The future is smaller for private equity
Investors’ faith in banks may be reviving, but 2009 is shaping up as a year of reckoning for private equity. Two of Europe’s most prominent listed buyout funds — Candover Investments and SVG Capital — are considering their options, with sale or dismemberment a serious prospect.
How the mighty are fallen! For more than a decade, the listed PE funds outperformed the market, and the managers earned rich fees nicknamed “2 and 20″ — 2 percent of funds under management and 20 percent of performance above a certain benchmark. But that outperformance has disappeared in little more than a year with many funds languishing in the “90 percent club” of shares that trade for less than 10 percent of their peak. Funds are blaming a killer combination of lousy returns, a debt drought and an investors’ strike.
Even when the current storm abates, PE will be a smaller, humbler industry. For starters, many PE funds are so cash-strapped that they are unable to meet their commitments to invest in the latest funds. In Candover’s case, it had to allow other investors to scale back their commitments to the 2008 fund too. Moreover, it has suspended all investments from its 3 billion euro 2008 fund and to levy fees only on that tiny portion of the fund already invested.
This recognition of commercial reality will cost in the region of 25 million pounds this year. It is a sign of the new balance of power between PE firms and their investors.
PE relies on a continuous cycle: raise money, invest it, add lashings of debt, tart up the portfolio companies and sell them at a profit. Once any link is broken, the whole edifice becomes extremely shaky. This is the situation the industry finds itself in now.
Of the handful of exits over the past 18 months, many have been forced, with PE firms walking away from companies that can never service their massive debts. This has not only hurt the equity investors, but also the banks that have provided the majority of the funds for deals. While they are reducing lending in general, they are especially reluctant to extend credit to PE, which they feel has sold them a pup. Write-offs have contributed to huge fund write-downs — 50 percent is not uncommon. Moreover, the humiliation is more public than ever.
Thanks to top-of-the-market listings by Blackstone and KKR and new transparency rules, much of the PE world has to admit the unpalatable truth about its performance.
GO-GO DAYS ARE GONE
In the go-go days, secondary investments in PE traded at a premium to underlying net asset values. Unfortunately investors in funds are now finding that PE is as difficult to exit as it once was to enter. PE works by gathering commitments rather than cash, and drawing on them as investments are made, like cashing post-dated checks. This structure appealed to investors because it contained hidden leverage. Part of their commitment would be funded by recycled cash released from the funds. That meant every 100 pounds of exposure only “cost” them a portion of this, say, 70 pounds.
However, this merry-go-round depended on a regular stream of profitable sales. With such exits as rare as house buyers, investors are being asked to invest cash they don’t have with people who have already lost a lot of their money. No wonder they want to tear up those checks.
Guy Hands bought out three cash-strapped investors in his Terra Firma fund at a discount. Permira allowed SVG to reduce its commitment by 40 percent, but at a cost. SVG has to pay fees on its original commitment, and must give up 25 percent of the eventual payout. That suggests that Permira’s bosses, like Candover’s, are more focused on the short than the long term.
They could be right. The current downturn in PE is no temporary phenomenon. The 7:3 leverage ratio that juiced returns will not return any time soon. Without it, the 30 percent-plus returns that attracted investors and justified long lock-ups and high fees are gone. Even the juicy fees are not immutable, as Candover has shown. With slimmer pickings, fewer bright sparks will seek to make their fortune in PE.
The industry will simply shrink, as building societies (thrifts) and life assurers have done before them. Some, like one-or-two branch building societies, will be picked up by firms whose bigger balance sheets provide the ballast to ride out the current recession. Others, like life assurers that no longer underwrite new policies, will be put into “run-off,” ie take on no new business, but be run solely to maximize the value of businesses already on the books.
The challenge for Candover and its ilk is to negotiate their most important exit: their own.