The checklist of items that institutions should look at when investing in a private equity fund may seem obvious. However, as fund raising continues to grow at a breakneck speed, investors should be extra vigilant that general partners cannot only deploy the ever-growing piles of cash but can also effectively navigate companies through an economic downturn.
The industry is booming and while few wish to predict a turning point, all agree that the upward trajectory will not last forever. One of the problems is that in today’s environment investors cannot waste time deliberating as vast sums of money are raised in record time.
Ralph Aerni, senior partner and chief investment officer of SCM Strategic Capital Management AG, notes: “Five years ago, it took a fund more than a year to raise $1bn (€762m). Today, the funding cycles are extremely short and it can take no time at all to raise $8bn. As a result, investors may only have two to three months to conduct due diligence.”
Institutions may also have to lower their expectations. Top-tier private equity firms are a loyal group and they only seem to open their gilded doors to a relatively chosen few. It is extremely difficult for newcomers to gain entry.
Data from Private Equity Intelligence reveals that, in global terms, 563 funds were raised in private equity in 2006, with aggregate commitments of $365bn - a significant jump on 2005’s figure of $293bn. These may be mouth-watering numbers but industry estimates also show that about 70% of capital in private equity funds worldwide comes from only 200 investors.
This does not mean that investors will be forced to pick up the crumbs. Far from it, as there are currently enough opportunities across the deal spectrum. No company seems off limits and the larger players are increasingly fishing for opportunities outside their home territories in regions such as Asia Pacific and emerging Europe.
Whatever the transaction, it all boils down to the management team, their acumen, stamina, industry experience and reward systems. It is no surprise then, as deal sizes balloon and financing becomes ever more complicated, that key man clauses in negotiations have taken on a new meaning.
As John Gripton, head of investment management Europe for Capital Dynamics, an asset management firm which specialises in private equity, puts it: “At the end of the day, you are investing in people and you want to make sure, especially in the investment phase, that if the key staff leave, you can at least suspend new investment.”
Mark Cunningham, managing director of Helix Associates, a placement agency that is part of Jefferies Co, also advises investors to remember that they are locking themselves in an illiquid investment often for a 10-12 year period. “The three most important things to look at when investing in a well-established, existing firm are the quality of the management team, who the key value drivers are and how well they work together. For a new fund, the due diligence should also be around whether the managers have [worked] or are capable of working together,” he says.
The ability to generate returns is also a high priority. “There is relatively little difference in the performance of quoted equity fund managers but there is a large differential between the performances of private equity managers making the selection of the better managers paramount,” notes Gripton. “What is important is that managers can work with larger firms as funds move up a notch and deal sizes increase.”
Mounir Guen chief executive and found-er of placement agent MVision, warns that there is a great deal of focus on the performance of the fund and whether it is in the top performing quartile.
“However, looking in the rear view mirror is not always a good indication of future results. Often the most popular funds are also the ones that generate consistent performance. This is why investors need to look at managers who not only have a track record but also have the depth and dynamics to sustain the business model in all market conditions,” he says.
One of the concerns today is that the private equity firm seems to be overrun with financial wizards who can recapitalise their way out of any situation.
This is a far cry from the early days when an industrialist led a management buyout charge and with a bit of luck floated the company on the stock market a few years later. The popularity of private equity has meant that there are more investment banking types filling the ranks but there should also still be a healthy dose of people well versed in industry and commerce.
As Jane Welsh, senior investment consultant, manager research, at Watson Wyatt points out, private equity is not just about financing. “You need managers who can run companies and know the tricks of the trade, particularly at this stage of the interest rate cycle when it will not be so easy to rely on cheap debt. It will be those funds that have managers with industry experience that will have the edge.”
Aerni of SCM Strategic Capital Management adds: “In the current market environment, it has been difficult for any funds, whether they be in the top, second or third tier, to lose money. The big question is how will the fund perform in a downturn? This is why you need experienced managers who have been through a few cycles.” Cunningham also notes that if a fund does go down the recapitalisation route then investors should carefully scrutinise the level of gearing after the deal. “The business will be slightly more mature and the question to ask is if the company is taking on more debt after the recap, is it a riskier asset in the portfolio as a result of the recap?”
Another key area to scrutinise is succession although, as Welsh notes, this can be a sensitive issue because of the timescales and long-term commitment required.
“You want to make sure that the firm has a plan in place that allows the founders to get their equity out while also providing for the next generation. Investors want to ensure that the right people are there for the duration of the investment.”
Although for now there do not seem to be any major reshuffles underway, market observers say they will be keeping a close eye on the old guard in firms such as Blackstone, Alchemy, Carlyle and Terra Firma, to see who they will be grooming for a potential leadership role.
Last but certainly not least is what type of remuneration system is in place, although this depends on the fund size. Management fees typically tend to run in the 1.5-2.5% range, and often scale down in the later years of a partnership to reflect the general partners’ reduced workload.
The management fee is not intended to incentivise the investment team. This is the job of the carried interest, where the typical split is 80% to limited partners and 20% to the general partners. It is normally based on the performance of the entire fund rather than on individual deals, although this is more common in the US than Europe.
Mike Newell, a UK based partner at law firm DLA Piper, says: “The carried interest model often depends on the strategy and focus of both the fund in question and the manager. Retaining key people is one of the main challenges for a private equity firm.
“A small boutique may consider it needs to incentivise principals who do not want to wait 10-15 years to get their money out.
“It might be harder, though, for a private equity team in a large institution to justify a deal by deal structure, for example. This is because large institutions should not have cash flow issues.”