Crunch time for captives

We were, all of us, shocked to discover in recent months that public equities analysts have been pressured by their colleagues in investment banking to give favourable research coverage to their clients.

Okay, not all of us were shocked. In fact, some of us, namely people who work at large financial institutions and, more specifically, at private equity firms owned by large financial institutions, had a pretty good idea about how the proverbial ?Chinese Wall? separating one business from another might have been breached. These captive private equity professionals understand that conflicts of interest between the various business units can be managed, often contained but never entirely defeated.

The ritual played out between equities analysts and investment bankers is by now familiar to all: investment bank seeks company's business; analyst provides favorable research coverage of the company; company becomes investment-banking client. This was a great system for earning investment-banking fees but, one might argue, rather a disservice to the investors who took the research coverage seriously.

Transfer the above (admittedly somewhat blatant) scenario to the world of captive merchant banking (a useful synonym for an in-house private equity investment unit), and you could get an environment for private equity investment that some investors might find less than ideal. Here's another scenario: investment bank seeks corporation as client; during pitch corporation expresses need to unload non-core business; investment bank makes call to captive private equity unit; this group expresses interest in non-core business; investment bank wins corporation as client; private equity unit buys non-core business. Again, a great recipe for fee income, but a system like this makes the distinction between ?proprietary deal flow? and ?dumping ground? potentially much more difficult to discern.

In truth, most captive private equity operations come nowhere near the de-based state described by the term ?dumping ground.? Far from serving as Trojan horses to collect investment banking fees, in-house private equity operations can be extremely selective, operating, as they do, at the highest altitudes of deal flow. Captive private equity firms are plugged into incredible networks of relationships, researchers, deal sourcers, capital providers and transaction experts and as such have access to intelligence and services not enjoyed by the average boutique private investment firm. It is this characteristic that has encouraged many institutional investors to have voted for the captive strategy with their dollars. Over the years, they have committed tens of billions to funds sponsored by large financial institutions.

Now, however, captives are under increased scrutiny due not only to conflict-of-interest scandals in other corners of the financial world, but also because of the grave underperformance of private equity in general. Making matters worse, most captives are housed in publicly traded corporations, and as such, the earnings volatility associated with private equity investing is a bit much for some shareholders to take. Witness JP Morgan Partners, which recently reported an operating loss of $284 million – the most recent in a string of write-downs to its investment portfolio. Sophisticated private equity investors know that losses of this nature are only place-markers on the way to the ultimate realization of investments; but try telling that to the not exactly long-term minded public equity market. Parent JP Morgan Chase saw its shares get pummeled with each new earnings announcement. This effect is putting pressure on banks to scale back their private equity activities. Investors and bank CEOs alike are increasingly asking, ?Should I stick with this programme??

The answer to that question, according to investors and current as well as former captive private equity professionals, is yes, so long as the right investment professionals are given the right compensation for the right reasons.

How real can potential be?
Proponents for captive merchant banks argue, quite correctly, that investors should note the difference between conflicts of interest and potential conflicts of interests. All captives posses the latter, and the best ones successfully manage the former. What is of especial interest though is the size of that potential.

One issue is that where a private equity unit and an investment bank are under the same roof, the fee-based and client-focused culture of the investment bank can be infectious, sometimes influencing the private equity deal team to agree to deals for not entirely return-driven reasons. To be sure, pressure to please the investment bank (whose CEO may well cast a sizeable shadow across the private equity unit) varies from institution to institution. ?Conflicts can be heinous or somewhat benign,? says a former manager at a captive who now advises institutions on alternative investments. When, for instance, a portfolio company is being leveraged up, ?You may hear [from bank leadership],? continues the former captive, ??We don't expect our guys to win every high-yield mandate, but we do expect them to be invited to every pitch.? The bank wants to see that you've been a good corporate citizen.?

?You end up spending valuable time dealing with internal politics,? says Charles van Horne, a managing director at New York fund-of-funds manager Abbott Capital. Van Horne used to manage funds-of-funds for financial services giant AIG. ?If one of the senior guys calls and says, ?Hey, I think this is something you should look at,? you're either going to do it, or you'd better come up with a good reason for why you're not going to do it. It becomes a tax on the organization.?

Coal oriented
An interesting case study for the ?synergies? (a two-edged term so often) found behind many captive private equity deals is the acquisition of coal producer Peabody Holdings by Lehman Brothers Merchant Banking. Peabody was, depending on who you ask, a pretty good to very good deal that only a captive private equity firm could have done. The private equity group purchased the coal company in 1998 for a total of $2.3 billion, committing a sizeable $400 million in equity from its $2 billion fund. Lehman Brothers also provided the lion's share of the debt financing.

More intriguing, the sale of Peabody was a condition of a merger between Peabody's parent, The Energy Group PLC, and Texas Utilities Co. Essentially, say sources close to the deal, Texas Utilities was going to walk away from the deal if Energy Group couldn't find a buyer for its coal division. This would have been very disappointing for Texas Utilities' advisor on the deal ? which was Lehman Brothers. ?Lehman [Merchant Banking] got the Peabody deal because of the relationship between management and the investment bank's natural resources group,? says a source close to the deal. ?It's an interesting example of how, at captive private equity firms, you get the Rolodex not only of the GPs, but of the investment bankers, too.?

The source also said Lehman professionals are given incentives to pass interesting deal ideas along to the merchant bank. ?There was an M&A banker who said [to Texas Utilities], ?Listen, our merchant bank may be willing to look at this,?? says another source who used to work at the bank. ?This is what got them the M&A business.?

In this case, the M&A business and the deal both proved lucrative. Lehman's merchant banking fund essentially doubled its money on the deal (not bad for a vintage 1998 transaction), and let's not forget the estimated $125 million in investment banking fees, not to mention underwriting fees when, in May 2001, Peabody was taken public. Lehman did that, too.

Sins of omission
In these conflict-sensitive times, perhaps a greater worry for investors should be that captive private equity teams may be prevented from doing good deals because of their relationship with the investment bank. Let's say the private equity group insists on being totally clean ? it refuses to acquire any companies linked to the investment bank. Now the conflict of interest issue is resolved, but the merchant bank is cut off from many possibly great, proprietary deals. And if the private equity team can't see house deals, whose deals can it see? The private equity division of Lehman, for example, is unlikely to get first dibs on the best companies represented by Goldman, which has a private equity group of its own.

Investment bank priorities may even hamper the ability of the captive private equity guys in helping their own portfolio companies. A portfolio manager at a major endowment says his due diligence into captive private equity groups has twice turned up situations where an attempt to hire a CEO away from a competing portfolio company was scuttled when the owner of the competing company, another major, independent US private equity firm, threatened to cease all business with the investment bank that sat alongside the captive private equity operation if the CEO in question was ?stolen.?

The list of potential conflicts goes on. Perhaps the captive private equity group will find itself competing for an asset against a rival that happens to be represented by the affiliate investment bank. Or perhaps it may be interested in acquiring a company that just happens to be represented by its affiliate investment bank. The list of such scenarios can become lengthy, quickly: the question is, how likely is it that such conflicts actually impinge on the captive fund's investment business? To some on the private equity buy side it seems very likely and they have chosen to avoid captives as a result.

David Swensen, the chief investment officer of Yale University's endowment, famously refuses to touch captive funds. In his 2000 book, Pioneering Portfolio Management, Swensen writes, ?Is the [captive private equity unit] serving the interest of a good corporate client by paying a rich price for [a] division? Or is it serving the interest of investors in the private equity fund by paying a low price? Under such circumstances? no fair price exists.?

Swensen goes on to advise investors that ?eliminating affiliates and subsidiaries of financial services firms? from the fund selection process is the smart choice, although he concedes that ?some reasonably high-quality opportunities may be missed? by doing so.

Smart networks
Proponents of captive merchant banking funds will agree ? with the second part of Swensen's point, that is. They argue that the upside to being a private equity group tied to a large financial organization is just that ? being under the same roof with any number of resources to help get an edge on the competition. ?The advantages of being affiliated with an investment bank are deal flow, contacts, resources, industry knowledge, access to capital markets ? it can be a host of things,? says Gwyneth Ketterer, senior managing director at Bear Stearns Merchant Banking. ?I think that as private equity matures, finding that competitive advantage is becoming crucial.?

Ketterer acknowledges that investors have always worried about conflicts at firms such as hers. She says that captive firms must work to manage conflicts, just as they must work to take advantage of the many resources made available to them. ?There are multiple potential conflicts, but the conflict that you hope happens is that the house cherry picks all the best deals and gives them to the merchant bank,? she says. ?That's what you hope, but you still need to work the system and leverage the franchise to make that happen.?

In emerging markets, where business networks, and even the rule of law, are not as established as in North America and Europe, private equity programmes tied to large financial institutions may hold additional appeal for investors. George Raffini, a managing director at HSBC Private Equity Asia, says HSBC's extensive network throughout the region helps him not only source deals, but also perform due diligence on local business owners. This, he says, gives him far more eyes, ears and ?smart commercial minds? than would be available to a boutique.

Leveraged buyout groups tied to large financial institutions have a particular advantage when doing deals ? access, or at the very least, perceived access, to debt financing. ?If you come to a company and you say, ?We're DLJ Merchant Banking,? the company figures you can always come up with the cash,?? says a lawyer who advises LPs. ?People on the debt side may have money tied up in the merchant bank,? says someone who used to work at a captive. ?So the relationship is already there.?

Compensation, compensation, compensation
But how best can you manage the often-complex interrelationships that keep a captive private equity operation on the right side of conflicts? Insiders say the key to conducting due diligence on a captive group is understanding the compensation structure. In other words, follow the money. If professionals at the other divisions of the bank do not have financial interests in the private equity fund, they will have little incentive to pass the best deals and ideas that way. If a captive private equity professional receives a bonus based in part on investment banking and other income, he or she may not be focused entirely on financial returns. ?You should find out if the head of private equity needs to go cap in hand to the head of investment banking,? says an advisor.

Bear Stearns' Ketterer says the professionals at her merchant bank receive compensation based only on the performance of the private equity activities. She says this structure held tremendous appeal for external investors who committed to the fund. ?Limited partners want to know that you are aligned with them,? she says. ?It's very important to them where your bread is buttered.?

Proper compensation is important for another reason ? if investment professionals are unhappy with their pay they are at risk of doing what merchant banking pros are famous for: spinning out. Over the years, captive merchant banks have served as a ready breeding grounds for independent firms. The greater the share of economics taken by the parent company, the greater the desire among the private equity team members to spin out (see ?Merrill Begat Stonington?? accompanying this article). One fund-of-funds manager says he has not invested in a bank-sponsored fund precisely because of this reason. ?We have seen vast numbers of teams proclaim incredible fealty to an organization and then three years later explain how they had to do it on their own,? he says.

Of course, in the private equity industry, where the average GP dreams of running his or her own shop, turnover is a universal problem. And given the drastic restructuring and regulatory scrutiny taking place at financial institutions now, one has to conclude that the captive private equity professionals who remain in place must be working to a system that even Yale's Swensen could accept.

?Merrill begat Stonington; Lehman begat Cypress??
The number of GP groups to spin out of captive private equity firms has taken on Biblical proportions. Not only do the merchant banking operations of large financial services groups provide great opportunities for professionals to build investment track records, they also tend to provide little incentive for ambitious deal teams to stick around ? hence the many spin-outs. Once outside the nurturing embrace of a parent, former captive teams have turned in track records as independents ranging from the oustanding to the best-forgotten. Below is a sampling of significant spin-out private equity groups over the years (with apologies to Genesis chapter 5).

Bank of America begat ? Willis Stein & Partners
John Willis and Avi Stein spun out of Bank of America's middle-market buyout arm, Continental Illinois Venture Corporation, in 1994 following the merger between B of A and Continental Bank. The two had run CIVC since 1989. Chicago-based Willis Stein's first independent vehicle raised $343 million. The firm's most recent fund closed in 2000 on $1.8 billion.

Bank of Boston begat ? Heritage Partners
The Heritage team spun out of Bank of Boston in 1993, having founded and successfully run a later-stage private equity division of the bank called Equity Partners. Heritage focuses on family-owned businesses. Its co-founders include Michel Reichert, Peter Hermann and Michael Gillian. The firm, based in Boston, closed its most recent fund in 1999 on $843 million.

BNP Paribas begat ? PAI Management
In 2001, PAI chief executive Amaury-Daniel de Seze finally succeeded in negotiating a buyout from French bank BNP Paribas and a year later, PAI Management raised €1.8bn for its first fund as an independent LBO house, with BNP Paribas contributing €250m. Established in the early 1990s to manage the corporate investment portfolio of Banque Paribas (later BNP Paribas), Paribas Affaires Industrielles quickly became an immensely profitable division. A first attempt by management to buy the investment portfolio out of the bank failed in 1993.

Citigroup begat ? three:
1. Welsh, Carson, Anderson & Stowe. Founded in 1979, New York-based Welsh Carson is one of the oldest buyout shops still in operation. The firm was founded by Russell Carson and Patrick Welsh, the former chairman and president, respectively, of Citicorp Venture Capital. The firm focuses on information services, communications and healthcare.

2. CVC Capital Partners. Founded in 1981 as the European private equity arm of Citicorp Venture Capital, CVC Capital Partners went through a management buyout in 1993 and is now independently owned and managed by a team led by Mike Smith. The firm, with offices throughout Europe, Asia and South America, closed a €4.65 billion fund for European investing in 2001.

3. Bruckmann, Rosser, Sherrill & Co. New York-based Bruckmann Rosser was founded in 1995 when Bruce Bruckmann, Harold Rosser and Stephen Sherrill, three Citicorp Venture Capital principals, left to form an independent private equity firm.

Deutsche Bank begat ? MidOcean Partners
Meet the newest spin-out group in the market. The German banking giant is reducing exposure to private equity in a big way. After months of negotiations dating back to last summer, Ted Virtue and Graham Clempson last month agreed to pay just over €1.5 billion for the former DB Capital, which consists of 80 investments in large and medium-sized enterprises in Europe and the United States. Virtue and Clempson, the chairman and European head respectively, of the firm, received backing from a syndicate led by Dutch firm NIB Capital Private Equity. Deutsche Bank will retain an interest of 20 per cent in the portfolio.

Dresdner Bank begat ? Kleinwort Capital
2001 takeover of Dresdner Bank by Allianz led to a quarrel over how to integrate Dresdner Kleinwort Capital, the bank's €3 billion diversified venture capital investment business, into the German insurer's existing private equity operations. After months of negotiations, London-based Dresdner Kleinwort Capital's chief executive, Christopher Wright, helped his former UK mid-market buyout team headed by Richard Green and Andrew Hartley secure independence before losing an internal power struggle with Allianz private equity chief Thomas Pütter, which led to Wright's departure.

The First Boston Corp. begat ? Vestar Capital
Vestar was founded in 1988 by a group of investment professionals from Bank Boston's management buyout group. The team is led by Dan O'Connell. New York-based Vestar invests opportunistically across a range of industries.

First Chicago Corp. begat ? Madison Dearborn Partners
John Canning, the president of Chicago's Madison Dearborn, was president of First Chicago Venture Capital before leading a team in 1993 to found an independent firm. Only four of 18 managing directors at MDP do not come from First Chicago. The buyout giant is currently investing from a $4 billion fund.

Fleet Bank begat ? Nautic Partners
Nautic combines the personnel and assets of the former Fleet Equity Partners and Chisholm Partners, which spun out of the bank in 2000 following its merger with Bank of Boston. Nautic, based in Providence, Rhode Island, is currently investing from a $1.1 billion fund.

Lehman Brothers Holdings begat ? The Cypress Group
Founded in 1994 by nine ex-Lehman Brothers Merchant Banking professionals led by James Stern, David Spalding, Jeffrey Hughes and James Singleton. The firm has raised approximately $3.5 billion for two buyout funds. New York-based Cypress got off to a rocky start after a number of the portfolio companies in its first fund went bankrupt.

Merrill Lynch & Co. begat ? two:
1. Stonington Partners ? New York-based Stonington became independent in 1993 after spinning out from Merrill Lynch Capital Partners, the private equity division of the financial services giant. The firm continues to manage $1.6 billion for Merrill Lynch.

2. HgCapital ? Formerly Mercury Asset Management, this London-based group spun out of Merrill in 2000. HgCapital, led by Ian Armitage, also maintains an office in Frankfurt.

National Westminster Bank begat ? Bridgepoint Capital
Formerly NatWest Equity Partners, the private equity division of UK retail bank National Westminster, London-based Bridgepoint Capital spun out in May 2000 when its parent merged with The Royal Bank of Scotland. Bridgepoint, led by William Jackson, is currently investing from a €2 billion fund focused on the European middle market.

Nomura International begat ? Terra Firma Capital Partners
Guy Hands' success as founder and first in command of Nomura's London-based principal finance business is the stuff of legend. In late 2001, his team of 70 became Terra Firma Capital Partners. A high profile €3 billion fundraising effort is currently underway, while the team is pursuing its debut investment as an independent entity.

Smith Barney begat ? Sentinel Capital Partners
New York-based Sentinel was founded in 1995 by David Lobel and John McCormack, two investment professionals with First Century Partners, the venture capital affiliate of Smith Barney (now part of Citigroup).

UBS begat ? two:
1. IRRfc – In July 2001, Swiss bank UBS shelved plans to sell UBS Capital, its loss-making private equity investment business, to management, which triggered the resignation of UBS Capital chief executive Pierre de Weck. In 2002, UBS Capital's UK buyout team, formerly known as Phildrew Ventures, bought itself out from UBS and relaunched itself as IRRfc, a private equity portfolio manager managing funds on behalf of UBS and other institutional investors.

2. Avesta – In the same year, members of UBS Capital's French operation set up Avesta Partners, an independent mid market investor active in France.

And on the horizon ?
HSBC may beget ?
HSBC Private Equity is currently investing its third European buyout fund, a £1.2 billion vehicle that has a £600 million commitment from its parent and another £600 million from third parties. The team has been negotiating a buyout from the bank for close to a year. HSBC Private Equity's managing director Chris Masterson, one of the most widely respected dealmakers in London's private equity community, is leading the talks.

In the House
Every major financial institution has at one time had a thriving captive private equity programme but the current state of the captive market varies from the thriving to the non-existent. Here is an overview of the still-standing captives and their parentage follows.

Bank of America
Banc of America Equity Partners manages a portfolio with a stated value of $8 billion. The division makes direct, opportunistic investments in the US through a $1.6 billion private equity group called Banc of America Capital Investors. The bank has set aside $500 million for venture investments and $1 billion for international deals, and is currently raising a European fund. The bank also has $1.3 billion committed to an independent Chicago based middle-market specialists CIVC Partners, although this firm gets no deal flow from the bank.

Bank One
Chicago's Bank One wants out of the private equity fund game, but it loves its new direct investment team, One Equity Partners. Formed in 2001 by former Citicorp Venture Capital president Richard Cashin, and backed by $2 billion from its parent company, One Equity has already made a splash with the acquisitions of Polaroid and German shipyard HDW.

Bear Stearns & Co.
In May 2001, New York-based Bear Stearns Merchant Banking raised $1.5 billion for a debut third-party private equity fund. The group, led by former Vestar Capital Partners co-CEO John Howard, focuses on ?old-economy? buyouts. Bear Stearns saw success last may with the IPO of portfolio company Aeropostale, a teen clothing retailer.

The reclusive giant of captive private equity programmes. New York-based Citigroup Venture Capital, formerly Citicorp Venture Capital, was founded in 1968 and is led by William Comfort, who, according to several industry sources, enjoys a significant share of the economics of the group, unlike many other captive entities. In 2001, the group raised a $2 billion fund called Citigroup Venture Capital Equity Partners. The firm has reportedly sought to exit many positions in recent months. Citigroup Venture Capital also manages mezzanine funds.

Credit Suisse First Boston
CSFB Private Equity is basically composed of the capital and management team of DLJ Merchant Banking Partners, the private equity division of Donaldson, Lufkin & Jenrette, which went through a painful merger with Credit Suisse First Boston in 2000. DLJ Merchant Banking Partners III raised $5.4 billion at the end of 2001. The group is led by Larry Schloss and Tom Dean.

Goldman Sachs Group
Although it manages one of the largest pools of private equity, Goldman Sachs Capital Partners maintains a very low profile. The division of Goldman Sachs closed a $5.25 billion fund in 2000 – $1.5 billion of it from the parent company and its employees. The Goldman Sachs Private Equity Group is led by Philip Cooper. The group's last direct deal was in January, when it acquired Gains International, the specialist voice and data network services subsidiary of U.K. inter-dealer broker Tullett.

Houlihan Lokey Howard & Zukin
The investment bank does private equity deals through Sunrise Capital Partners, a New York-based firm that focuses on distressed situations. Sunrise is led by David Prieser. Houlihan Lokey also has an affiliation with independent private equity firm, Los Angeles-based Century Park Capital Partners.

JP Morgan Chase & Co.
JP Morgan Partners manages a portfolio with a stated value of roughly $24 billion. The firm invests across industries, geographies and investment stages. JP Morgan Partners, headed by Jeffrey Walker, closed a $7.7 billion fund last November, with $6 billion of that committed by JP Morgan Chase. Some doubt has arisen recently as to whether the bank truly intends to put out that much capital over the fund's life, as the bank has drastically scaled back its other private equity operations. JP Morgan Partners also has a significant mezzanine group.

Lazard Freres & Co.
Financial services boutique Lazard's US direct private equity investment programme, Lazard Capital Partners, was dealt a blow in 2000 with the resignation of group co-head David Tanner, who left with other senior Lazard executives to join media private equity firm Quadrangle Group. Lazard has shelved plans to raise a transatlantic fund through a division called Fonds Partenaires, according to reports. However, the firm remains active through Lazard Technology Partners, a US venture firm that raised a $300 million fund in 2001. Lazard's US office recently hired the majority of Merrill Lynch's fund placement team, but the firm is remaining tight-lipped about its plans.

Lehman Brothers Holdings
Lehman Brothers Merchant Banking has been a long-time fixture in the private equity world. The last major third-party fund raised by this group was a $2 billion vehicle closed in 1997. That fund is not yet fully invested. Lehman rounded up $800 for a communications fund in 2000 ? dubious timing. A year ago, one-time Cypress defector Anthony Trutrone returned to head up a ?reinvigorated? third-party private equity programme.

Merrill Lynch & Co.
Although Merrill Lynch was very active during the late 1980s managing private equity capital through Merrill Lynch Capital Partners, the firm decided in 1993 to discontinue seeking third-party capital for direct deals. Merrill briefly considered re-entering the third party game in 2001 with a healthcare fund, but scrapped the effort several months after the launch of fund-raising, citing a ?strategy redirection.?

Morgan Stanley
In 1999, Morgan Stanley held a final close on a $3.2 billion merchant banking fund called Morgan Stanley Capital Partners IV. That fund took approximately two years to raise, despite the frothy market for private equity funds. Since then, the private equity arm of Morgan Stanley has invested at a cautious pace. The firm recently acquired a division of Tulsa, Oklahoma-based Williams. In addition to the Capital Partners fund, Morgan Stanley Private Equity operates venture capital and emerging markets operations. In 2001, the firm suffered the departure of Alan Goldberg, the chairman and chief executive of Morgan Stanley Dean Witter Private Equity. Morgan Stanley Private Equity is now led by Howard Hoffen.