Anyone taking note of headlines in the mainstream press could be forgiven for thinking limited partners are wringing their hands, wiping furrowed brows and planning escape routes from their private equity programmes.
“Deals head for rocks”, “The trouble with private equity”, “Buyout all-stars stumble”, and “Puncturing the private equity bubble”, are just a sample of the ominous headlines that have been splashed atop the business pages of highly regarded newspapers and magazines.
But talking to general partners, limited partners and intermediaries provides a more tempered view of the current climate and of investor sentiment regarding current portfolios and future commitments.
Thomas DiNapoli, who is the New York State comptroller and thus head of the $155 billion (E99.6 billion) New York State Common Retirement Fund, the US' third-largest public pension, says seasoned LPs are “absolutely not” panicking.
“New York and our peers among large funds are sophisticated investors and have weathered a number of financial crises over our 25-year history of investing in private equity,” DiNapoli says. “Smart investors always have to monitor the economy and financial markets and make adjustments, but panic is not there.”
There is less shock than you might have thought, as well. Some LPs have been preparing their programmes for a recession, says Sheryl Schwartz, head of alternative investments for US public pension and financial services giant TIAA-CREF.
“We knew we were going to have an economic downturn, I mean everybody did, we didn't know exactly when or how severe it would be,” she says. “So we were planning for this, and we partnered with groups we thought would have the track record and the expertise to do well in an economic downturn. That's really been our focus for the last few years.”
She points out, however, that TIAA-CREF has features that other institutional investors do not. Its alternatives programme's small size in the context of TIAA-CREF's total assets (the programme is under 2 percent of some $435 billion in total capital), coupled with the alternatives allocation not being based on a percentage of total assets, means that capital calls, distributions and stock market movement or volatility in other asset classes do not impact its allocation weight.
Other LP portfolios are being thrown off kilter by this so-called ‘denominator effect’, however – a fact illustrated by a recent dinner party Schwartz attended. A dozen or so institutional investors were present, the bulk of whom represented endowments or non-profits with anywhere from 10 to 20 percent of their assets allocated to alternatives, she recalls.
“They were all saying they need cash flow to fund their operations, so when liquidity dries up they have to get it by possibly selling in the secondary market, where we don't have that issue.”
CHANGING THE MIX
Those types of secondary sales, however, should not be regarded as a sign of panic, says Tim Jones, partner at London-headquartered secondary specialist Coller Capital. Instead, he said, it's “a reaction to a change in asset liability mix. They've decided rather than change the mix, they'll sell”.
DiNapoli adds that most of the secondary sales by public plans and endowments have “been driven by portfolio construction needs and a desire among well-established LPs to trim dormant relationships, not by short-term concerns”.
He adds: “Secondary market pricing does not reflect panic sales by investors.”
John Gripton, the Birmingham, UK-based head of European investment management at Capital Dynamics, a Swiss-headquartered alternative asset investment consultant, says that while some LPs may exercise caution so as not to become overexposed to private equity, “generally, our LPs do not seem overly concerned”. He emphasises: “Certainly, there's no hand-wringing going on.”
The head of alternative investments at the $4 billion Alfred I duPont Testamentary Trust, Michael Beblo, echoes this sentiment. “We continue to search out unique, experienced groups who are experts within certain inefficient niches,” he says.
Many LPs are anxious, however, as to how commitments made to 2005 and 2006 vintage funds that invested heavily during 2006 and the first three quarters of 2007 will fare, says Allen Waldrop, a managing director at LP Capital Advisors, a California-based gatekeeper whose clients include the California Public Employees' Retirement System.
As a result, he says, LPs are doing more diligence on those investments.
“They are spending more time talking with the GPs trying to understand recent performance and how that compares to plan; the amount and terms of leverage on the company; and any contingency plans to deal with a slowdown in their business,” Waldrop says. “In addition to that, LPs are also spending more time talking to portfolio company management teams and others in the industry to understand their perspectives and what other factors may affect the company in the near term.”
We were planning for this, and we partnered with groups we thought would have the track record and the expertise to do well in an economic downturn. That's really been our focus for the last few years
Many general partners are regularly offering their perspective on the current economic climate and how they believe it will affect portfolio companies [see related article on page 62]. There's also a greater focus on outlining specific ways the GP plans to help portfolio companies prepare or manage throw a slowdown, Waldrop says.
“You're seeing it in the quarterly letters and you are seeing it addressed in the due diligence materials on new funds.”
The “good GPs” are always reaching out to investors, informing them of activities and market environments, said both Coller's Jones and New York's DiNapoli.
“We have an internal investor services department, but we as partners, for example myself and Jeremy Coller, who's the CEO, we very proactively talk to our investors,” says Coller's Jones.
That means phone calls and face time, wherever possible, he adds.
“Investor relations is very, very important in this type of marketplace,” Jones says. “In this market, the deal teams are reaching out to investors to explain what's going on, some proactively, some less so. This is an industry with wide variations in standards of investor relations.”
Everyone interviewed was quick to point out that many firms engage in such proactive communication, regardless of market cycle.
Patricia Hedley, head of marketing and communications for growth-capital focused private equity firm General Atlantic, says the firm is “always talking to our capital partners and is fortunate they have a long-term focus on global growth investing so they understand that markets are sometimes volatile”.
Battery Ventures' chief operating partner, Chris Hanson, echoes Hedley. “In our quarterly reports we do include GP letters which will add in a paragraph about what's going on in the marketplace, what we see as impacts, what we're doing relative to those concerns,” says Hanson.
“Additionally, we make note to our LPs that we track certain key indicators for each of our portfolio companies,” Hanson says. “We're more focused on doing that in this environment, where we're trying to get out in front of and see any concerns to their business models where we might need to react sooner to, say, managing costs better or slowing down hiring plans, or reacting to fall off in revenues or any other issues that might be developed.”
He recalls quite a few drop-ins by anxious LPs during the “stark winter” following the dotcom bust, and says that while that's not happening in this current environment, “when they want to come in and see us about concerns they have, they're going to get some attention from the right people to talk that through”.
How LPs are treated, both in good times and in bad, often has great bearing on people's interest in investing with the firm, Hanson adds.
The duPont Trust's Beblo observes that most “state of the market” communication so far has occurred verbally, at annual meetings, rather than via letters. The sentiments he's heard range “from very concerned that this will be a very rough time for at least 12 months, to others that look at the environment as a minor hiccup to completing deals”.
GOOD TIMES FOR SOME
Turnaround and distressed funds, he adds, “actually relish the current opportunities they are finding at much more reasonable valuations than 10 months ago”.
The fact that GPs don't seem to be hearing much from LPs, however, may not indicate they are totally calm about current market conditions.
“It's hard to see it demonstrated visibly – investors are normally very coy about being open with their general partners until things go wrong,” says Jones.
His firm's recently published Global Private Equity Barometer, an anonymous polling of LPs, found roughly three-quarters of them very concerned about style drift, be it by sector, deal size or geography.
“Investors will give GPs a lot of leeway until they lose confidence or until the returns aren't there,” Jones says. “And I suspect part of their drift away from the larger funds is designed to get more into narrowly tied in, sector-focused, geography-focused funds where they know the general partner's going to be more acutely focused on a particular sector and not have the ability to drift away from that.”
Quite simply, Jones says: “The best way an investor can articulate a concern is not to reinvest.”
Dan Vene, vice president with US-based fund placement agent CP Eaton, says this also means first-time funds, or teams that have never managed funds during a downturn, aren't likely to attract capital.
“I think people have a stomach for putting money with GPs who've managed through this before,” Vene says.
Waldrop agrees: “The really good managers are still having no problem raising money, they're raising it quickly.”
That's no surprise to Schwartz, a veteran institutional investor.
“The truth is, in this asset class, the best performance has been demonstrated in times of volatility and turmoil,” she says. “It's actually probably going to generate some great activity and great opportunities for some smart players who know how to play it.”