Private equity is ‘train crash’: expert

The collapse of a private equity manager lacks the impact of a hedge fund failure: it’s like a “slow-motion train wreck,” says Chris Hunter, managing director of Cambridge Associates in London. Now that fundraising among private equity managers is down, leveraged finance is scarce and the market for exits is weak, mega-buyout funds are busy keeping portfolio companies from grinding slowly to a halt. Simon Mumme reports.

“It’s been at the top,” Hunter says, commenting on the type of managers finding it most difficult to move on from the financial crisis. The mega-buyout funds, each managing in excess of $4.5 billion, are in the most strife – particularly those that rapidly spent the capital raised in the booming years of 2006 and 2007.

Many of the funds that put capital into highly leveraged investments are now in distress: there is little hope of a supportive exit into public markets or another private buyer, banks are strictly policing debt agreements, and fresh capital is hard to come by. Managers can get caught in a “negative feedback loop,” in which commitments can no longer be funded, Hunter says.

“These sorts of things can cause the implosion of a private equity firm, which tends to be slower than a hedge fund event.”

Preqin, an alternative investments researcher, finds the aggregate performance of mega-buyout funds has endured a precipitous fall to become the worst performers among private equity managers. While their collective five-year internal rate of return (IRR), or the rate of growth their investments are expected to generate, is more than 20 per cent, over three years it becomes marginally negative and their one-year performance nosedives to -30 per cent.

But some big shops will have enough capital to survive until markets become less hostile. Hunter says one such manager spent all of its capital on 2006 vintage assets, primarily in consumer and retail businesses, which suffered heavily in the crisis.

But the manager was able to raise a second fund in the first half of 2008, which it ultimately used to stabilise its earlier, troubled investments – good news for investors in the first fund, but not for the newcomers.

“They did two to three years of cost-cutting in one quarter,” and changed the management of the company, because “the team you need in a rising market is different to what you need in a down market,” Hunter says. The manager then devoted one-fifth of its staff to find new investments, and the remaining four-fifths to keeping existing assets alive. “They stabilised the portfolio, and no companies failed. They lived to fight another day.”

“Now we’re in another day. Private equity can be a slow-motion train wreck, and many of these problems are still playing themselves out.

“If they get their money back, they’re saying that they’ll be fine, and that reasonable outcome will be defined as getting their money back with a small amount of profit or small loss.”

While the attention paid to older assets might appease investors in the 2006 vintages, it won’t benefit those in the later fund, who paid fees to see their capital used to pump life into troubled assets.

Despite the harsh market, most managers persistently sought investment opportunities and worked on portfolio companies. Few chose to return uninvested capital to clients. But Hunter observed as one firm, which raised US$300 million in 2006 for its second institutional fund targeting small companies, gave capital back to investors after making just two investments that absorbed 20 per cent of its capital.

The first investment, in a tanning salon, was ill-fated due to disagreements between business partners. The second investment was in a sound business, but it was in the logistics and oil field services industries, both of which got “hammered” as the oil price fell and economic growth dried up.

Even though 80 per cent of the fund’s capital was not invested, investors were paying full management fees. The manager “thought about cutting the management fee, but if you do that you reduce revenue to the firm at the wrong time,” Hunter says. “So they made a rare decision. Since they couldn’t invest the fund, they left it with the majority parent and two investments to exit, and returned the capital.”

“It was honourable. They didn’t want to put good money after bad, and it helped limited partners with liquidity. Someone finally stood up and understood the reality of the situation.”

The decision- the equivalent of harakiri in private equity circles – will undermine any attempts the manager might make to raise capital in the future. But it was a rare show of respect to investors in an industry in which, the forfeiting manager told Hunter, “there are so many firms in our position that won’t admit it”.

Hunter expects low returns from private equity investments in the next few years as managers use what capital they have to turn their companies into viable prospects for sale.

“It is a slow-growth environment. We’re seeing managers fail, while some are wildly optimistic for the next year, but are struggling to get their investments off the ground. To get gains will take two-to-three years.”

The managers who will deliver the best returns should be those acquiring controlling stakes in distressed companies and implementing turnaround strategies, which essentially involve “getting the debt and taking control of the company through some restructuring company, rather than getting out like in a private equity strategy”.

“2010 and 2011 might see a lacklustre economy. But if you build a position in a company, when debt goes down and it has to go through restructuring, later you might create a good company.”

Preqin also sees a tough few years ahead for private equity managers: “With deal-flow down, fundraising down, leveraged finance not available at the same rate as in the past, and the market for exits also suffering, the state of the [industry] looks relatively bleak.”

But the researcher puts hope in data suggesting that buyout funds raised in difficult periods usually go on to perform well. Emerging from the dotcom crash, buyout funds enjoyed an IRR of 24 per cent in 2002, it states. But whether or not a similar pattern will be seen in the recovery from the financial crisis depends on the ability of managers to finance and complete deals.