Friday Letter: Investor Power

The decision by EAC, a UK mid-market private equity firm, to wind down its investment capability and let go three partners including co-founder Robert Mason was no surprise to investors in its fund.

But it was not a case of careful communication between a cautious manager and its investors that robbed the news of its power to shock.

The investors were behind the decision to slim the firm in the first place. Bill Robinson, a co-founder, and Erick Rinner, a partners, are staying on to manage the portfolio to exit.

It has been easy to forget in this bull market that investing in private equity is not just a question of handing over the money and waiting for the returns to roll in.

It is even less the case when a fund runs into trouble. Investors cannot just shrug their shoulders and walk away. They have a fiduciary duty to maximise the returns on the capital deployed

EAC billed the departures of Mason, Paul Downes and Jonathan Heathcote, both partners, as an opportunity for them to pursue different career paths.

In truth, several months of concerted co-operation and communication between the manager and its investors left the partners little choice but to walk.

The firm had made a loss on its investment in LDV, the UK van manufacturer and one of its biggest deals, which it sold to Sun European Partners at the end of 2005. And critically it had not managed a single exit from its 2002 third fund.

As one investor said: “While most managers were making hay, EAC was not great at selling.”

Limited partners remained convinced, however, that there was value in the portfolio the firm had built. They were anxious not to watch that leach away to secondary investors at a discount and with another layer of fees.

 Instead, they engaged with the firm and provided an exemplary model of private equity governance.

One investor said: “Private equity is a long-term model and the fund can still work out. We just needed to change the economics to incentivise the less senior guys to stay and work the portfolio through to exit.”

And to get rid of some of the more expensive partners and cut management cost.

It seems unlikely EAC will raise a fourth fund, but perhaps now it is not impossible, provided investors see a decent profit on their capital. At least the firm is in a position to shape its destiny, when it looked for a time as if it was running aground.

To critics of the private equity model, the resolution of EAC’s predicament provides a useful counterweight.

While private equity firms may be entirely opaque to outsiders they are transparent to investors – even when they are temporarily misfiring.

And secondly, at a time when much of the interest in private equity is in the record fundraisings which give rise to record deals, one may lose sight of the fact that the industry exists primarily to deliver returns to its investors. It is mostly their capital that is at risk, whatever the media, regulators and politicians may say or do.

Of course this alignment of interest between an investor and its fund manager means investing in a private equity firm is not for the faint of heart. Passive investors beware. Active engagement is at the heart of the buyout model and it should also be at the heart of the relationship between managers and investors as well.

The industry would do well to remember this for when the going gets tough. There may be more EACs to work through when the market turns.