Shifting sands

The future of the private equity industry is up for grabs. The global banking crisis and concurrent recession will force the private equity model to change and firms which resist this change will find it difficult to remain relevant. There are signs that the widely held belief that the current structure of limited partnerships is the most efficient way to align the interests of investors and general partners is giving way as a new economic reality dawns.

Time to innovate

Speaking exclusively to unquote” soon after quitting as managing director of UK mid-market firm August Equity, Andrew Hartley offered up the following opinion: ‘The traditional 10-year, 2 and 20 limited partnership is viable, but I no longer believe it is the only way of using capital and the skill-sets of private equity professionals. We should be looking to more flexible ways and, when people do, the model will be challenged. There has been a lot of inertia between GPs and LPs over the last 12-15 years: strong performance has attracted investors and they’ve come to expect returns of at least 15-20%. But that is not always sustainable and especially not in a downturn. So are investors getting value with this model? Not necessarily.’ While the core private equity business of buying and selling companies will not change, the challenge to the model will come from those firms which question long-held beliefs and methodologies and attempt to innovate.

Holding Periods

The liquidity bubble that gave rise to the private equity boom (along with many other booms) was a once-in-a-generation occurrence. More conservative lending practices and tighter terms mean that cheap and easy refinancings are no longer a guaranteed route to exit. Rising asset prices and growing economies assisted decision-making but more than anything it was the promise of refinancing that led to questionable deals being done for questionable prices over the past few years. Longer hold periods on current and future funds are inevitable, with some predicting a doubling of the three to five year hold, which will drive returns down and, as Hartley says, necessitate a different skill-set. Finding individuals with the appropriate operational abilities will be more difficult than tapping the cream of the investment banking community. ‘Those fund managers whose past performance relied heavily upon financial leverage and that are predominantly staffed with former investment bankers will find it more difficult to create value in portfolio companies in the changed environment,’ says Mirko Jovanovski at CAM Private Equity. David Currie at SL Capital Partners says that his firm will be ‘looking for those funds more orientated to operational improvement.’

If hold periods increase to the extent some are forecasting, the traditional fund lifespan of 10 years will need to be adjusted. While John Gripton at Capital Dynamics argues that the current structure is ‘flexible and almost all of them incorporate a two or three year extension period,’ others believe it increases the pressure to sell. ‘The traditional ten-year lifespan is not completely efficient as it can force you to sell a company too soon and of course you can incur huge transaction costs doing so,’ says Sam Robinson at SVG Advisers. To mitigate this pressure, some firms are looking at increasing the lifespan of their up-coming funds. Altor Equity Partners courted controversy among the LP community recently with the terms of its new fund which has a fifteen-year lifespan and an interim carry structure. While a fifteen-year structure can ease the pressure to exit, the downside is the increased cost to the LP in management fees. As the bulk of the work often goes into a deal in the first few years charging the same level of management fees on a fifteen year fund with the rationale that the increased length is necessary to continue to improve the company may be a difficult sell for a GP. Gripton sees a more fundamental problem. ‘The danger is that a significantly longer lifespan will damage the IRR to the point where private equity funds won’t outperform the public market. For this reason I would be reluctant to see the model tweaked.’ These tensions between GPs which want to increase the flexibility of funds in order to manage investments during a downturn and LPs sceptical about motivation and impact on returns are likely to increase as GPs attempt to navigate the downturn with changes to fund structures.

Carry issues

Interim carry is a contentious issue because it is perceived to disrupt the alignment of interest that the fund-as-a-whole carried interest model creates. While some LPs are sympathetic to the idea (Robinson says sometimes it may be necessary in order to recruit new talent and incentivise them) others are less understanding. ‘We prefer it if structures are performance related and for this reason interim carry is not something we like to agree to,’ says Peter Cornelius at Alpinvest. In the case of Altor, the documentation allows the firm to lock-in a return and claim carry based on a pre-exit valuation on select assets it believes have further growth left in them, thus taking a deal-by-deal carry model and moving it further toward the interest of the GP. One can see how GPs may use the downturn and the resultant difficulty in striking deals as an argument to support interim carry. With demand for operational expertise on the rise and supply relatively limited interim carry may be necessary to entice operational specialists away from a position bringing in regular income.

Although a more challenging environment for private equity may be used by GPs to tweak terms and conditions in their favour, it could also provide an opportunity for LPs to negotiate more favourable structures. ‘It was difficult to influence terms previously because the best-performing funds had fairly limited access so if LPs were being too aggressive on terms they could be excluded. In this new environment LPs will try to improve terms to some extent,’ believes David Currie at SL Capital Partners. Cornelius says that ‘no matter how good the track record it will be challenging for private equity firms to raise funds of the same size as in the previous cycle,’ and the extent to which LPs will be able to influence terms is likely to depend on the reduction in available capital and the flight from the asset class. ‘Investors who came into private equity late, in 2004 or 2005, may be more inclined to reduce exposure to private equity – you have to be there over the cycles (to get the full return benefits),’ believes Gripton.

Forced changes

If only the more recent and perhaps less-sophisticated investors get spooked, movement on terms will be difficult and the ball will remain in the GP court. However, the longer the banking crisis and the deeper the recession the greater the number of investors likely to pull their private equity fund commitments. In this scenario, GPs may have to make more concessions to the increased level of risk and illiquidity a private equity allocation will represent. In addition, some LPs may also have modelled returns based on the high level of distributions of recent years and falling distributions combined with declining public markets may cause private equity allocations as a percentage of a portfolio to rise. Robinson says that in ‘2002-2003 it was an extremely common occurrence for LPs to be overweight on private equity because of the out-performance of private equity relative to the public markets.’

A further challenge for private equity firms to overcome is the changing pension fund landscape. ‘One of the biggest sources of capital in the past has been pension funds, particularly defined benefit schemes. With these being wound down and defined contribution schemes required to invest in more liquid assets private equity firms may have to look at changes to fund structures (to capture the defined contribution capital),’ says Currie. Listing a private equity fund or trust is one way around the problem of illiquidity and some believe this is where the future of private equity lies. ‘There is a supply-side imbalance and as a result the energy is moving from the private to the public market. It is a mystery why LP funds have ten year terms. You end up with two five year cycles, first the initial investment cycle and then the liquidity phase. This warps the business strategy and can prove especially problematic if the economy slows down,’ believes Frank Ballantine at Reed Smith Richards Butler.

Update to outperform

Private equity firms will need to think practically and creatively about the challenges the fund model is up against. In practical terms the model has to continue to align the interests of LPs, GPs and management teams and generate sufficient revenues for all. Creative thinking will be necessary to determine whether the existing model is still relevant in a much-changed economic and deal-doing environment and, if the model is not relevant, how it should be changed. Some of this creative thinking will have to be reactive and will depend upon the extent to which traditional sources of capital dry-up, requiring new sources to be sought out and new (perhaps more liquid) vehicles structured to accommodate them. Lifespans and carried interest regimes will need to be reconsidered to take into account longer hold periods, the new set of demands placed on fund managers tasked with creating value and the difficulty in recruiting (and retaining) individuals able to create value. Those firms which marry successful reactive policies to insightful proactive strategies, whether that be targeting new geographies, employing new methodologies or trail-blazing in uncharted sectors will be the outperformers of tomorrow.

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