Tuesday, October 2, 2012

Too Much Is Never Enough

Bain Capital holiday card, 1693
Villager: “How can we find a samurai we can pay with only rice?”
Gisaku: “Find hungry samurai.”

— The Seven Samurai

The private equity industry has a problem.

And no, by a problem I do not mean the Presidential candidacy of one of its former grandees and the unwelcome proctological scrutiny which that has called down upon its normally painfully private denizens. Instead, these fiercely proud ronin are running out of time.

Let Andrew Ross Sorkin explain:
The private equity world is sitting on [approximately $1 trillion of uninvested capital]. It’s what the industry calls dry powder. If they don’t spend their cash pile snapping up acquisitions soon, they may have to return it to their investors.

Nearly $200 [billion] 1 from funds raised in 2007 and 2008 alone needs to be spent in the next 12 months or it must be given back.

Private equity executives, after spending the last several years largely on the sidelines amid the economic uncertainty — often proclaiming “patience” as an explanation — have begun to be anxious that they may need to go on a shopping spree.

Now a person educated in the aspirational propaganda of Atlas Shrugged and the Private Equity Growth Capital Council might wonder just what the panic is about. Surely the gimlet-eyed fiduciaries of Park Avenue, when faced with the unattractive selection of poor quality, overpriced corporate merchandise for which they blame their relative inactivity over the recent past would be cold bloodedly rational enough to simply return their investors’ capital with a smile and a shrug and a “Better luck next time, Old Bean,” no?

No, not really. Not even close.

* * *

First, to unpack this mystery one must dispense with a couple mischaracterizations Mr. Sorkin and his sources employ which cloud the issue at hand. Mischaracterizations, truth be told, which I and almost everyone else in the finance industry use as descriptive shorthand simply because it takes too much time to speak completely accurately. The biggest of these is that private equity firms actually have the hundreds of billions (or trillion) of dollars of limited partner funds they raise to invest in their sweaty little hands.

Tempting as it may be to imagine Steve Schwarzman and Leon Black dressed in top hat, tails, and duck bill masks whooping and hollering atop $10 billion mountains of gold coins in swimming pool vaults deep under Midtown Manhattan streets, private equity firms almost never get to hold the actual money nominally under their control for longer than it takes to keystroke a wire transfer into somebody else’s bank account. The multibillion dollar funds they raise with such fanfare in the press represent commitments by their limited partners to invest up to that amount in appropriate investments described and limited by the master fund agreement, not actual currency sitting in a bank account. When the financial sponsor finds and buys a company, it levies a capital call on its investors, and they are contractually obligated to deliver those funds in a timely fashion so the general partner can purchase the target. The trillion dollars which Mr. Sorkin so gleefully describes is not actual money gathering dust under the Carlyle Group’s mattress but rather a promise to invest that much by the pension funds, university endowments, and other institutional investors who employ it and its brethren to make money.

Second, there is the issue of how long financial sponsors actually get to call that money from investors, the key issue at hand but one which Mr. Sorkin skips rather lightly over in his haste to portend doom. For while most private equity firms raise investment funds with lives of a decade or more, by the same token most of them have significantly shorter actual investment periods. Usually, if the general partner is unable to find appropriate companies to buy or other investments to make within four to six years of the initial closing of the fund, the limited partners’ obligation to fund further capital calls goes away. More importantly, from the private equity firm’s perspective, the fund agreement dictates that it can no longer charge its full (2%) management fee on the full committed amount. In other words, if financial sponsor Dewey Trickem & Howe only spends $4 billion of its $10 billion DTH Rape and Pillage Fund XXIII by year six, it can no longer charge its limited partners $200 million per year in management fees. Instead, it can only dun them for 2% (or less) of the actual money invested, $4 billion, or a paltry $80 million. Given that DT&H has lots of expenses to pay, including luxurious Park Avenue office space, oodles of advisors and consultants, and legions of sharp-toothed Henry Kravis wannabes, you can just imagine how little they want to let that $6 billion of uncommitted capital (and, more importantly, $120 million of annual income) slip through their fingers.

Gross these management fees up across the multiple funds which large asset managers run in parallel (Fund I, fully invested and in harvest mode; Fund II, recently fully invested; and Fund III, recently raised and currently being invested), and you can see the 2% management fees which these firms charge add up to some serious revenue. Spread it out across multibillion dollar investment firms which employ a relatively paltry few hundred professionals, and you may understand that incentives to make investments which actually make money for limited partners get materially blurred by the incentive to gather assets.

In fact, faced with the decision to stick to its investment criteria and let lousy, overpriced opportunities pass—thereby losing associated management fee income—it becomes painfully clear that many private equity firms face very strong incentives to take a flyer. After all, the funds they are investing are, for the most part,2 not their own but rather their limited partners’. Why not invest them in second-rate, overshopped, undermanaged properties at 10 times EBITDA? Sure, the likelihood that you’ll earn a decent return is slim, but the financial sponsor’s employees hold a contractual option to 20% of the upside (the famous “carried interest”) on the off chance it does. In some respects, it is a free option, and everyone knows you shouldn’t give up free options without a fight. Sure, the investment will probably be crap, and may even go belly up, but dem’s da breaks, no? Caveat (institutional) investor.

* * *

So it is a fair and reasonable worry that the wall of soon-to-expire institutional commitments to private equity may trigger a bout of less-than-fiduciary shenanigans on the part of the finance professionals entrusted to manage them. This situation is also a timely reminder that the primary mission of any institution, once it becomes large enough, is the perpetuation and survival of the institution itself. Notwithstanding private equity’s reputation for attracting ruthless, clear-eyed homo economici, it is well to remember that incentives are not always what they seem, and often cut both ways.

It is also a salutary cheer to me and my colleagues in my industry, who are busy sharpening our skinning knives and licking our chops as the bison herd thunders toward the commitment expiration cliff. For it’s an ill wind that blows nobody any good.3

Kambei Shimada: “Go to the north. The decisive battle will be fought there.”
Gorobei Katayama: “Why didn’t you build a fence there?”
Kambei Shimada: “A good fort needs a gap. The enemy must be lured in. So we can attack them. If we only defend, we lose the war.”

Good. I’ve got a couple of real lemons to unload.

1 The original article published Monday evening cited $200 million as the amount requiring investment, but I have taken the liberty of correcting it, since this is clearly ludicrous. Two mid-size financial sponsors could spend $200 million in an afternoon without hardly trying, much less Blackstone or Carlyle. I wouldn’t be surprised if Steve Schwarzman spent $200 million on crab claws alone each year. An otherwise uneducated reader might also wonder what the fuss is about if only 0.02% of the trillion dollar total is expiring by year end. It seems they need to teach some remedial mathematics in journalism school.
2 Now to be fair, many private equity firm professionals invest a significant amount of their own money in their funds alongside limited partners, and this can act as a powerful reinforcement to their proper fiduciary duties. But without this natural alignment of incentives from skin in the game, limited partners should be exceedingly skeptical that financial sponsor employees have their best interests fully in mind at all times.
3 And it’s a big bison herd. Levered up at a typical 30% to 40% equity ratio, $1 trillion of uncommitted equity in private equity hands translates to $2.5 to $3 trillion of purchasing power. Fire up the barbie, Ralph!

© 2012 The Epicurean Dealmaker. All rights reserved.