The back page

Private equity in the dock
?Court rise, for Lockley's Urban Metropolitan Public Employees Retirement Superannuation (Lumpers) Fund vs Black Box Partners, part the third.? At this, the gaggle of financial journalists huddled in the gallery at last fall silent.

Imagine we are at the first ever trial between a general partner and a limited partner. The multi-billion pound pension fund is pressing for compensation for its investment in Black Box Partners' fifth fund, a buyout fund that strayed into tech companies. And lost the plot and most of the money.

If it sounds far-fetched, think for a moment about the very real financial dirty laundry currently on display in Unilever's case against Merrill Lynch Investment Managers (MLIM). The Unilever Superannuation Fund is suing MLIM, formerly known as Mercury Asset Management, for £130m. It says that MLIM negligently took too much risk when managing £1bn for it during a 15-month period.

Think too about the deal hatched between Hicks, Muse, Tate & Furst and its limited partners, where the buyout firm offered guaranteed returns of 20 per cent to its limited partners to keep them on board, after its buyout fund had made one venture type investment too many.

The losses on private equity funds invested at the top of the market could make MLIM's quoted fund's underperformance look like loose change. But what would the judge make of the famously opaque world of private equity: private companies investing in private companies?

?So, if I am to understand you rightly, you receive quarterly updates on the progress of the portfolio companies and these include valuations? And the valuations are decided by the portfolio managers? But these may ultimately have no relevance to the final valuation on exit? It all seems a bit vague?, says the judge to the Lumpers representative.

The magic box that is a private equity fund can seem impenetrable to all but the practitioners of these black arts. Talking to the average pension fund trustee can make private equity sound like the ultimate bet, based on a host of very human factors. As one pension fund manager says, ?you can't buy past performance, you're looking for the team, the contacts, the processes.? In short they are buying a whole raft of intangibles.

It is in fact worse than that. As the push for more transparency rumbles on, there is no agreement that the interim numbers for a fund are of much relevance at all. Freeze the frame at almost any point during the life of a fund, and you may find violently misleading numbers. Stop the clock retrospectively, one consultant says, at one, three or five years and I will show you a disastrous looking fund that in year 10 turned out be one of the best performers ever.

Naturally the judge struggles with this too: ?You would invest in a vehicle that when you model the performance numbers, they may be wholly misleading? So what do you do before investing in the vehicle??

Well. Lumpers, like any investor worth its liabilities, will model the vehicle to try and assess the likely returns against the risks attached. But the variables involved are such that you might just as well try and model the impact of the flap of a butterfly's wing on global warming. They do run the model nonetheless, but investors know that a good fund will take its incentive from the carry and that this is the best guarantee that the fund will do what it has set out to do.

So does Lumpers have a case? Hardly, unless it can prove that Black Box Partners departed from the stipulations made in the investment memorandum. That is, according to sources, what irked the investors in Hicks Muse's fund. Pension funds know the risks, even if they find them tricky to quantify. Most sophisticated pension funds will only lose a little sleep if a private equity fund turns sour. As long as the fund's manager had stuck to the plan and lost the money in the way they had initially planned to make it.

Stellar returns are the goal in private equity investment, and when it works everyone is smiling. But when it doesn't, it is better to get the bad news to the limited partners before it reaches the courts and makes the headlines.

All rise, case dismissed.?

Nicholas Lockley is private equity correspondent of Financial News.