Inside JC Flowers’ troubled fund

It was never going to be straightforward or easy-going for financial services-focused funds deploying capital just prior to and during one of the largest disasters in economic history. So it is perhaps unsurprising that the FIG-focused firm founded by J Christopher Flowers – who has achieved great success in the sector both as an investor and as an advisor to governments and institutions – has a 2006 vintage fund with some problematic investments.

JC Flowers Fund II, which raised $7 billion in 2006, has been plagued by a number of issues since its launch. Most notably, the firm’s investments in lender Hypo Real Estate, HSH Nordbank, Shinsei Bank and broker MF Global, which account for more than 60 percent of the fund, have dragged down returns.

As of 30 June, Fund II was generating a 0.33x investment multiple of invested capital and a negative 29 percent internal rate of return, according to Regents of the University of California documents.

The firm valued Fund II’s realised and unrealised holdings at $2.7 billion, of which $1.85 billion remained unrealised, as of 30 June. Fund II is approximately 95 percent invested, according to market sources who also noted the firm cut its management fees on the fund by 10 percent. JC Flowers declined to comment.

Limited partners in Fund II have indicated that they don’t expect the fund to get above water.

“Fund II’s not going to recover,” one LP told Private Equity International, adding that key holdings like Hypo, HSH and Shinsei have dragged down its performance to the point where the fund’s more successful holdings won’t be enough to generate returns.

Hypo and MF Global will likely be total losses, while Shinsei and Nordbank have struggled to fully recover in the wake of the economic collapse that rocked the financial sector in 2008 and 2009. Having clear explanations as to why these four deals didn’t perform as expected – as well as solid performance from the $2.3 billion Fund III it raised in 2009 – will be key to the firm’s ability to raise a Fund IV.
 
CORZINE’S DEBACLE

MF Global is the most recent in a series of busted investments for the fund. As of 30 June, Flowers controlled 7.3 percent of the commodities and listed derivatives broker’s voting securities. At the time, MF Global appeared to be one of the fund’s success stories, generating a 1.9x gross multiple on invested capital, according to a source.

The broker was led by Christopher Flowers’ friend and fellow Goldman Sachs alum Jon Corzine, who’d become an operating partner at Flowers’ firm after losing his re-election campaign for New Jersey’s governorship.

At MF Global, Corzine oversaw a strategy that invested heavily in European sovereign debt – including $6.3 billion in short-term debt exposure to Italy, Spain, Belgium, Portugal and Ireland, according to a Financial Times report. On 25 October, the broker reported losses of $191.6 million – in large part because of its massive exposure to Europe. MF Global declared bankruptcy six days later.

Amid the bankruptcy proceedings, regulators reportedly found the broker was missing around $1.2 billion from customer accounts.

Although Flowers’ losses in MF Global will likely be small relative to Fund II’s size, having only invested $87.4 million in the broker, its vote of confidence in Corzine as chief executive is another black eye in light of the bankruptcy.
 
PROBLEMS IN GERMANY

In the case of Hypo Real Estate, positive returns will never come. Hypo was generating a 0.1x return multiple after the firm was forced to exit in 2009 when the German government nationalised the troubled lender, according to financial documents seen by Private Equity International.

In 2008, Flowers led a trio of investors to purchase a 25 percent stake in Hypo for a little more than $1 billion, or €22.50 per share. The real estate lender had struggled in 2007 amid concerns over the sub-prime mortgage market, and was eventually bailed out by the German government only months after Flowers acquired its minority stake. A year later, Germany used its new status as a majority shareholder to force the firm to exit Hypo at €1.30 per share – 5 percent of the firm’s original purchasing price.

Flowers has since taken the German government to court over the deal, claiming that the government’s actions represented a “violation of constitutionally protected ownership rights and result in the expropriation of shareholders”, according to a statement. The Regional Court of Munich dismissed the suit in January 2011.

The firm’s problems in Germany were not limited to Hypo. Fund II’s largest holding, German regional bank HSH Nordbank, was generating a zero multiple as of 30 June, according to two people with knowledge of the investment. Flowers has invested $1.94 billion in the bank through the fund, having led a group of investors in acquiring a stake in 2006.

Nordbank showed signs of a revival last year, with net income increasing by 188.9 percent between the first half of 2010 and the first half of 2011.

However, the bank took a hit after it was forced to pay €500 million to the states of Hamburg and Schleswig-Holstein, which own 85 percent of the bank, last year. The one-time payment is part of a restructuring agreement that was completed by the European Commission in July, in which Hamburg and Schleswig-Holstein will provide liquidity guarantees of up to €17 billion for Nordbank. The €500 million will be reinvested into the bank through a share increase, which will result in the further dilution of minority shareholders, according to a market source. The payment was not included in the firm’s valuation of the bank.

RETURNING TO JAPAN

Flowers, alongside Ripplewood Holdings, made a name for himself with the epic turnaround of Long Term Credit Bank of Japan. Renamed Shinshei, the bank was repaired and taken public in 2004, and resulted in one of the most lucrative private equity exits of all time. The investors purchased the bank in 2000 for $1.2 billion and later sold a 67 percent stake in two tranches of shares for $4.7 billion following its public listing.

In 2008, Flowers went back for more with his firm, leading a trio of investors seeking a 30 percent stake in Shinsei. The firm invested $1.4 billion in Shinsei through Fund II, according to LP documents. Including follow-on investments, Fund II had a 14.5 percent stake in the bank as of 30 June.

Although Shinsei has performed better in 2011 – its net income rose by 31 percent compared to the same period in 2010 – its stock price has never fully recovered from the effects of the financial crisis. The bank’s earnings and share price were buffeted by the turbulent market in the fall of 2008, and remains well below the firm’s ¥425 per share purchase price agreed in 2008. As of 3 January, shares in Shinsei were trading at ¥81, or 19 percent of Fund II’s original investment.
 
FRESH START

Flowers returned to market in 2009, raising $2.3 billion for Fund III – short of its $3.5 billion target. While one source said closing on a lower-than-targeted amount may have been due to unfortunate market timing (with fundraising tough universally), others have indicated that the performance of Fund II had shaken investors’ confidence. Yet a look at the LPs for Fund III seems to discount that view: more than 60 percent of Fund III’s LPs were also investors in Fund II.

Fund III was generating around a 1.3x multiple on total costs of press time, according to a source with knowledge of the fund. Among its investments are IndyMac, the California mortgage lender that Flowers and other investors purchased for $13.9 billion in 2009, after it had failed and been seized by the Federal Deposit Insurance Corp. Last year it also picked up a stake in Brazilian bank BTG Pactual for $1.8 billion alongside the Government of Singapore Investment Corporation, the China Investment Corporation, the Ontario Teachers’ Pension Plan Board, the Abu Dhabi Investment Council and a number of family offices.

How these and other investments in Fund III turn out will play a large role in the firm’s future fundraising abilities. As one market source said, it will take “off the chart” returns for JC Flowers to attract anything close to the amount it raised for Fund II. Given Flowers’ history it would be foolish to think the firm incapable of making that scenario happen, however. But for now, the investment legend’s firm remains under scrutiny.