The 2007-09 crisis has had visible and long-term consequences on the small world of private equity, writes Cyril Demaria

If anything illustrates the relative state of denial in which private equity continues its activity since the financial crisis, it is the advent of dividend recaps in 2010.

The principle of dividend recaps is simple: a private equity general partner (GP) acquires a healthy company through a leveraged buyout (LBO). Theoretically, this company should be sold after a few years, which, in fact, was not possible because of the past crisis. With the leverage effect decreasing over time (the debt of acquisition being regularly repaid), there is still the option to re-leverage and distribute ‘anticipated profits' to limited partners (LPs).

Theoretically, dividend recaps are putting everyone at ease. GPs can please LPs with distributions, and hence prepare comfortably their next fund raising. The underlying company has no right to voice any concern, but its management is relatively pleased to avoid any additional pressure to find a trade buyer which does not exist at that time. The LP gets cash in a period when liquidity and rates are low.

In 2010, $234bn (€162bn) was lent for leveraged loans (versus $77bn in 2009) according to S&P LCD. Some 84% of these loans were granted to distribute dividends to private equity funds. Clearwire Communications and HCA, among the largest LBOs of the 2006-2007 bubble, were the target of dividend recaps. It is probable, however, that 2011 will bring a correction.

Dividend recaps have two main consequences. The first is to reintroduce risks in LBOs. In a classic LBO structuring, the highest point of the risk is during the first months, when financial leverage is high. Theoretically, this risk is compensated by the added value which will be created by the investor. Re-leveraging is not compensated by additional value creation - it is a ‘wait-and-see' solution. The default rate of high yield bonds has evolved from 13.6% in 2009 to 2.9% in 2010 and Moody's projects a rate of 1.8% as of November 2011. If economic growth lags, meanwhile, this default rate might well increase - and re-leveraged companies will be the first to be hit. This risk is not compensated by an additional return potential.

The second aspect is that these dividend recaps have the inconvenient capability to ‘break the return thermometer', that is to say to suddenly skew one of the private equity fund return measurements: the internal rate of return (IRR). A small example shows that an anticipated cash distribution by a dividend recap can simultaneously increase the IRR and impoverish the investor: the investor realises an IRR of 20% and multiplies his investment by three, when the investor who realises an IRR of 26% multiplies his investment by 2.5.

The classic answer of general partners is that LPs will always prefer liquidity to increased performance. This remains to be proven. First, there is no guarantee that the LP will find an investment opportunity performing at the same level as in the example.
Second, the transaction costs to find and invest in an LBO of the same quality will lower the overall performance of the LP's portfolio.

CalPERS is no longer your friend
The evolution of the attitude of private equity investors is the second major factor. LPs do not want to pay fees which are, according to academic studies from Harvard Business School and HEC Paris scholars, capturing the performance created by LBO investments. Large American institutional investors such as CalPERS have already started to adjust, notably by buying stakes in GPs with whom they have invested considerable amounts. This allows them to get a share of the management fees without forcing the general partner to lower these fees (notably through the application of the ‘most favoured party' clause). Other investors have requested the set-up of co-investment programmes or asked GPs to manage segregated accounts.

So the trend is towards pre-defined budgets and progressive carried interest (which grows with the realised performance), and away from percentages of assets under management. GPs will need to align themselves with that trend if they are to attract LPs. On the other hand, the best are are already attracting too much capital and will continue to set up conditions which are favourable to them. The result could be a dual system of private equity fund management.

Funds of funds at the crossroads
Funds of funds are the great losers of the crisis. They have not attracted larger institutions for some time and are now experiencing an obvious lack of legitimacy. They will probably be the first victims of the ‘war on management fees' that GPs are anticipating. Returns are declining and one of the surest ways to preserve a certain return is to reduce management fees (which are 0.8-1.0% of assets over 13 years at the moment, plus 5-10% carried interest).

We see a response to these pressures already. APG and PGGM have sold AlpInvest (a private equity fund of funds manager running $32bn) to a joint venture between Carlyle and AlpInvest management. This, in turn, should help to fuel the listing project of Carlyle, which is less diversified than its competitors KKR and Blackstone. Other GPs, such as Apollo in the US, are also preparing for listings.

This is a race towards large size. AXA Private Equity has been a frontrunner with the acquisition of portfolios from Bank of America and Natixis in 2010. With Basel III toughening bank solvency ratios and the Volcker rule limiting the stake of banks in GPs to a few hundred basis points, we can expect this to be just the beginning of the trend.
The targets are not lacking, either because they do not have the critical mass (Unigestion, Adveq, FondInvest, SCM, Alpha Associates, Capvent), or because they have weathered difficult times (Capital Dynamics has lost one of its main mandates) or both (see Access Capital Partners' involvement in the ‘pay-to-play' scandal in the US). Quite a few have not raised funds for some time, which questions their value-add. Moreover, they do not benefit from any special treatment due to their reduced risk profile under Basel II or III, nor under Solvency II.

Regulatory inflation
The advent of the AIFM Directive in Europe, but also of the Foreign Account Tax Compliance Act (FATCA) in the US, should bring some additional changes. GPs argue that multiple regulations (Basel III, Solvency II, AIFMD, Volcker rule) will dry up the sources of private equity financing, and hence of private companies. Given that banks have severely reduced their exposure to SME lending, any change in the capital flow towards SMEs could have considerable consequences on already anaemic economic growth.

The consequences of the AIFMD or the FATCA are not yet fully known, but it is probable that they will result in a massive and durable slowdown to the emergence of new GPs due to costs, and the temptation to go around the regulation either through innovation, or by exploiting loopholes. The latter might remind us of what happened in the past with junk bonds and securitisation: the misuse of interesting innovation to circumvent legislative excess, which leads, finally, to another crisis.

One of the unexpected consequences of the regulatory changes from the mid-2000s is a strict avoidance of IPOs. The development of private markets - SecondMarket, NYPPEX and Fidequity, for example - has allowed certain private companies, such as Facebook and Groupon, to avoid IPOs. Investors are rushing to participate in private placements. Groupon, once rumoured as a $6bn acquisition target for Google, has raised $500m with the option to raise additional $450m. With this private liquidity available, an IPO is not necessary.

The emergence of private markets offers the possibility to get liquidity for existing investors. Of the $500m raised by Groupon, $345m was reserved for the exit of current investors. Facebook investors used SecondMarket to exit from their investment. Private companies can also keep their key employees in the firm if private markets allow existing investors to exit, they are not facilitating the exercise of stock options and do not offer sufficient liquidity to handle the resulting shares. Staying private hence becomes a competitive advantage against public companies.

Back to basics
GPs will have to face the consequences of a major trend - the decrease of future returns. In LBO, this will force GPs to extract most of the value of their investments, and will put many out of business - it is estimated that 20-40% of LBO teams could disappear over the next few years.

In venture capital, European (and even North American) under-performance is structural. Seed investing did not recover from the internet bubble burst of 2001-03. Incubators have almost totally disappeared, and seed funds barely attract investors due to lacklustre returns. According to Thomson Reuters, the average performance of early stage venture capital funds was -3.8% as of the end of 2009, versus -2.2% for venture capital. Median multiples of investment were respectively 0.85 and 0.9 times. Start-ups are valued at notoriously high levels. Government measures in favour of direct investments in SMEs from individuals in certain countries, for example, can only strengthen this vicious circle - and hence reinforce the problems of venture capital funds.

As for the temptation to go into Asia, the experience of past failed diversification of general partners during the internet bubble should be a very clear warning: private equity is a local business. LPs surely remember clearly the excesses of the internet bubble. It is now time for GPs to look into the problems and make the necessary efforts here and now.

Cyril Demaria is a professor at the HEIG-VD, Switzerland, and the author of ‘Introduction to Private Equity' (Wiley, 2010)