Friday Letter: The return of the dreaded style drift

According to a recent survey, an overwhelming majority of investors are concerned at the prospect of their chosen managers going off piste and damaging their returns.

Four years ago investors punished IK Investment Partners, the European buyout firm formerly known as Industri Kapital, for the temerity of its ambitions. In what investors considered to be a rush of hubris the firm had sped to market with a plan to do bigger deals and move out of the mid-market where it made its name. However, with little by way of distributions to show from its €2.1 billion 2001 fund, IK's pitch fell on deaf ears.

Investors made an example of the firm and cut it down to size. After an arduous fundraising IK closed its 2004 fund on €825 million. Since then, the firm has made a series of strong exits and enjoyed fundraising success. The 2004 fund had returned all its capital by October last year, enabling the firm to close its sixth fund on €1.6 billion.

As a cautionary tale it has a happy end. For a period IK went off piste but managed to get itself back on track. Others were less fortunate, such as erstwhile US LBO leader Hicks Muse Tate & Furst, whose escapades in TMT deals ultimately killed the franchise.

The relevance of these stories to today’s private equity community is obvious: managers considering investment adventures at the margins of their limited partner agreements would do well to consider how this may play with investors in a tougher fundraising environment.

Many LPs are unconvinced by recent trends in the market. There are mega funds pursuing growth capital deals; mid-market firms doing infrastructure; and equity investors buying debt. Many GPs are looking further afield to try their luck in new markets. Three quarters of investors, according to Coller Capital's Global Private Equity Barometer published this week, see this as style drift and worry about it. Almost 85 percent of US investors believe it will hit returns.

But is this not a case of buyer’s remorse? These are the same investors that signed the limited partnership agreement giving the firms the rights to buy debt, to dip down into the mid-market and to invest a portion of their funds outside their core regions. LPs argue they had little choice in the buyout boom: under pressure to secure access to brand-name funds, they had no time to haggle over the small print.

General partners for their part argue that their ability to invest opportunistically to suit the dealflow is what investors rightly pay high fees for. This is true, of course, and if LPs are uneasy now they only have themselves to blame. But it is also true investors expect out-performance for those fees.

The private equity model compels firms to refresh their capital base every few years in a new fundraising. Superior returns will cover a multitude of sins, but firms that have strayed from their core competence will have to make a very persuasive case for their actions – especially if distributions continue to be slow in a tougher economic climate. Cash constrained investors are already slowing down their new fund commitments, Coller says. And with less money to spend investors will get choosier.

So caveat vendor. And be very careful when you go off piste.