Opinion

The Great Debate

Trouble in private equity paradise

September 11, 2009

wwwreuterscomnyse– Neil Unmack is a Reuters columnist. The opinions expressed are his own —

The masters of the universe seem to be losing control of their own destiny.

Jon Moulton, founder of private equity firm Alchemy Partners, has walked out acrimoniously amid a succession and strategic spat with his partners, and Dominique Megret, chairman at PAI, has been ousted. Both cases could trigger so-called “key-man” clauses in the groups’ funds, a nuclear option that allows investors to halt new investment, or in extreme cases even liquidate the fund.

Both Alchemy and PAI’s bust-ups are unique, but we’re likely to see more like them as the private equity model comes under pressure in the aftermath of a global credit crisis.

Key-man risk has always been an issue in private equity. Because investors commit to tie up their capital for several years, they need some kind of fallback mechanism in case a key partner walks out. The clauses also typically have a “level 2″ layer, which is triggered if a certain number of senior managing directors leave. More than 90 percent of buy-out funds include some form of key-man clause, according to Preqin, an alternative assets research firm.

In the good years such clauses are less of a problem because managers are typically locked in by their share of the funds’ profits, or carry, which is paid out over time once a hurdle rate is reached.

The fact key-man risk is now emerging illustrates the precarious and bloated state of the private equity industry as it grapples with the post-crisis financial world. The logjam in the leveraged finance market makes deals harder to do, and defaults are climbing, forcing managers to write down investments. Valuations are depressed, exits are likely to be fewer and at lower multiples than originally expected.

That reduces transaction fees and hurts carry, putting strain on managers and bringing latent tensions to the surface.

The strain is both managerial — how to hold on to good staff who can no longer hope to receive the same payback for their hard work; and strategic — how and when to invest in a new era of tight credit and economic uncertainty.

Investors say it’s not easy to work out which firms will come under stress next. Groups that raised too much and invested too quickly during the boom years may be particularly exposed to writedowns and high overheads, but they could also have older funds that are performing better and still meeting their hurdle rates.

Managers will often try to sort out their differences behind closed doors, for example by reallocating more of the carry to other partners.

If they can’t, the key-man clause transfers power to investors, who must approve an alternative. However, their options are limited. Finding a new firm to manage the fund would be messy and complicated and nobody wants a fire sale.

Investors can press for lower fees, though sticking the knife into a struggling manager may only lead to worse performance. Their best bet may be to reduce future commitments and press for greater transparency over ancillary charges, such as transaction and consulting fees.

This doesn’t mean the private equity model is dead, but there is a certain irony here. After years of proselytizing private equity as a superior form of corporate ownership to the public equity markets, some managers are in danger of struggling to manage even themselves.

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