Private equity bubble hangover yields HR headache

May 11, 2012

By Quentin Webb

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Private equity’s bubble hangover has brought staffing headaches – and Terra Firma is suffering acutely. Guy Hands, the boss of the British buyout firm, is dipping into his own pocket to fund 20 million pounds of bonuses for employees over the next two years. The largesse is a necessary step to keep staff through an otherwise lean period. But Hands has made life particularly tricky for himself.

The industry used to be a millionaires’ factory. “Carried interest” typically gives private-equity partners a 20 percent share of profits from a successful fund, usually above an 8 percent annual return hurdle. For large funds, fees based on assets managed can also bring in sizeable annual sums, which cover a firm’s running costs and big salaries too.

Promises of great wealth ring less true now. For ambitious staff, hedge funds and even banks can start to look like more alluring destinations. The boom years were full of expensive, over-leveraged buyouts. Some collapsed, while others have proved hard to sell on to corporations or stock-market investors. In September last year, the median European buyout fund raised in 2007 had generated a median internal rate of return of just 0.6 percent, Preqin says. True, these funds run until 2017. But some will struggle ever to generate carry. And investors are being pickier about backing new funds.

Terra Firma has a bad case of this, and that’s largely its own fault. Partly the problem is insufficient diversification. Its 2007 fund is 40 percent underwater, after the firm lost a total 1.75 billion pounds on EMI, the record label. The fund could yet break even, but may never pass the carry hurdle. A follow-on fund is at best some way off. And as is typical, management fees have halved after five years, as the fund switches focus from buying to selling.

Then there’s weak cost control. Hands is to pay 10 million pounds annually for the next two years, lifting Terra Firma’s salary and bonus bill to about 50 million pounds. For a 100-person firm, with about 60 “investment professionals”, that implies an average payout of 500,000 pounds, including non-financial staff. That seems an extraordinary reward at a firm whose current fund may at best return investors their original stake.

At least Hands is footing the bill personally. But he has no choice. He doesn’t want to miss out on the wave of future bargains he reckons European investing will yield – and can’t surf the next deal wave alone.

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