China - the first overseas sourcing operation by any domestic retail chain.

“For retail chains across the globe, the world is becoming a single market. We are looking at markets across the world from where one can source merchandise at the lowest price. We have opened our global sourcing offices in Hong Kong and China a few days back,” Future Group's CEO Kishore Biyani reportedly told a correspondent.

Now it’s the 800 pound gorilla’s turn to shake up the Indian Film industry and the budding online DVD rental outfits funded by Venture Capital firms in India. Huge PE investments ( $ 7.46 billion in 2006 across industries, bulk in infrastructure and real estate including multiplexes ) have been made in India anticipating blockbuster performances of these businesses.

The fun has just begun. With Indian VC investors quaking in their boots, it sure has all the trappings of an edge-of-the-seat thriller. Watch the space.

Vultures can't give India a miss, cagey just yet.

Private Equity funds which feed on distressed debt - buying them at a steep discount, turn them around and sell off at a fabulous premium later are an asset class by themselves - known as “vulture funds” got a shot in the arm in Nov 2005, when Reserve Bank of India ( “RBI”) allowed Foreign Direct Investments up to 49% in the equity of Asset Reconstruction Companies (ARC). The RBI circular no.16 dated Nov.11, 2005 also allowed Foreign portfolio investments in security receipts issued by ARCs upto 49% of each tranche of such issue. There has been several legislations in this direction for quicker unlocking of value from stressed assets.

A cursory glance at the nature and size of distressed debt available is quite mind boggling. The total distressed asset market in India is estimated at about $ 35 billion at last count.

But dealers in distressed assets, like the Asset Reconstruction Company of India Limited ( ARCIL ) are far from happy.

WITH the upturn in the economy raising the prospect of windfall gains from bad loans, banks are demanding a share of the upside from potential buyers of bad debt. This has come in response to the normal stance of private equity (PE) investors asking exiting debt-holders to exit the distressed company by taking a haircut of nearly 20% of the debt. In the recent past, some PE players such as Spinnaker had invested in IG Petrochemicals, Clearwater in Gayatri Waters and WL Ross in OCM.

There is also a long pending need for rationalisation of stamp duties by different state governments. In the case of a financial weak company, the government should allow conversion of debt into equity without triggering the Takeover Code of Securities & Exchange Board of India ( SEBI). – which imposes the obligation on the acquirer to make an open offer to buyout public investors.

India is becoming a hot destination for ‘scavenging’ despite all these pain points. Cash-rich private equity distress funds are hovering atop the $35-billion distressed asset market in the country sighting enormous wealth-creation opportunities. According to experts, 2006 has been an eventful year for distress funds as estimated investments in non-performing assets have grown from around $1 billion in 2005 to over $1.7 billion. It has been a safer bet for private equity (PE) players investing in distressed assets as many have fair potentials of recovery and are largely secured against tangible assets including high value real estate.

Barbarians at the ( India ) Gate...?

If the bidding frenzy for Hutch Essar made interesting read, it was much more intriguing to read about Ranbaxy and Cipla being wooed by bigtime PE funds like KKR, Blackstone and other usual suspects for the generics business of Merck at a perceived valuation close to $ 5.1 billion – as a consortium. While the PE funds bring in the money in a mix of equity & leveraged debt, the Indian companies are expected to provide management expertise.

We’ve heard about the biggest buyout deals by PE funds in healthcare and real estate in the US, though. KKR and others bought hospital company HCA (NYSE: HCA - news) for $33 billion, breaking the $30.6 billion LBO record that KKR established in 1988 with its takeover of RJR Nabisco. The record was broken again when Blackstone and other investors bought Equity Office Properties Trust for $36 billion.

How long would it take for the PE attention to turn towards lowly geared Indian Public companies…? What will it portend for Indian retail investor…?

Imagine a Reliance Industries, Infosys, Wipro, Telco, Tisco going private…? Then to go into PE hibernation for about 3-5 years, dole out large dividends with leveraged debt before re-emerging with more vigour and higher valuation in the public markets again…? Not farfetched. Rather it’s a snap job given their relatively low market cap vis-à-vis that of the US corporate majors which have been gobbled up already.

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It flashed across my mind as I read the news “Essar Group to exit from Indian bourses”. The cost of the acquisition of shares will be in excess of $ 435 million, a back-of-the-envelope calculation showed. This is small change for the Ruias ( majority holders of Essar ), who are expected to get around $ 1.3 billion if and when Hutch Essar, in which they own 33%, is sold to the highest bidder.

Going by the trend, I wonder is it not being signalled by the string of PE buyouts in Indian Companies big and small, the latest one being Blackstone investment of $ 275 million in Ushodaya Enterprises Ltd (UEL), a large media and film production company owned by Ramoji Rao,

P.V.Shahad’s VC Circle reports this is probably the largest deal in the Indian media and entertainment business. UEL is also raising bank financing of $190 million, which takes the total fund infusion to $465 million.

In the US, Managers of companies bought out by private equity funds are seen resorting to savage cuts to pay the interest on huge debts taken on to finance the deals and give pay-back to the private equity owners, meanwhile allegations of collusion to force down buyout prices are being made against private equity companies KKR and Blackstone.

2007 could be the year when private equity chickens may come home to roost. But should you buy when Private Equity sells ?

While Regulators on both sides of the Atlantic are investigating the sector, class action law-suits against private equity firms for collusion in the US are being initiated, and some deals are beginning to unravel messily. SEBI had better keep a close watch.

As the year closed, private equity firms took perhaps the ultimate step toward joining the business mainstream. On Dec. 26, 11 firms formed a Washington lobby group, The Private Equity Council. Private equity firms have begun to come under closer scrutiny, as the size of deals they pull off has soared and the amount of money they wield has grown. Success always comes with a price. In this case, it's attention.

Did you hear the doorbell...?

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Wait - it could well be Barbarians at the (India ) Gate !

PE and LBO - where are they headed...?

Some excerpts from an insightful interview by Justin B Wender, president of Castle Harlan, a Private Equity firm in New York as appeared in New York Times. Covers a lot of contemporary questions on club deals in private equity, their sustenance and how fair it is to Public investors when PE funds take public companies private etc. It gives some wonderful insights

( may need a simple process of registration to read. Worth it. Just check out ).

Few snippets :

“ Q. Will the wave of private equity deals increase, or is it nearing the end of the cycle?

A. Given the dollars raised in private equity, it’s likely we’re going to continue to see significant-size leveraged buyouts. But it’s important to remember that this represents a relatively small percentage of all the securities traded in the United States. I don’t believe this is a huge cycle that’s cresting. It’s just a function of the money that’s been raised.

Q. Why are public companies going private to fix themselves, instead of restructuring while they are still publicly traded?

A. As to why some companies are going private, there is increasing scrutiny and regulation, namely the Sarbanes-Oxley Act, and that has had an impact. Chief executive officers are spending much more of their time on compliance issues and dealing with shareholders and analysts and the outside world. They have less time for their business than they might like. And when they’re private, they can dedicate time to the business itself.

Q. Are you suggesting that a climate has been created in which public companies can’t really take tough steps to correct their business model?

A. I don’t think that’s true. But there are challenges in making changes in public companies. There is constant scrutiny. The research analysts and others are constantly digging into the business and putting out research. You have a lot of public documentation that has to be filed. You can’t spend 100 percent of your time fixing the business.

Q. Who are some of the C.E.O.’s who’ve been lured into the private sector?

A. One good example is David Calhoun, leaving General Electric for an opportunity to join an LBO of the Dutch firm VNU. The public speculation was that he got a $100 million package to lure him. So here’s a guy who was a vice chairman at G.E., where he ran $60 billion in revenues, and he left.

Q. Isn’t it bad for the average investor that people are taking companies private and reaping big gains that public shareholders might otherwise have shared in?

A. The only way that a private equity firm is going to buy a business is as a result of a process in which the board looks for other buyers. Nobody is buying a business without paying a market-clearing price. Now, are private equity guys taking upside profit that shareholders would have gotten? The complication with that analysis is that doing a buyout creates a different risk profile. If you take a business and double its debt, you’re taking different kinds of risks than when public shareholders were involved. The other point to add is that most of these buyouts probably will end up being taken public as an exit vehicle for these private equity firms.

Q. Isn’t it bad for the average shareholder, at least in the short term?

A. Isn’t that an apples-to-oranges analysis? Return and risk are correlated. When these buyouts happen and more debt is put on the company, it’s a different level of risk. It’s not exactly comparable to say that the same amount of equity value would have been created. There may be situations where the public market doesn’t appreciate aspects of a business that a thoughtful private equity investor might see. “

More concerns on optimal deployment of mega PE funds

I have aired my concerns ( “No Way Out”) relating to the prospect of PE investors funds getting locked up for lack of exit opportunities. At that time, I was fresh from the report of Sevin Rosen Funds having retuned funds to investors citing lack of investible opportunities and laggard IPO markets.

I was also not pretty much sure about the potential for optimal deployment and returns generating capabilities of PE firms engaged in a bidding war in most emerging markets ( “Flipside of PE buyouts” ), where the acquisitive ego often side-stepped valuation math. I had flagged caveat emptor for the winning bidders in Hutch Essar.

I recently found support in a Red Herring article, where there’s an added interesting perspective on such record PE fundraising in 2006 ( 322 firms raising $215.4 billion ) and its impact across industries, Venture Capital and the relative risk and suspicion. Very insightful.

Flipside of PE buyouts

Private equity has been a turbocharger for the market. Every time private equity takes a company private, they pay a big premium and investors mark up the rest of group in the hope that another PE firm will come along. This has forced private equity to pay ever higher prices for the deals they do. As long as rates remain low and the economy is strong, private equity can pay up.

What if tables turn…?

Our capitalist system has a habit of swinging between fear and greed and right now we’re seeing it lean toward greed – at least in private equity. Wealth has accrued, and investors — many of them public pension plans — are searching for places to put their excess capital. So they’re parking it with the huge private equity firms and hedge funds promising to put large dollars to work profitably. As per reports, PE firms firms raised a whopping $198 billion in 2006 ( a record ) and almost five times the amount raised in 2004. They pumped $ 725 billion to take public companies private, and buying divisions from public companies that are trying to restructure. That’s another record, more than twice the level in 2004. The trend is expected to continue this year. One firm, Apollo Management, alone participated in $37 billion of transactions in just three days.

Looks like things are getting out of control. With PE firms buying up all these companies, they will need to sell or take those companies public again, in order to cash out of them. But no one knows how they will do that. If you try to sell these companies on the public market at the same time, the resulting downward pressure will kill the stock market. ( Firms will have to hold their stakes, thus lowering returns, and causing a shakeout). Meantime, the excess cash is pushing up stock values artificially, because if a company doesn’t like its stock price, it knows it can get a premium price by selling to a private equity investor. Alternatively, if a company’s stock price dips too low, it becomes an acquisition target. So, of course the market has gone up! The Dow is at record highs.

That’s the problem. Most economists would like 2007 to herald an economic slowdown. If it slows too much, we could be in for a choppy ride. It takes a long time to unload stock, even in the best of markets. I recall Roger McNamee helped buy disk drive maker Seagate in 2000 while he was at Silver Lake Partners. Though Seagate’s value rose within a year or two, and is now near an all-time high — creating handsome profits for Silver Lake on paper — the firm has been unable to sell Seagate shares very quickly. It still owns a large portion of Seagate shares — six years later. And that’s a near-ideal case.

For the past couple of years, private equity has been a safety net under the public market. Stocks go down less than you would expect on bad news because private equity is there….So many companies went private in such a short period of time, that you have to wonder what happens in three years when they all want to go public again. What happens if the market says no ?

Another example is the purchase of Warner Music Group for $1.25 billion in 2003, by a group of investors led by Thomas H. Lee Partners. Within two years, Warner Music made dividend and other payments to those investors of $1.43 billion, in other words paying off the Thomas Lee and other investors the entire cost of the acquisition. Like Seagate, the investment represents a fortuitous case. However, even in these best of conditions, Thomas Lee has been unable to knock it all home with a sale. It is stuck holding to the company, with a declining stock price. Warner can’t merge with EMI, as originally envisioned, because European anti-trust regulators have said no.

The bubble might continue to grow for a while, because there’s so much cash still looking for a place to go. But its time for investors — and here we mean state employees and others whose pension fund money is being pumped into these PE funds — to start asking questions. It’d be too bad if joe public investor is left holding the bag again, just like in 2000. I’d rather hope not.

No Way Out

Private Equity firms buy and sell companies using money raised from Limited Partners who are savvy Institutional or accredited Individual investors. PE buyout firms used to take four to five years to spend their funds, allowing investors to receive returns gained from the sale of assets over that time. These LPs include mainly Pension and Endowment Funds, University funds and other large institutions with huge annual revenues looking for a temporary parking lot before the incidence of predictable future outflows. So they invest these funds in PE funds and try to gain max return on their investments before it is paid out. Right now the money is not flowing back in and is mainly going out.

So many PE firms who have accepted large sums of money from LPs have used up most of their commitments and are hungry for more. If $ 36 billion RJR Nabisco buyout was a one-off large deal for KKR a few years back, now these kind of deals are put together even in emerging markets. This ravenous hunger for large ticket deals is sudden and directly corresponds to the large number of PE firms active in the markets across geographies. The LPs are naturally getting jittery.

What is the reason behind this sudden one way trend…? Reasons are not hard to find.

Almost all equity markets have run up quite high and the average PE is close to 25. This is normally considered overheated in those far eastern markets and the local investors have already pulled back. The PE firms and hedge funds with their financial muscle force their way in not because they find them attractive, but due to absence of investible stories elsewhere. This is extremely risky for the investors as well as those local economies, since the borderline between fundamentals and exuberance is being redrawn and the local investors and fund managers are equally confused. Result, they end up entering at the peaking end of the curve only to have a hard landing. These markets after a fall from such heights rarely get back up for another three or four years since it takes such a long time for the painful memories to fade and for local liquidity to build-up. Restoration of faith in markets will still take some time more. The cycle has to reverse for the foreign PE players to take to these markets again ( they have to run out of options elsewhere ) which is just about one in as much as a decade.

Eventually this rubs off on those developed markets where PE fundraising gets harder by the day. With fewer exit options available, the LP investors are increasingly reluctant to commit more funds until they see returns from their earlier investments winding its way in. After all, they are just custodians of `faith money’ entrusted by employees and universities and someday they have to pay it all back. There is a limit to the interim risk that they can assume – no matter how enticing the returns be.

What drives Private Equity today...?

We have surely missed some reasons underlying the private equity wave, but it should be clear that there are a number of important reasons behind this powerful trend. For individual investors who do not have the ability to access private equity directly, what does it all mean for their investments ?

Most would agree that the stock market has been reacting in part to the continuing wave of buyouts. Buyouts and share buybacks, net of share issuance from IPOs, have been draining market capitalization from the U.S. stock market. This “de-equitization” may be leading investors to bid up stocks in anticipation of further deals.

The presence of deep-pocketed corporate and private equity buyers standing at the ready creates what Citigroup strategist Tobias Levkovich calls “an underlying bid,” which tends to dampen volatility and stop prices from falling too far. And it tends to scare away short-sellers.
So, what drives PE deals today…?

Capital / Liquidity

Could it simply be the case that private equity firms now feel the need to put to work their vast war-chests? The easiest way to do this in a hurry is to ratchet up one’s target size. In the last few years private equity firms have been flooded with an unprecedented amount of capital. Growing liquidity is fueling the private buyout boom for one. There is tremendous liquidity in the market. Deals are being done because they can be.

More than any other factor, the ascendance of private equity buyers over the last few years reflects the willingness of well-heeled investors to pony up mountains of cash in search of better returns than they can earn in stocks or bonds. Unfortunately this makes it all the more difficult for individual investors to find attractively priced asset classes. There’s lots of money, and it’s being put to work. Never mind that finding bargain-priced deals is getting harder by the day. The money will keep flowing until Mr. Market (or Ben Bernanke) yells stop. For the moment, however, there are only celebrations. Looking for historically healthy risk premiums, as a result, remains a thankless task.

The buyout boom is more than just an abundance of private equity capital. Deals can only be made when there is abundant debt available to finance these leveraged transactions.

Credit

A major reason behind the number and size of buyout deals is that ample high yield financing, with reasonable covenants, remains available. Many of those issuances offer surprisingly low yields, suggesting that despite the glut of new debt, demand is still outpacing supply and investors are betting companies won’t default on their new, risky loans. A further sign that borrowers, rather than investors, are calling the shots is the growth of pay-in-kind notes, which allow a company to pay a bond’s interest with more debt rather than with cash. Both Freescale and HCA used pay-in-kind notes to finance their buyouts. There’s a huge amount of money out there looking for a place to go. So private equity groups are buying companies and debt investors are pouring money into risky bonds to chase returns.

Complexity

Another observation is how markets are hooked on “complexity.” Given, of late, the muted returns on plain vanilla stocks and bonds, investors have sought out more complex structures that have the potential to provide incremental returns. Alternatives like hedge funds and private equity clearly fit the bill. They both in turn create demand for more additional financial instruments that can provide additional return leverage.

The private equity-led buyout boom leads to a self-reinforcing cycle of high yield debt issuance, credit derivatives and unnaturally tight credit spreads. These credit spreads therefore allow for even bigger deals. Where this all ends is up for debate, but one must realize that the desire for complexity on the part of investors has created an new industry infrastructure that has yet to be truly tested in light of a significant market (and/or economic) downturn.

Control

Of late, a trend is also emerging out of how the changing pressures on the CEOs of public companies has provided them with an incentive to align themselves with private equity shops to take control of their current employers. The financial incentives of a buyout are clearly an attractive factor for an incumbent CEO to take part in an MBO type-deal. However the chance to control their own destiny absent the many distractions inherent in running a public company must also play a role.

Clearly the lack of constraints on private equity managers to run their companies as they see fit can be an important catalyst for strong performance. Freedom to pay is just one example of an advantage that many PE veterans consider critical: general freedom from the pressures of the stock market, media and Wall Street analysts. Remember, these companies have strong incentives to act quickly - but acting quickly often produces volatile quarterly earnings, which Wall Street doesn’t like.

In a perfect world it should be possible to run a large corporation just as well as a private or public company. At the moment it seems that the playing field has tilted towards private ownership. However a changing political landscape may shift it once again.

Congress

Given the increased pace of deals it begs the question: is there some exogenous event accelerating deal making? It has been speculated that the looming change in control of Congress may be forcing the hand of some deal-makers. While Congress has limited power to regulate deals, it could very well be the case that the anti-trust crowd at the Justice Department may feel a new wind blowing.

The past six years has seen a lax attitude toward deals making. More important may be a socio-political shift that may be against big deals. If this really were a binding constraint on private equity then we may very well be seeing the last gasp of this boom. While possible, we would discount this possibility. So long as the economics of large buyout deals remains attractive, deals will continue to be announced and closed.

The pointers….

At some point this buyout trend will dissipate. Any, or all, of the five C’s mentioned above could reverse in whole, or in part. Fears that the public market for equities will become marginalized are undoubtedly premature. The fact of the matter is that to reverse a private equity-led buyout of any magnitude usually requires a public offering. We have already seen some of those, often in the form of a LIPO, or leveraged IPO. The question is not if we will see some of these very same companies re-list on the various stock markets, the only question is when.

Systematic approach to PE investing - FoF Model

As the march away from stocks and bonds brings new, well-heeled investors into the world of private equity, the positive story continues for Funds of funds (FoF). The asset class is attracting streams of new capital and amid the mushrooming marketplace, Funds of funds have moved to distinguish themselves from the crowd.


Certainly it’s a great time for Funds of funds. The whole private equity industry has so much drawing power right now.


This year, while it seems a bit slower than last, one could still track almost $5 billion in new capital that has rushed into the marketplace in just the first six months. Industry sources even believe anecdotally that the amount of capital raised could be almost double that figure.


It's that old fundraising axiom—you raise money when you can. People are throwing money at private equity and there’s people there to collect it.


Part of the popularity for Funds of funds stems from the arrival of new investors interested in getting into private equity for the first time. Many of these new LPs are often coming from overseas, with a knowledge base of zero. These new groups need a fund of funds to assist them in overcoming the learning curve.


Institutions like to get their feet wet... They'll do one or two Fund of funds over the first five years, and then start to invest directly into PE funds themselves.


However, in the interest of keeping their limited partner base intact, many Funds of funds have developed specialized strategies, which at the same time help Funds of funds distinguish themselves from the growing crowd of rival firms.


For whom does it serve best...


Fund-of-funds investing is not reserved for the greenhorns. To attract institutional investors that have been investing in private equity over decades as opposed to years, there is a growing population of funds of funds that have established specialized vehicles as a way to give the more experienced investors exposure to specific niches.


Specialization is one way to attract both new and experienced LPs. And for an industry that targets the same "top-quartile" GPs, it can also help to distinguish specific fund-of-funds managers from their peers. This is key, as the industry tries to avoid becoming simply an index of the private equity space.


New specialist funds of funds crop up everyday. Among those currently raising capital are Singapore-based Axiom Asia Private Capital, which was raising a $350 million Asia-focused fund. Parish Capital Advisors was raising $550 million for emerging markets only. Piper Jaffray Private Capital, which is raising Piper Jaffray Clean Technology Ventures LP.

Siguler Guff has been a long time proponent of specialization. This year it has raised two such funds, the $1 billion Siguler Guff Distressed Opportunities II and the $600 million Siguler Guff BRIC (Brazil, Russia, India, China) Opportunities Fund. It is also in the market with a $300 million-targeted small market buyout fund, an area that the firm believes is being ignored by most funds of funds.

Specialization's Detractors

Not everyone is necessarily singing specialization's praise. Many pros say that being a successful fund of funds investor still basically comes down to access. When top notch fundraisers can't be reached, it's up to the funds of funds to provide investors with an "in".

Simply put, It all gets back to discipline and access to relationships.

In some cases specialist strategies can get groups into trouble primarily because it creates demand for a market that may not even be there. For example, in looking at the distressed space, one gets a feeling that a lot of capital has already been formed to take advantage of the distressed cycle, but it hasn’t happened.

Is that capital going to be put to work in a suboptimal way ?

With that said, there are also those who believe the industry needs to bill itself on more than simply an "in."

Fund of Funds can't merely play the role of access-provider. A successful Fund of Funds has to cater to larger and more experienced institutional players.

Private equity is about targeted opportunities. It’s about finding areas of capital starvation around the globe. Smarter LPs, endowments and foundations, they aren’t looking for plain vanilla Funds of Funds. They need someone who’s going to bring a cutting edge idea or open up a new market niche.

Thoughts…?

One Swallow a summer maketh...?

I’ve been following a spate of Private Equity funds coming into India with Fund Managers (FM) who were previously successful local / expat entrepreneurs. Most of them have just one success story in IT, Consumer Internet or ITES. So far so good. Others are even worse. They have good academic track record complete with an Engineering degree from IIT and a B-School MBA. But how do brilliant students qualify as good FMs….? ( Warren Buffet, George Soros, Donald Trump never went to a B-School. B-Schools went to them with their honorary fellowships once they proved their mettle. ) I doubt. Not at least by what we get to see on ground. FMs are a breed by themselves who should be adept fundraisers, excellent turnaround strategists endowed with powerful team building and execution skills, early sensors of an opportunity and well, a clear futuristic investment logic to enable high IRR exits from a portfolio of investee companies. In short, the LPs who trusted them with their funds should be coming back to them in droves with loaded moneybags.

Here’s why they failed to connect.

Entrepreneurial success comes from deeper commitment and the constant prodding from within. One has to make it with little resources to boot and constantly in a pressure cooker atmosphere. The problem here clearly is of scarcity. But as a FM, he has a different set of variables to contend with. In fact, a good FM has a problem of plenty. Having raised his money from LPs who are left with little or no fresh asset classes to invest, the FM has to spot new investment opportunities. Unfortunately, the PE managers have neither any previous investment experience nor have they practically any clue about it - except what they have read in B-School courses which they post regularly in their blogs. I have read some of their blogs and almost all of them betray their essay writing skills than investment logic. They have shown alacrity to post news on their recent investments ( as if they were doing a favour on the LPs ) and went on with their post investment blah blah…! Perhaps these posts were their way of communicating to their LPs their weird logic ( or the toal lack of it ) which the GPs don’t allow them to beef up their internal reports with.

The point is B-Schools train them to deal with problems of scarcity and if they are suddenly left to deal with a diametrically opposite problem of plenty, they are lost. Its altogether different that they hate to admit this. They have egos as large as all outdoors. I wonder whether it is part of their package. Do their GPs say something like this while these FMs are selected… “ Oh, yeah, you got your B-School degree from the 1st world…now go manage my funds in the third world emerging markets…here’s your appointment letter and don’t forget to pick your load of Ego from the garage below “ . That explains why almost all FMs have one common refrain – “can’t find good investible ideas”. Goddamit….they don’t know where to look and what to look for. There’s a famous Indian proverb when translated means “ If you don’t know to dance, blame the floor”.

Then who will connect….?

The best way to select a good FM is by searching for his knowledge about the local industry, public policy, investment rationale, Market characteristics and the like. Ask him if he were to invest a million dollars of his own money today, where would he invest and why…? Most of the FMs of today would fail this test. B-Schools have taught them to use Stock and Index charts, CAPM models, Portfolio management techniques which they would rely upon for they don’t realize that they are being hired to invest for tomorrow and not yesterday. These are tools which rely on historical data and not on future. They are pretty much useless.

My piece for FMs. The best way to survive as a good FM is to gain skill of insight. This is indeed a tough task. But you are in a game which isn’t really easy. To develop a sense for an opportunity is by constantly interpolating the metrics of judgement with your own clear inner vision. Keep benchmarking this vision with the way future unfolds and keep correcting the deviations as you coast along. This may not guarantee the emergence of a visionary just yet, but you would surely be humbled by your mistakes and the load of ego is off your back. The game gets far more easier because you begin to work hard.

Like Edison quipped “ Opportunity is missed by most people because it is dressed in coveralls and looks like work….!”

Wisen up, guys...!

I checked out a few Institutional Limited Partners and prominent Angel investors for their assessment of fundraising competence of GPs / VCs. It threw up some interesting anecdotes which could be best avoided by prospective GPs and resource raisers. Give it a good read before you take the dive.

If you're going to try to raise money from Limited Partners (LP) / Angels , make sure you know who your competitors are. My experience says LPs are often amazed to hear managers say, "We don't have any competition," or "We don't know any other firms that do what we do." Even if you're bluffing, the message you're sending is that you're unaware of your own industry.
And don't bother trying to convince Investors that your deal flow is "proprietary." He's heard that one too many times.

I asked these LPs to give us some examples of where fund managers typically make mistakes in their presentations. "Most people are generally well prepared for their meetings with us," they say. "One of the times when things fall apart during presentations is when people insist on sticking to a fixed script for a presentation." For example, often LP ( institutional ) team member may want to drill down into a point made on the third page of a PowerPoint presentation, but the fund manager refuses to deviate from the PowerPoint. A related mistake is coming in and expecting to do all the talking. "We tell people that we want a dialogue when we meet with them- that we've read the PPM already," they say.

Another area where I see a breakdown is analytics. "Either they're untruthful or they're in a gray area where the presentation is being made in a disingenuous fashion," he says. For example, a manager might say that the track record data being presented reflects all of his firm's deals, but then "we look at all of a firm's cash flows and we find 15 deals that were not in the track record," one LP said. "When we ask why those deals weren't in the pitch or PPM, we're told it's because those failed deals are not part of the direction of the firm in the future. It's a classic mistake for a GP to think that the LP is not smart enough to ask for the details or to think that an LP won't ask for all of a GPs numbers after a presentation."

The key to a successful fundraise meeting is not necessarily the pitch. "We don't back the best pitch," LPs note. "[We back] people who make the best investments. It's our job to look beyond the well-designed PPM and the gifted speakers."