Private equity endures the winter of its discontent

Today's management teams at private equity firms find themselves in straits often resembling a work of Shakespeare. Upon the throne and at the top table sit the senior directors – the ones whose names adorn the glass of the reception area – and whether they be aged veterans of serial super funds or boy kings looking to raise a third, the question of who will lead when these top-rankers go has begun to enter everybody's minds. For in their court is the next generation of directors, who themselves have led their share of deals, eagerly anticipating who amongst them will be promoted and preferred, and wondering when and how this process will begin. Meanwhile others look on: the limited partners and gatekeepers are left to fret over whether the succession drama unfolding in front of them will end as tragedy or comedy. Except in this case, there can be several billion dollars of investor capital staked on the outcome.

?One of the most important issues going forward in the world of private equity is who are the players going to be,? notes D. Brooks Zug, a senior managing director at Boston-based private equity advisor HarbourVest Partners. ?Will these individuals who have created a huge return in the past be the same ones doing it in the future??

There's no doubt the question has taken on more of an edge over the last few years as established groups sporting marquee names like Kravis, Forstmann and Lee have raised ever larger pools of capital – even as their leaders are approaching or have achieved the 60 year mark. And while many of private equity's elder statesmen would stubbornly argue that they're leading as many deals today as they did 20 years ago, LPs are more concerned with whether the founders have done the most to ensure that the next generation of rising talent in the firm will follow in their successful footsteps. That, according to LPs, has a lot to do with sharing the wealth from each fund. ?If you have an older set of partners, are they planning for succession or is the firm going to fall apart after they lose interest?? wonders Mario Giannini, president of Philiadelphia-based advisory firm Hamilton Lane. ?We have walked from funds over this issue, the idea that the size of the fund has grown dramatically and the carry is not being disbursed relative to its size.?

Or as Clinton Harris, managing partner at Wellesley, Massachusetts.-based Grove Street Advisors which handles LBO fund selections for the massive California Public Employees Retirement System (CalPERS), asks: ?If you're a senior guy, the question you have to ask is how much do you deserve? Because the junior guys can always leave or at least threaten to.?

A More Complicated World
So how did it get to this point? The passage of time is one inevitable factor. Most of the big name buyout firms have their roots in the mid-1980s (although the more prestigious venture capital outfits were launched more than ten years earlier), and a good proportion of the founders are now approaching an age when the well-heeled contemplate retirement. This has prompted a sea change in how private equity funds are being evaluated by LPs and gatekeepers. Until now, the LP base has been able to satisfy its due diligence by looking largely at the traditional gold standard of the LBO industry: historic returns. ?In private equity, past performance historically has always been something that you can hang your hat on – far more than in public market funds,? notes Grove Street's Harris.

However, as returns and fund sizes increased in the mid- to late-'90s, a different game emerged, one in which junior level partners became disenchanted with the cut they were receiving for deals they led. Some of these young stars opted to quit their parent group, forging not only new firms but also a common source of concern for investors who had tied themselves up in ten-year illiquid partnership agreements.

Because of these two phenomena, the investment community has been forced to alter their focus when conducting LP due diligence, moving away from past fund performance and toward looking at private equity firms as businesses. ?People in our world – be they LPs, financial intermediaries, or the press for that matter have not really thought of LBO firms as businesses unto themselves, but rather as distinct funds,? says Dean Kehler, a founder of New York-based private equity firm Trimaran Partners.

But the due diligence process is changing and now includes this new sensitivity to the strategic and operational structures in place at private equity firms. Tellingly too, this fine-toothed comb approach is not only being practiced on relatively new firms, but also on established titans. ?There's much more of a critical eye being turned toward established groups. People will be looking at all partnerships – big and small – more critically,? Kehler notes.

But trying to create a new model for assessing firm stability is a daunting task. Just ask Tom Bell, a partner at law firm Simpson Thacher & Bartlett. Bell has spent the lion's share of his career drafting and advising on the formation of private equity partnerships, working with such firms as Washington, D.C.-based The Carlyle Group and New York's Cypress Group. ?If you look at 10 different funds, they'd all have the same basic terms so that you're playing between the 45 yard lines,? he says. ?If you look at the way 10 different firms are set up, however, they'd be all over the map. They range from town hall democracy, with one man one vote, to absolute monarchy, in which you serve and are paid at the pleasure of the king. And you have all sorts of variations in between.?

While Bell admits that even despotic arrangements by senior management at buyout firms have, in the past, managed to produce funds that have garnered respectable returns, he questions whether groups that persist in this approach will continue to be able to raise capital. ?On the whole, LPs like GP arrangements that promote stability and cohesion, which means that the senior partners don't hog the carry, professionals are given a contractual right to a share of the carry rather than a mere expectancy and vesting into the right to carry occurs over an extended period of time to incentivise people to hang around,? he says.

However, even in situations where junior partners are receiving their fair share of the carry, that's no guarantee that this new generation of dealmakers will stick around. After all, going out on your own not only ensures a larger cut of the profits – should you be able to raise a fund, that is – but also the freedom to pursue whatever opportunities you wish.

Gatekeepers who are continually assessing private equity firms for their clients admit that working out whether the management of a fund will remain intact three or four years after it closes is more art than science. On some levels, it can require little more than having a rapport with the partners and trusting them to be up front about their intentions. ?By talking to the individuals at the firms you can actually get a pretty good sense of what their plans are,? Harbourvest's Zug says. ?Some will acknowledge that this will be the last fund that they'll be active in, in which case you figure they'll be there 100 per cent.?

In those cases where GPs are less than forthright about their intentions, key-man clauses in the documentation (which can allow for the return of capital and in some cases the dissolution of a fund should certain essential directors depart) can be employed. However, key-man agreements have some pitfalls of their own. ?The weakness is that you usually can't get key man language that covers just one or two people out of a team of six,? Zug notes. ?Sometimes you get GPs trying to replace departing individuals with more junior people from the firm, but that will usually need to be voted on the by the LP group.?

Also, never underestimate the importance of keeping an ear to the ground where due diligence is concerned. Grove Street's Harris notes that among his firm's most important research tools are contacts at executive search firms. ?If VPs are out shopping themselves around we'll generally hear about it.?

GPs Retrench
But even as LPs and gatekeepers are reassessing how they decide which firms to invest in, GPs are faced with the task of revamping their own operations to keep the interest of both their investors and their personnel. And they're discovering that the traditional private equity model has some glaring weaknesses that are all the more apparent during a weak market for exits. Private equity firms labor under periodic fundraisings that generally only meet with success if the last effort was successful. The professionals receive most of their compensation from profits, and if the year is a bad one or even just a dry one, there's a temptation to start looking for greener pastures. ?When it becomes clear that a firm will not be generating carry from its current fund, or that it won't be able to successfully raise another fund, key people tend to look around and say: ?No matter how good we do our job, we're not going to get any carry. Why are we hanging around??? Simpson Thacher's Bell says. ?If your name is on the door, you're probably going to stay, but if it's not, you're likely to say, ?Nuts to this.? By and large, you don't see hedge funds or the Fidelity's of the world having this problem to anywhere near the same extent because they don't put the franchise through the wringer every three to five years in the same way.?

Trimaran Partners' Kehler agrees. ?We've all gotten used to the idea that private equity firms would raise a fund, they'd get strong returns, and once they got 80 or 85 percent invested, they'd go out and raise another fund,? he says. ?It isn't clear now in this fundraising environment, whether you'll be able to raise another fund and that's definitely got firms worrying.?

The way around this when-it-rains-it-pours rub that's been embraced by a notable few private equity firms, entails selling a portion of the firm to an external investor, thereby receiving a cash infusion with which to placate partners in down times. In 1998, New York-based The Blackstone Group sold eight percent of itself to insurance company American International Group for $150 million. Following suit, Boston-based Thomas H. Lee Partners in 1999 sold a 20 percent stake in the firm to mutual fund giant Putnam Investments. In the meantime, CalPERS has invested a substantial stake in both The Carlyle Group and David Bonderman's Texas Pacific Group (TPG).

But while these examples seem to offer a solution to the feast-or-famine plight of the private equity firm, a few problems persist. For one, it's unclear how many groups would be able to replicate the examples of these firms, all of which are currently investing multi-billion dollar vehicles. ?Everyone I know would love to do a Putnam deal, but how many firms like Tommy Lee are there around?? wonders Bell. ?If you look at who's done it, it's generally the elite firms like Blackstone, Carlyle, Tom Lee and TPG.?

Then there's the issue of tinkering with a compensation model that's been around since the early days of the industry. While the cash being handed over by Putnam and AIG and their brethren offers private equity firms some security in trying times, it also takes a chunk out of their partners' pockets when times are flush – which is quite similar to the original argument being voiced by junior partners: people who aren't doing the work are getting a piece of my action. As Hamilton Lane's Giannini points out, ?It cuts both ways. The argument against it is that private equity is an entrepreneurial business, and you have the carry going to someone who's not doing the deals. I think the jury is still out as to whether the industry does institutionalise.?

So the process of ensuring smooth succession and stability at most private equity firms will retain some elements of drama still: the cast will change at unexpected moments and the plot will still take some new twists and turns. Hard to follow? Possibly. Unhappy ending? Far less likely when those underwriting the programme have their say.

Robert Dunn is a New York-based private equity journalist and a former editor of Buyouts.