Friday Letter: Club concerns

Investors in private equity worry about many things. For instance: will the mounting wave of money kill returns in the asset class? Or: have I picked the right funds? Or: what are management fees doing to manager motivation? And: are club deals good or bad?  

This last concern is the topic of today’s Friday Letter. Club deals, or equity investment syndicates, have become endemic: the majority of very large European LBOs (€1 billion plus) completed in the last 12 months had more than one equity sponsor in the capital structure.

Club deals happen partly because large buyouts, cheap debt notwithstanding, still require large amounts of equity: although mega buyout funds are becoming more mega practically by the month, there still isn’t a fund out there that could single-handedly put up €1 billion of equity without falling foul of maximum capital commitment rules in its fund terms. So if you want to buy a big asset, you need to call in some friends.

In addition, syndication can be an effective tool to take some of the heat out of the auction process.  If you can’t beat them, join them, which, everything else being equal, should improve your chances of closing the deal at a less inflated valuation. “Clubs deals are affecting the auction dynamics enormously,” mutters a London-based investment banker with a focus on big LBOs. There are far fewer bids if all the bidders are holding hands.

Investors accept that club deals tend to improve a fund’s diversification (though if you are an LP in several of a syndicate’s funds the opposite is true of course). They can also help keep a lid on purchase prices. Still, limited partners – and even some managers – point out that club deals remain essentially unproven, as many of the recent ones are yet to go past the inflection point on their J-curves.

The successful conclusion of some recent club investments, such as the planned IPO of Legrand, the French electrical equipment manufacturer purchased by Wendel Investissement and KKR in 2003 and slated to list next year with a target return multiple of 2.5 times money, would of course go some way towards validating the concept.

However, sceptics maintain that in general, several A-type personalities from different firms trying to steer an aggressively leveraged portfolio company isn’t an obvious recipe for success. If private equity’s most powerful trump over public market company ownership is indeed tighter control over the underlying asset, then too many self-opinionated cooks can by definition create a risk that needs to be taken seriously.

Portfolio companies whose equity is being held by more than one buyout investor don’t have to get into financial distress in order to finish up a disappointment to all concerned. In a shared deal, different funds are likely to have different strategic priorities and schedules, both in terms of how to best work the asset in order to create maximum value, and with regard to when and how to realise the investment.

Syndicates, according to this argument, are likely to be less effective managers than sponsors going it alone – and hence are prone to leaving money on the table. (Asked whether his firm was likely to fund a tertiary buyout, a partner at one of Europe’s largest buyout groups said earlier this week: “Only if the previous owner was a private equity consortium, because they likely wouldn’t have run the business as efficiently as possible.”)

Houses that know each other well can of course be expected to form a more effective team than houses that don’t. However, curiously, there are no lasting alliances in today’s LBO market place: although competition between the leading shops is fierce, there seems to be no combination of syndicate line-ups that isn’t possible. Firms appear to be choosing their partners utterly opportunistically: Bain today, Cinven tomorrow – on the face of it, choice of bedfellow simply doesn’t seem to matter, so long as the capital and inclination are there.

No wonder LPs are asking the question as to what club deals will yield. There are no signs that the phenomenon will become less prevalent any time soon. Far from it: with ever-larger corporate assets becoming potential acquisition targets for private equity firms, the trend seems bound to continue.

However, the moment a syndicate-owned portfolio company falters, the debate over whether a single equity investor could have avoided the problem will be a lively one. Don’t be surprised if it begins sooner rather than later.