In his book, The Future of Finance: How Private Equity and Venture Capital Will Shape the Global Economy, Dan Schwartz delves into the world of private equity, giving outsiders of the industry a window into a business that is both inscrutable and opaque. Schwartz, who headed the Asian Venture Capital Journal in Hong Kong for more than 15 years, recruited some of the biggest names in private equity, including top executives from Bain Capital, The Carlyle Group, and Kohlberg, Kravis & Roberts (better known by its acronym, KKR), to comment on the industry, its future and the challenges ahead.
However, the book is not a confessional, tell-all spin-a-yarn about the inner wheeling and dealings of the world of private equity. Readers looking for a colourful tale akin to 'Barbarians at the Gate', the intriguing story of RJR Nabisco's 1990 leveraged buyout, will be disappointed. Instead, Future of Finance comes across more as required-reading for a private equity course: More instructive than entertaining. It is Private Equity 101 for anyone who wants to understand the nuts and bolts, its players, jargons, and the issues plaguing the industry in a post-Lehman world.
The nuts and bolts
The book is set against the backdrop of the intense financial turmoil that global markets have only somewhat emerged from. Stock markets have fallen precipitously off the cliff. Investors weathered unprecedented wealth destruction. Banks went under, or sold themselves to rivals. Once considered unassailable, insurance giant AIG helped popularise the phrase too big to fail. Even Freddie Mac and Fannie Mae, two entities linked to the US government, had to be bailed out with taxpayer money. The private equity world has inherited a precarious slew of issues that it has to deal with.
But before diving into these issues, Schwartz lays the ground with some basics, helpful for anyone unfamiliar with the private equity and venture capital industry. For instance, it explains the difference between a general partner (GP) and a limited partner (LP).
Broadly, GPs manage the fund, raise the money and decide where to put the money. LPs, on the other hand, are essentially customers of private equity and venture funds. They stump up the capital which GPs put to work, and they can come in different shapes and sizes ranging from pension funds, to university endowment funds, to sovereign wealth funds.
Pension funds have long been major investors in private equity. Such LPs include the likes of California Public Employees Retirement Scheme (CalPERS), Government Pension Investment (Japan), Postal Savings Fund (Taiwan) and so on. These are major players, waving the wands, controlling the huge flow of funds throughout the world. According to a survey, assets of the world's 300 pension funds grew 14.2% in 2007 to nearly US$12 trillion before falling 12.6% to US$10.4 trillion in 2008.
Then, there are the private endowments, which, while generally smaller than the pension funds, are often nevertheless multi-billion behemoths in their own right. The largest is the Bill & Melinda Gates Foundation, followed by the J Paul Getty Trust, and the Ford Foundation. Other examples of LPs are the university endowments, the largest of which are endowments for Harvard University, Yale University and Stanford University.
Other relevant terms are explained to the novice reader. For instance, the book explains the 2/20 rule. This refers to the payment structure that most (but not all) GPs receive. GPs are typically paid a management fee of 2% and are entitled to a cut of the profits (a whopping 20%) once investors' money has been repaid.
The book also explains jargons, such as 'covenant lite debenture' - a term that most people outside the banking industry are unlikely to be familiar with. Basically, it refers to a bond without the traditional terms that require borrowers to maintain certain liquidity and operating ratios. In other words, there are hardly any rules bossing over this kind of financial instrument. These were more regularly issued during the easy-credit period before the financial crisis of 2008.
Brave new world
With the basics explained and out of the way, Schwartz dives straight into the topical issues faced by the industry. At the top of this list are the flood of redemptions and the sudden evaporation of any form of exit strategy. To be sure, 2008 was a painful year for investors.
Schwartz cites the example of Harvard Management Company, the Ivy League university's endowment fund, which had recently been through a bleak period. For the year through October 31, 2008, the endowment reported a 22% decline, and had put US$1.5 billion of its interest in private equity partnership up for sale. Despite bids estimated at 50% of the face value, recent reports suggest that only US$300 million to US$400 million has been sold, Schwartz wrote.
As exit routes started to close off, the industry also imposed the requirement that private equity and venture capital firms mark-to-market. This yardstick is generally comparable with public companies. But unfortunately, the move came at the worst possible time, leaving investors feeling more than just miffed.
Philip Bilden, managing director, Harbour Vest Partners, Hong Kong, was quoted in the book: The industry adopted the standard in the most volatile year. Most LPs and trustee boards will be confused by the volatility of interim returns. Ultimately, it is the realised returns (cash) that matters after a long investment life cycle.
Along with disastrous returns, private equity funds and venture capital funds have also been hit by massive de-leveraging. Banks have been forced to cling on to cash, so that they can somewhat plug the gapping holes in their own balance sheets and are no longer willing to extend credit.
After binging on too much credit for years, suddenly, the banks have gone into withdrawal mode. As Steve Pagliuca, the managing director at Bain Capital points out, The key issue we're seeing is a massive de-leveraging in the world. It has been caused by the previous ten years of overspending by consumers and over lending by the banks.
As a result of the credit crunch, much of the acquisition financing for buyouts has evaporated and private equity firms can no longer pay exorbitant amounts for acquisition targets. Some industry players suggest that this is not a bad thing entirely, as excess bank debt inflated the prices of assets in the past.
Ralph Parks, the chairman of Oaktree Capital (Hong Kong) was quoted in the book: The value of businesses had been inflated by investment bankers, industry peers, and even hedge funds that were eager to subscribe to pre-IPO convertibles.
Due to easily available credit, private equity firms were able to pay higher and higher multiples for the businesses they were acquiring. Ralph Parks explained that the multiples rose from five to six times Ebitda (earnings before interest, tax, depreciation and amortisation), to nine to ten times Ebitda by 2008. However, once the banks refused to extend credit, the party came to an abrupt end, and the leveraged buyout business screeched to a virtual standstill.
Meanwhile, the sources of debt have also changed, with greater dependence on non-bank institutions. While ten years ago, 75% of lending would have been from the banks and the remainder from non traditional sources, over the past five years, 75% of lending has been from non-bank institutions.
The road ahead
The financial landscape is changing rapidly. The recent crisis has thrown up lots of debris, which are posing not just challenges, but also creating opportunities for the private equity industry. For one, there are more and more of so-called distressed situations type of investment opportunities available. When a company can no longer service its debt, the equity owners are wiped out and the creditors become the new owners of the firm. This is the opening for private equity players to gain control of troubled companies - through the debt portion of the balance sheet.
At times, it is one private equity firm versus another. Masonite International Inc, a Canada-based door maker, was an example of such change in control as a result of such a distressed situation investment. Bought over and taken private by KKR in 2005 for more than US$2.7 billion, the company soon suffered from slowing sales and was further hit when Home Depot, an American home furnishings chain store that was also its biggest customer, switched suppliers.
To fund its acquisition, KKR had to borrow US$1.5 billion and to also issue another US$770 million in high-yield bonds, saddling the company with hefty interest charges to service. When the market turned sour, Masonite had to file for bankruptcy protection in March 2009.
As part of the restructuring deal, Masonite's creditors agreed to reduce the debt from US$2.2 billion to US$300 million. In turn, they will take a 97.5% stake in the company, effectively wiping out KKR's ownership. Among one of the lenders assuming control of Masonite is Oaktree Capital, another investment firm.
Masonite was not the first of such distressed situations, and will not be the last. In the view of Harjit Bhatia, managing partner and head of Credit Suisse private equity Asia, much of private equity activity in America and Europe will be in the distressed space. The funds will get active but with less leverage. The fund size will become much more sensible, he was quoted as saying.
Still, there are indications that the private equity industry may return from the financial crisis on a stronger footing, healthier and free of the excesses that once plagued it. There is still plenty of cash in the industry, with sources indicating that the industry has US$400 billion to US$470 billion of dry powder, according to Schwartz.
The top three private equity firms with the most dry power, or cash to invest, include TPG (US$24.9 billion), Bain Capital (US$19.1 billion) and Carlyle Group (US$17.3 billion) as of June 30, 2009. Despite 2009's slowing deal flow, these numbers are certainly not rounding errors.
On July 18, Healthscope, Australia's second largest hospital owner, accepted a US$1.73 billion joint bid from TPG and Carlyle, two leading private equity names. This deal is the largest in Australia since 2007. The losing bidder? KKR. So scoff not at the private equity industry. The story is far from over.