OK, you gotta help me. Private equity is basically levered equity. Yes, the claim to add value in various ways, but many academic studies question that theory. The big source of profits is leverage and financial engineering. Neither of those approaches were spectacularly successful in any sector I can think of in 2008.
In addition, many PE firms have companies in their portfolio that are in a world of hurt right now, due to a combination of fundamentals that fell off a cliff, high debt loads, and in many cases, debt maturing in the next year or so.
So how can PE companies (on average) possibly report returns that are better than equity averages last year? It strains credulity. Leverage cuts both ways, and it most certainly would not, in most cases, have done PE owned firms much good last year.
And making the expected mere 20-30% losses (versus public market declines of more like 40%) comes when PE firms are held to more rigorous standards in valuing their holdings. That alone should have a return-depressing effect.
To its credit, the Financial Times article does say the losses could be considerably worse than the rumored level.
From the Financial Times:
Private equity firms will in the next few weeks send their investors grim letters telling them just how much – or little – the companies they invested in are worth today, with many executives saying the reported fall in value will be 20-30 per cent.
According to regulations that are applied this year for the first time, private equity firms are required to value their companies at what they would be worth in the market today rather than merely disclose the original cost of the investment.
By some calculations, the actual losses could far exceed 30 per cent, since many of these companies were bought and taken private at the peak of the financial frenzy. In many deals – particularly ones struck in 2006 and 2007 – private equity firms paid a 25 per cent premium to public market levels to take their targets private.
They then put massive amounts of debt money into their companies, suggesting the drop in value should be more like 60 per cent, some industry experts estimate.
With public markets down about 40 per cent, the equity may well be worthless today – save for the fact that the private equity firms have years to try to restructure and restore value to their companies.
Once year-end figures are known, many cash strapped investors, themselves reeling from losses, are likely to put more pressure on private equity firms to refrain from doing deals that would require them to write more big cheques.
These investors are also expected to dump more of their private equity holdings in the secondary market.
In the dot-com bust, investors demanded that venture capital firms reduce the size of their funds (my recollection the shrinkage was on the order of 50%), which a dramatic reversal of fortune for the funds, since most tried to cover their overheads and salaries with the management fee (the 2% of the typical “2 and 20” formula). And of course, in that environment, upside fees were pretty much non-existent. Most business don’t cope well with a 50% cut in what they took to be annuity revenues (and more like a 90+% fall in top line when upside fees are included)
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I estimate 50% losses, via the simple calculation that they still have the “private” part, but the “equity” part is long gone. :-)
I lived through the dot-com bust having had my tech company purchased by a PE firm (CD&R). I lost out big time, but I have to say that CD&R had a big impact on strategic decisions, and I would say in a very positive way. Before cratering, I spent several years working on a very important project, and I thought the PE folks were brilliant, thoughtful, demanding and appropriate.
regarding VC, I also have done VC financing, and my contacts in that business tell me that capital is extremely scarce. They are quietly consolidating their capital into a couple of already established winners, so as not to half starve every company in their portfolio. They are encouraging companies to go slow, conserve cash and pick things *not* to do.
For companies not yet funded, they say to you: there is no funding. VC's value serial entrepeneurs, so I am sure there are some people who can get funded in this environment, but for everyone else it is winter.
I would be guessing, but I think the fall is worse than the dot-bomb slow down, and is more reminiscient of the late 80's.
VC is the most cyclically funded finance sector, and I disagree with your "don't cope well" hypothesis. at least for the top tier.
The party is starting Merckle just stepped off the ship holy *@&@&%^#% and he was one of the good guys of capitalism. Why is it the madoffs stick around, where the productive Merckles go for dimensional travel when their house burns down. Go figure.
Skippy
bg,
Curious what are you doing now? Are you in a venture or just taking it easy?
One of the way to not report the actuals is to invest in out-of-the-way places and things that are virtually impossible to value objectively.
For example, a major private equity firm had one of these investments in China, where basically they where physically tossed out on their ears when they tried to “take control”.
That “investment” is probably still on the books at their cost or higher.
D
I am at a big tech company now. Not taking it easy (I would die in retirement), but it is a lot easier than startups and LBO. I am not a 1st tier player, but still happily a player.
bg,
CD&R has long made it a point to sell their operating expertise, and they do have a lot of former executives who appear to have gotten their hands dirty in their stable. But they also did deals like Hertz, where they in a very short period of time (9 months or less) dividended out so much cash that it made for a great deal and pretty much wrecked the company. So I am not sure I trust the records even of the ones that do have reputations as operators.
I don’t know about these “more rigorous standards.” I know that hedge funds are being held to more rigorous standards regarding their illiquid and private investments because there are fee and liquidity issues, but based on what I see that same standard is not being applied to PE firms. I know of a firm with a particular fund that should be down 50%+ for ’08 that’s going to report a 30%-ish decline. The reason I’m being told auditors aren’t being as hard on private equity valuations is that (1) the money’s locked up for long periods of time, and (2) management fees for most PE funds these days are calculated on COMMITTED capital as opposed to net asset value or invested capital for the first five years of the fund. Therefore, the auditors reason, it doesn’t really affect the LPs too much if the valuations are too high (other than that the returns they have in their mental accounts are wrong)… so why push it?
The same cannot be said of hedge funds, in which the valuations affect management fees and might affect whether or not the LPs decide to bolt.
ys,
I lost a lifetime of earnings with the help of CD&R, so I didn't mean to defend them or the industry. I just wanted to share my personal experience that some of their claims are not window dressing. I will defend VC more vociferously, as I am am certain of the value they have created.
If the PE losses are understated, then many endowments and foundations have understated the magnitude of their losses. Yale, for example, seems to be dramatically lowballing its loss estimates.
Mark-to-fantasy accounting. They may say they have strict accounting standards, but most of any PE firm’s assets are unlisted companies. There *is* no market value; generally there’s not even a rough approximation, so the PE firm is basically forced to invent number. Obviously in current circumstances they’ll invent generous numbers.
This month’s Vanity Fair has a funny (nauseating?) article about this subject:
http://www.vanityfair.com/politics/features/2009/02/wolff200902
A lot of the PE deals over the last 2 years had covenant light debt, which is basically equity now. So the leverage may not be as high as stated.
Nevertheless, clearly a 30% value decline is too low, as indicated by poor secondary market valuations. The secondary market sales are the real leading indicator of the hell about to ensue. A limited partner in a fund cannot generally afford to decline a capital call, as he gets seriously ground on his previous investments in that fund. However, a buyer in the secondary market doesn’t care about sunk capital (it wasn’t his money), and will invest or not on the basis of go-forward economics.
Most funds, I’ve been told, have no right to prevent secondary market sales, even to non-creditworthy counterparties. So, basically, a PE fund is calling capital only if desperate because it doesn’t know if LPs are going to step up or not. (Actually, I think they do know, but don’t like the answer).
Gonna be carnage. Couldn’t happen to a nicer bunch.
By the way, I don’t think this is cyclical. Not only to PE fund managers make 2/20% fees, but they pay 20% of gains to the managers of their portfolio companies as well. I think, in a delevered future, there’s just too little juice to go around for this compensation scheme to work.
Canadian Biz channel: BNN
Show: Squeezplay, Dec 6 episode (online)
Kevin O’Leary is a HNW individual active in investing. Last night He reported from West coast after talking to a PE firm there.
According to the guys at the firm, they expect 25-40% of PE firms (or was it companies?) to go under, and that there will be heavy losses and lots of bankruptcies of the portfolio companies.
So, he wanted to get a hold of the debt of these companies, as the debt holders will become the new equity holders.
That might be a good idea. Anyone know how a smaller guy could get a hold of that? Any fund that might go hunting for bargains there?
Just a thought.
Will
I suspect the infamous shenanigan of borrow a ton of cash then issue a special dividend to the PE firm has helped to shield them from some of the losses as the PE firms were realizing gains within the first few months of the deal, of course at the cost of permanently crippling newly acquired company with a mountain of debt. I doubt any of the PE hold any equity in most of the existing over levered portfolio companies
One area PE firms generally did not put high investments in was financials (yes there was Bonderman in WAMU, but that was the exception). I think the Finance sector of the S&P 500 performed worse than the Non Financial in 2008 so PE could perform better simply because generally they avoided, maybe by luck, the worst performing sector.
Anon 12.15: Is Warburg Pincus’ two yards in MBIA also an outlier?
Add TXU, Toys R Us, a ton of other garbage deals that don’t make sense anymore. The Bell Canada buyout firms probably thank their lucky stars every day that they didn’t have to close that either.
The publicly listed private equity funds were down over 60% in 2008. PFP and PSP.
Another excellent post.
More of very good commenting– with nothing to add here.
The thrust of the story is basically correct. Although people generally underplay the extent to which PE valuations are stale (meaning out of date) and are reliant on heroic sets of assumptions. FairEconomist says it exactly right – tough and MTM accounting standards does not mean nearly the same thing as most people think it means.
Macnub misses several of the key points. e.g. The extent to which deals are “cov-lite” has no relation to the leverage in the deal. The term reflects the number/tightness of the terms which govern the debt and therefore reflects the ability of the lenders to influence/exercise control over the company’s managers/equity. This might limit the number (or at least timing) of PE portfolio company defaults but is relevant to estimating the value of the equity in the company.
Almost every LPA gives the GP control over the transfer of an interest from one LP to another. PE funds are in an enviable position wrt capital, they only need to call after an investment has been made. If they think their LPs can not meet their capital calls (which is a massive issue in the industry) they simply do not need to execute the transaction. (Yes, there are a limited number of transactions that might have been made before the extent of LP problems was clear).
While secondary buyers might not care alot about the value of the existing portfolio, they certainly might take it as a good indication of the ability of the GP to select good investments and manage the portfolio.
Again, the basic thrust is correct, on MTM earnings are down on 2007, valuations have fallen in public market comps, and leverage is higher than in comp public markets. Therefore valuations could/should take a strong hit. That said, figuring out by how much an asset would be sold if it had to be sold is a guessing game. Most economic theory is based on prices transacted between the marginal willing buyer with marginal willing seller. Asking the holder of the asset to estimate what others might pay for a similar asset IF it were sold is a different story entirely. Ask oil companies about the calue of their reserves in the ground; insurance companies about the value of customer’s assets; or municipalities about the value of a taxpayer’s real estate.
Macnub misses several of the key points.
Maybe.
The extent to which deals are “cov-lite” has no relation to the leverage in the deal.
Not legally, but economically, it makes all the difference in the world. Cov-lite terms reduce the ability of bondholders to exercise their rights, which increases the risk of the bond to be more equity in nature. That’s what I meant by cov-lite bondholders being the equivalent of equity now… the degree of economic leverage is less than the degree of accounting leverage, particularly after the market value of equity blasts through the zero bound (as the BCE deal would have been on day 1).
In the limit, for example, PiKs (payment in kind) deals are pure equity risk.
Almost every LPA gives the GP control over the transfer of an interest from one LP to another.
Here we are at an impasse. My source assured me the opposite (with a few exceptions). I may well be wrong here, but I pressed him hard on this, rephrased different ways, because I just couldn’t believe it. He told me, basically, “Yup.” Have you heard of secondary deals that failed because of a GP veto? Or secondary investor qualification by selling LPs?
While secondary buyers might not care alot about the value of the existing portfolio, they certainly might take it as a good indication of the ability of the GP to select good investments and manage the portfolio.
Agreed. But economically rational actors (unlike human beings) don’t care about sunk investments. Secondary market purchasers are more economically rational than founding LP investors
because human beings care very deeply about sunk costs. The fact that secondary purchasers are more rational should be terrifying to PE funds.
That said, figuring out by how much an asset would be sold if it had to be sold is a guessing game.
Agreed, until the value is a low value of zero (in the sense that 2+2=5 for high values of 2 and low value of 5; an 80% leverage deal which has fallen in value by 40% has equity valued at a low value of zero), which should make up a lot of highly levered deals right now.
Macnub,
Thanks for taking the time to respond.
Macnub: Cov-lite terms reduce the ability of bondholders to exercise their rights, which increases the risk of the bond to be more equity in nature.
But I still disagree on this point. Cov-lite does limit the conditions under which bondholders can excercise their rights, which might increase the risk that the recovery of the bonds is lower. But that does not make the instrument more equity like. It just lowers the value of the bond. The investment risk might be more like equity but the nature of the control ( as you pointed out) is definitely not more equity-like (the same goes for mezz PIK).
Macnub: Have you heard of secondary deals that failed because of a GP veto? Or secondary investor qualification by selling LPs?
Phrased in this way, the point is closer to the truth. All LPAs give the GP the right, but it is fairly uncommon that it is exercised. That said, I am aware of a few instances where it was invoked. And in many cases there is no need to technically invoke it because a preliminary conversation between a secondary buyer and the GP makes the potential for a transaction clear. The effect of all of these restrictions (and others) leads to a relatively inefficient and therefore opaque secondary market.
But more importantly, while GPs have clearly slowed investments in Q3/Q4, and in some cases renegotiated commitments with LPs, they will call as needed. GPs will however actively speak with LPs to try and avoid any defaults. That said, I agree that there are a lot of severely capital-constrained LPs out there.
Macnub: The fact that secondary purchasers are more rational should be terrifying to PE funds.
The impact of capital-constrained LPs selling commitments has made this issue a very interesting one. Although PE funds have traditionally been thought of as long-term investments where interim valuations don’t matter will be eroded as sales begin to make clear what those valuations are. Whether the much-vaunted illiquidity premium that used to be the basis for PE returns will disappear or be reinforced as a result will be interesting to observe.
I’m not sure if I understand your final point. But as was mentioned previously by conservative and reasonable valuation methodology many of these deals might are likely not worth much more than a fairly far out of the money call option. The point is, let’s see if that’s how they are valued.
GPs will however actively speak with LPs to try and avoid any defaults.
Agreed. Many GPs have told me the same: they cannot risk calling right now. Makes me wonder what the private equity value proposition really is, if the capital isn’t there through thick and thin.
My final point is that many of these equity investments are clearly worthless, and not by a little bit. Those are easy to value, if anybody had the incentive to mark them. Of course, nobody does: certainly not the LPs.
It just lowers the value of the bond.
True, and increases the volatility (beta) to more equity-like levels. I think we’re both right: you looked at equity in terms of control (which is appropriate), and I looked at it in terms of risk and volatility.
I too find the impact of cash-poor LPs interesting. What I do know is that GPs are not nearly as long-term in nature as they think they are. I can’t tell you how many times I’ve heard, “We’re long term investors with a 7 year hold.” Yeah, that’s forever to a 25 year old PM, but a pretty short time for a startup business.
Therefore, I surmise that interim valuations are suddenly going to really start to matter.
Thanks for your insight.