Bloomberg News has an excellent round-up of recent figures of the private equity space: ‘Golden Era’ May Elude Private-Equity Investors as Prices Rise.
Private equity firms (especially the “mega funds” of $5 billion and above) have now significant amounts of money to invest, as in half a trillion dollar. These funds come with a “due date” on them: most funds were raised in 2005-2008 with an investment period of 4-5 years, meaning that this dry powder is going to “expire” in 2010-2012. Only invested funds will earn a 2% management fee when the investment period ends, which creates a perverse incentive to invest at any cost.
Finally there is a major supply and demand imbalance that is building up: when the time will come to realize these investments (made when funds needed to invest a lot of money) in 4-5 years, there won’t be as much “dry powder” floating around, given a 70% plunge in private equity fundraising that is now back at “new normal” levels of 2004.
As unlikely as it may seem, there is still a massive slack in the private equity industry (again, especially in the large LBO market) that will take another 4-5 years to work out.
As banks evolve to become government-regulated utilities, private equity firms and hedge funds will have an even harder time securing financing for their investments.
The specific points at issue are ownership or sponsorship of hedge funds and private equity funds, and proprietary trading — that is, placing bank capital at risk in the search of speculative profit rather than in response to customer needs. Those activities are actively engaged in by only a handful of American mega-commercial banks, perhaps four or five. Only 25 or 30 may be significant internationally. Apart from the risks inherent in these activities, they also present virtually insolvable conflicts of interest with customer relationships, conflicts that simply cannot be escaped by an elaboration of so-called Chinese walls between different divisions of an institution.
If this re-regulation process continues, private equity funds and hedge funds will need to adapt their business model to a “new normal” where debt financing might be scarce. Or the new regulations will open up a space for investment funds focusing on providing debt for “speculative” activities.
Applying boring checklists to the investment process works. “Airline captains”, or those investment professionals in venture capital, private equity or stock investing that adopt a checklist method in their investment decisions, have a better track record because they control better our brain biases and common misperceptions.
Sure enough, when Smart tracked the venture capitalists’ success over time, it became clear that the airline captains had by far the most effective style. Those investors taking the checklist-driven approach had a 10 per cent likelihood of later having to fire senior management for incompetence or concluding that their original evaluation was inaccurate. The others had at least a 50 per cent likelihood. The results showed up in their bottom lines, too. The airline captains had a median 80 per cent return on the investments studied, the others 35 per cent or less.
For sure it is a tough sell, but I believe that using a methodical checklist-based approach helps guide our primitive brain to make complex decisions.
Big buyout firms need to reinvent themselves because their investors are not going to pour billions into their next funds after the bust of the LBO boom and related losses.
So Kravis of KKR says:
The days are long gone when you just buy a company and hope that financial engineering will work. Our job today is to create value. Private equity, to me, is acting and thinking like an industrialist.
Firms like KKR are thinking about tapping the public markets to raise permanent capital for their equity investments and move to a more “berkshire-like” investment model. Until now private equity firms would raise closed-end funds with a predetermined life time, usually 10-12 years, which entails launching a new fund raising process every 4-5 years (a few notable expections are evergreen funds, such as Golden Gate Capital’s).
Let us see if the public equity market is going to be more foregiving than institutional investors. I don’t see why it should be.
Candover has agreed with investors to terminate the €3bn ($4.5bn) buy-out fund it raised last year, turning the group once considered the gold standard of European private equity into the industry’s first big victim of the credit crisis.
Private equity firm TPG got a heavy tax bill from Australian government.
MELBOURNE, Nov 25 (Reuters) - Australia’s tax office has hit U.S. private equity group TPG [TPG.UL] with a $628 million bill for tax and penalties, in a dispute that threatens to deter further foreign investment in the country.
TPG last month sold its stake in top Australian department store chain Myer (MYR.AX) in an initial public offering, netting a profit of A$1.58 billion ($1.46 billion). The dispute centres on how to tax those gains.
The Australian Taxation Office’s claim hinges on two issues: whether private equity asset sales should be taxed as a capital gain or as business income, which would mean a higher rate, and whether TPG’s structure using tax havens was designed to avoid tax.
It is shocking how much money is spent in the private equity industry on tax advisors and consultants to structure deals in supposedly safe tax-friendly countries, just to discover at the end that it is useless and damaging.
The value of simplicity is vastly underestimated.
The effects of the booming years of the credit bubble 2003-2007 will take a long time to work through the system. Issuance of leveraged loans and commercial real estate mortages increased 2x and 4x respectively during the bubble, and are now coming due.
From the Financial Times Wall of US maturing debt threatens to extend crunch article on November 12:
About $2,700bn of commercial mortgages comes due in the next five years, peaking in 2011, and $1,500bn of leveraged finance debt comes due, peaking in 2014. The pattern of contractual debt maturities is front-end loaded for commercial real estate and back-end loaded for leveraged finance debt.
After the leverage buy-out frenzy of 2003-2007, even the equity market will face a wall of “equity coming due”. Since private equity funds have a life of 10 years, that can usually extended by 1-2 years, management teams will have to divest their companies and wind down their funds. A market with many sellers and fewer buyers (because private equity fund raising tumbled and will not go back to pre-bubble levels for a long time) will put pressure on valuation multiples and bring a lot of investments in negative equity territory, as leveraged loans and mezzanine financing weighing at 5-6x EBITDA at entry are still there, on poor cash generation and lower EBITDA.
