Couples at the crossroads

PEI examines the long-term relationships between six major LPs and GPs and assesses the state of their unions in a changed market.

CalPERS and Apollo. Oregon and Lone Star. Blackstone and CalSTRS. These “couples”, if you will, have been joined at the hip for years by dint of massive capital commitments and shared optimism about the future performance of the private equity asset class. But the romantic days of massive commitments given to bulging funds that produced swoon-inducing distributions are no more.

A look at these three important case studies has crucial lessons for any party involved in a private equity partnership investment programme today.

Marriage counselling

Apollo and CalPERS have been investment partners since 1995, but recent events have put a strain on the relationship.

The giant California Public Employeesí Retirement System has brought in an outside advisor to help it review a key relationship that has come under increasing strain: its long-term commitment to Apollo Global Management. 

That relationship started with CalPERS' first $150 million commitment to Apollo Investment Fund III. The early days were good – Apollo III and Apollo IV, to which CalPERS committed a total of $300 million, each produced return multiples of 1.5x. CalPERS gave $250 million to Apollo V and more than doubled its money.

But some of Apollo's recent funds have not been performing well. A fund called Apollo Artus Investors 2007, set up to buy discounted senior debt, received a CalPERS commitment of $100 million to the $107 million fund. Apollo called down the entire commitment and the fund had a net internal rate of return of -100 percent as of 30 June, 2009.

Apollo Fund VI, raised in 2006, has a -15.4 percent internal rate of return as of 30 June.  Apollo has called about $589 million of CalPERS' $650 million commitment, and the pension has gotten back about $11 million.

Adding fuel to CalPERS review of its Apollo relationship are questions surrounding how the relationship grew so large.

CalPERS is questioning Apollo's use of a former member of the pension's board, Alfred Villalobos, to solicit money from the pension. Apollo apparently needed help asking CalPERS for money even though the pension owns a 9 percent equity stake in the firm, which it bought for about $600 million in 2007. Apollo paid Villalobos more than $60 million in fees to secure more than $3 billion in commitments from CalPERS over five years.

CalPERS, which has more than $200 billion in assets, has been looking back over its long years with the Leon Black-led firm to figure out how much Apollo has charged the pension in fees, how its funds have performed and how much the firm has paid out to placement agents. The pension hired Houlihan Lokey Howard & Zukin last year to perform the review.

The fees paid by Apollo to Villalobosí firm, ARVCO, prompted CalPERS to initiate a ìspecial reviewî of all placement agent fees paid by fund managers that work with the pension.

Negotiating power

Lone Star Funds and Oregon's state pension have had a long relationship that has consistently made the pension money. Despite the track record, Lone Star has been made to work for its re-up

The Oregon Investment Council has become something of a lobbyist for enhanced limited partner power. The pension, with $60 billion in assets, was one of the first to publish a set of guidelines it consults when considering future commitments with private equity managers.

The guidelines give the pension leverage at the bargaining table with fund managers, and OIC has wielded its principles several times since publishing them last spring.

Even its long-term managers are subject to the negotiations, as Lone Star Funds discovered when it went to Oregon for a re-up last year. Oregon has been an investor in Lone Star funds since 1994, when the firm raised its first pool of capital. Oregon has trusted Lone Star with more than $1.8 billion in total.

Lone Star is trying to raise a massive amount of capital in today’s anemic fundraising environment. The firm, founded by John Grayken, is targeting a total of $20 billion between two funds – Lone Star Real Estate Fund II and Lone Star Fund VII.
Oregon invested $400 million in the funds – $300 million to the second real estate fund and $100 million in Fund VII – and pledged to commit another $400 million depending on early performance of the funds. The recent commitments are lower than the $600 million the pension allocated to Lone Star in 2008.

But the commitments did not come easy. Lone Star found the re-up process to be far from a formality. Oregon and Lone Star negotiated based on the LP guidelines and as a result the firm cut back the fees on its two new funds. According to the Wall Street Journal, the firm cut its management fee to .35 percent from .75 percent in its prior fund. Oregon did not respond to request for comment.

Lone Star reached first closes on its two funds last year on $1 billion each. The firm has a long way to go to reach its goal, but it has a pretty consistent track record to flout. As Oregon illustrated, however, even with a good set of numbers, LPs are not simply going to open their wallets.

Schooled in California

Blackstone has found CalSTRS to be significantly less forthcoming for its latest fund

The California State Teachers’ Retirement System, the second largest public pension in the US, dramatically chopped its commitment to The Blackstone Group’s most recent fund, when it committed about $270 million to Fund VI. This compared to the pension’s $1.7 billion commitment to Blackstone’s Fund V, which ultimately collected $21.7 billion to become the largest buyout fund ever raised.

CalSTRS’ reduced commitment seems endemic of a wider issue for Blackstone VI, which will reportedly close on $9 billion, a significant reduction from its initial target of $20 billion when it entered fundraising in January 2008.

Several general factors consistent across the private equity industry explain the firm’s inability to get close to its target for Fund VI. One is the ubiquitous problem of over-allocation and liquidity problems plaguing many LPs around the globe. Also, many LPs like CalSTRS made massive commitments to Blackstone V, which had an original target much lower than its eventual total, making it enormously oversubscribed.

One market source told PEI that no mega-buyout funds raised in the last few years are currently “in favour” and Blackstone V is not doing particularly well. Recent analysis from Prequin shows Blackstone V, which is overall 74.5 percent called, sitting at a return multiple of .72x with a -17.8 percent internal rate of return.

“None of the mega-buyout funds that have come to market recently have been doing well as the entire sector is out of favour – and the larger the worst,” the source said.

Blackstone also entered fundraising for Fund VI as the global financial sector was approaching meltdown. A few months after Blackstone VI entered the market, Bear Stearns was rescued by the US federal government and eventually sold to JPMorgan for $2 a share.

CalSTRS has entrusted more than $2.5 billion to Blackstone since 1994, making it the pension’s largest relationship. The pension even purchased $9 million worth of secondary interests in Blackstone’s second fund in 1999 to get more exposure.

The pension declined to comment on its ongoing relationship with Blackstone, but a CalSTRS spokesman did comment more widely on the market. “As the market slipped into recession, the opportunities for buyout activity has been limited,” he said.
In its latest semi-annual performance report, the pension cites mega funds as being the most affected by the financial crisis: “The lack of leverage is believed to have hit the largest firms the hardest, as investors have greater concerns about how the mega funds will operate in the market environment going forward.”

Blackstone and CalSTRS have one of the longest-standing relationships in private equity. How the relationship plays out may depend a lot on the ultimate performance of Blackstone V.