TAKING OUT THE MIDDLE MAN

Alignment of interest is an evergreen topic in private equity – and currently a big talking point once again. At the top end of the market, where the largest LBO firms have excelled at raising multi-billion investment funds, management fees as a percentage of committed capital have swelled to unprecedented levels. They can make the recipients very rich indeed. Carried interest on generated profits will make them even richer, but if carry doesn't materialise because the fund fails to perform, the fees will still compensate the general partners handsomely. This isn't good for us, the investors say, and lament that general partners now have less incentive to make money for their clients than they used to.

Fee inflation, in theory at least, is also putting pressure on the alignment of interest between GPs and the management teams of portfolio companies. If maximising the value of the underlying businesses in order to maximise carry is a less important driver of the general partner's bottom line, management teams participating in MBOs might find that the GP's views on how to best run the company might differ from their own. Say a portfolio company experiences problems: a GP craving carry, everything else being equal, will stand shoulder-to-shoulder with the executive team and give it their all to turn the company around. A general partner already earning millions in management fees might be willing to cut losses sooner.

Both limited partners and portfolio company managers therefore have good reasons for wanting to see an overhaul of fund economics. So far the market mechanism has failed to force any change: with demand for big funds at a peak until recently, GPs were able to dictate terms. Now that the pendulum appears to be swinging away from mega-deals, demand may slow. But even if fundraising becomes harder, it is by no means a certainty that next-generation mega-funds will be offered with a radically different fee structure. It wouldn't be the first time that private equity's to-die-for business model would prove resistant to change.

If fees do hold firm, investors determined to stay active in the asset class will have no choice but to pay up. Unless, that is, they have the skill and confidence to go around the middle man: instead of buying private companies through funds, institutions may choose to buy them directly.

This isn't as far-fetched as it may seem: direct co-investment in sponsor-led buyouts is popular with many LPs, not least because the cost of making a co-investment is typically lower than the cost of investing via the fund. A handful of LPs such as Canada's Teachers' Private Capital and Dubai International Capital in the UAE have already gone a step further and are buying companies outright. And if it's appropriate to describe this as a trend, the recent arrival of the so-called sovereign wealth funds (see p. 66) could accelerate it further. Given the enormous amounts of capital these increasingly active vehicles are looking to deploy, even the largest buyout funds would struggle to give them meaningful allocations. More importantly still, the fees they can save by going direct will buy plenty of investment talent. Combine this with the lower cost of capital the sovereigns enjoy, and it is easy to see how they could soon provide serious and regular competition for LBO firms.

What about those corporate executives keen to buy the businesses they run and then set the agenda as they see fit – could they do without private equity as well? On the face of it, depending on the size of the businesses in question, this may seem less plausible. Then again, consider this: a London-based fund placement specialist told me recently that not one but two corporate management teams had approached him with the following idea: to finance a buyout, could he not help them round up equity capital from a syndicate of institutions directly – without getting a private equity fund involved?

Intriguing as this concept may be, there are many reasons why it won't change the nature of the asset class. GP disintermediation will happen on occasion, but there is no way the private equity business model that has worked so well for so long will soon be redundant because of these developments. Nevertheless, to state the obvious: general partners in charge of big funds will still need investors and managers to want to work with them. To make sure of that, it beholds the general partners to keep interests aligned.