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."