Ten or 12 funds set to dominate

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While current times appear to be a golden environment for private equity, is it a one hit wonder? That was the question asked by Terra Firma’s Guy Hands at the recent Super Investor conference in Paris in and discussion on the possible regulatory threats to the private equity industry was one of the dominant themes of the conference.

The great success of the private equity industry over the last few years has led to fund sizes rising by an order of magnitude in many cases, without necessarily more than a doubling of staff numbers. Needless to say, fees have remained largely unchanged, resulting in immense wealth being generated for the owners of many private equity firms.

Hands pointed out that investment values for private equity firms are trading at between one third and one half of the funds under management so if you raise a $5bn (€3.77bn) fund, it is worth $1.5bn, so you can earn more by taking the private equity company public than you can from fees!

It is no wonder that the private equity industry is now concerned that its public profile is increasing in ways that may not be attractive, and the political fallout might lead to unwanted regulation having an impact on the very characteristics that differentiate private equity from public equity.

A key attribute of private equity that is often argued as one of the contributors to it outperforming public markets, has been the lack of the enforced regulation seen in the public markets. For example, the onerous requirements for quarterly reporting, which often leads to short-term thinking as well as the increasing corporate governance burden.

Private equity firms are also able to incentivise management through pay structures that would be deemed unacceptable in the glare of the public markets.

Jos van Gisbergen, the director of alternative investments at Mn Services in the Netherlands, made the point that comparing public markets to private is like having two football teams playing, with one, the public markets, having their arms shackled and wearing chains, so it is not surprising that the other team wins. However, with bigger targets for acquisition by private equity firms, it also means greater visibility and as Alchemy’s Jon Moulton pointed out, some industries such as UK retail are dominated by private equity.

Indeed, 20% of the workforce in the UK works for private equity owned companies and it is now double figures in Europe. Key issues of concern include the fact that public to private transactions are reducing the size of the public markets; the reduced level of corporate governance in private equity, although the companies are owned ultimately by essentially the same institutional investors; and taxation consequences to governments as interest payments from private equity debt is paid out to non-tax payers leading to a net loss of revenues.

While media attention is often focused on the attractions of venture capital for stimulating new growth in mature economies and as a result, venture capital tends to be extremely popular with politicians, it is only a tiny proportion of the private equity market and becoming increasingly less important.

For Moulton, regulation is the enemy of enterprise. It is expensive although he sees no evidence of abuse and instead views the current trends to increasing regulation in private equity as a steamroller slowly going over the industry. He bemoans the fact that private equity is often lumped with hedge funds in the
alternative investments category.

Hedge funds, he argues, are more likely to see abuses as they pay
bonuses on valuations rather than realisation. But raising the debate is essential if private equity is to be
used to stimulate vibrant economies without falling into some sort of structural cul de sac of exorbitant
fees and tighter regulation.

As Delta’s Patricia Cloherty argued, it is a “mistake for any industry to take refuge in sanctimony”. Indeed, the higher profile for private equity in Germany achieved through the debate over whether private equity firms are locusts, stripping companies bare, led to more managers becoming interested in private equity and more deals being done.

But there are a number of areas where both limited partnerships (LPs) and general partnerships (GPs) raised
serious concerns during the conference. Transaction fees for example, were viewed as “obscene” by one leading LP, “with GPs getting transaction fees and making a fortune before LPs get a return”.

The FSA in a recent report did raise a number of concerns including the weight of money, pressure on returns and leverage levels. But should private equity be subjected to increasing scrutiny regarding possible market abuses?

Club deals will raise concerns about collusion and have not been helped by comments from leading commentators from mega buy-out firms declaring that if you are not part of the magic circle you are irrelevant. But do club deals reduce competition? Commentators argued that consumer legislation is being used for corporates.

Hands viewed private equity as facing a number of key threats: the growth of infrastructure funds he sees as “very scary as they have big war chests” but many are charging higher fees than private equity firms, and bidding higher levels which will drive down returns until something goes wrong, which is “when the regulators will step in”.

He said that infrastructure funds have become the latest fashion accessory, even though infrastructure investment is the same as project finance which has always been around, and has
not had good returns as the Eurotunnel experience has shown; regulation is a growing threat and one that will not go away. Hands pointed out that governments can regulate through ways such as tax deductibility of interest payments and good will write-offs;

The huge wealth being generated by private equity firms for the partners is also leading to an increasing misalignment of interests between LPs and GPs.

The huge compensations through fees alone means that the motivations of participants have changed, according to Hands. Now private equity is like a casino, the first class get the free room, meaning good co-investment opportunities and no fees on them; the second class get free food, meaning good access to co-investment but having to pay fees; while the third class just pay, which in private equity terms means paying fees for bad deals. So what do you do?

For Hands, the options are to either relax, invest in mega funds and hope they will do club deals; head for the bridge ie take your winnings and go for the public markets; or look for
GPs with transparent alignment of interests between managers and the investor. But where is the market
heading? Wim Bergdorf of AlpInvest, one of the world’s largest private equity investors and responsible for the private equity investments of ABP and PGGM, argued that the segmentation of the market is here to stay. By 2010, market segments greater than $1bn will make up 75% of the invested volume in private equity.

Ten to 12 firms will dominate that space so there would be a huge concentration ahead. How do you place bets in that kind of world? In terms of returns, the dispersion of returns will be fundamentally different between the mega buyout firms and the small and mid-cap. In the small-mid cap, you have a huge number of operators with very different strategies so it is natural that the wide dispersion of returns will continue. But is its very different at the mega end.

The number of operators will be very small at 10-12 and more importantly; the targets will be a lot of public companies that will go private, with stable assets and predictable cash flows.

These can be invested via a syndicated process in a small pool of participants, so that the distribution of returns will go dramatically down. As an investor, you need to develop a strategy, as investment in mega funds will be like investing in an index fund, so a dramatic change is likely from existing paradigms.

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