London Business School Coller Institute of Private Equity

Ann Iveson's Blog

With news that Blackstone is planning a hedge fund to take big (?) bets just how timely is our second report in the ADVEQ series "Risk Management Practices within Private Equity" ?



Risk Management in PE
Are the regulators still playing catch up?

Private Equity pleaded for separate treatment when regulations were introduced in the aftermath of 2008 financial meltdown but with news of Blackstone's latest hedge fund plans (http://online.wsj.com/articles/blackstone-readies-big-bet-hedge-fund-1404082286) and several direct lending funds announced in the last month just how important and how appropriate are the risk management practices within the private equity industry?

However this report goes beyond what is prescribed from a regulatory perspective and attempts to take a broad view of the risks faced by private equity and how they are measured and thus managed.

Please download our latest report on the subject. (http://www.collerinstitute.com/content/userdocuments/newsdocuments/21.pdf

Risk management is a clear focus for many GPs - however the extent to which the risks and their respective management is reported to LPs is less than might be expected. Whilst you don't need a sledge hammer to crack a nut, the sophistication adopted may also raise a few eyebrows. 

I sense a huge amount of sensitivity around this topic and it would be good to have some feedback once you have had a chance to read it. This is an important contribution to what is a surprisingly barren yet important issue.

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Why you should eat at PE owned restaurants | Private Equity Findings Issue 10


Academia goes creative
Who says academics aren't creative? This has to be one of the most creative approaches to testing whether PE really adds operational value to a business. No need for a pure review of the numbers - that's so McKinsey!

Shai Bernstein and Albert Sheen of Stanford and Harvard respectively devised a far better method for drilling down to determine the operational impact of PE at the micro level of the firm.

In their paper "The Operational Consequences of Private Equity Buyouts: Evidence from the Restaurant Industry" they examine the health inspection records of 94 restaurant chains with a presence in Florida during the period 2002-2012.

They find that the number of health violations fall 15% in the four years post PE acquisition for the directly owned and managed outlets. They are able to compare this to franchisee owned outlets within the chain. Furthermore these improvements did not come through hiking menu prices. Prices  actually fell 4.4% whilst headcount was reduced by 2.8%. Finally the study found that PE owned outlets were 4% less likely to close.

This is just one of the many interesting research articles in the current issue of Private Equity Findings - Serving Up Change.

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University Endowments – No longer the stellar investors | Private Equity Findings Issue 10


University Endowments
There was a time when private equity and a particular group of investors, the university endowments, seemingly contradicted the second law of thermo dynamics. The pe firms that performed well continued to be the top performers and the endowments were the group of LPs able to generate the best returns, consistently. There was no evidence of entropy according to the early research. Theories are not facts but mere stories to explain the available data. To this end recent data reveals a different story for endowment performance that refutes the early theory regarding LP out performance.

In Private Equity Findings Issue 10, Professors Michael Weisbach , Berk Sensoy and Yingdo Wang have updated an earlier work.  In their paper “Limited Partners and the Maturing of the Private Equity Industry” they examine whether the Endowment out performance of 20% over other limited partners, identified in the Lerner, Schoar and Wong 2007 paper, persisted. That paper covered returns from 1991-1998. The current paper covers investments made between 1991 and 2006. And guess what - it doesn’t.

In fact most of the earlier out performance came from venture capital investments where endowments had better access and then rode the wave. From 1999 that venture wave was coming to its end but the endowments didn’t or couldn’t shift. Additionally their reinvestment decisions during this later period were not superior to other LPs decisions. It may come as a shock but they are not and may never have been the smartest investors and the one aspect of the research which is perhaps most revealing is where the authors specifically look at endowments’ ability to pick the best performing first time funds. Endowments are no better during any time period.


So what happened next – did they do better in the aftermath of the financial crisis? I have no comparative data but the numbers from NACUBO reveal that on average they returned a negative investment return of 19% for their fiscal year ended 30th June 2009 with a rebound in 2010 and 2011 of 12% and 19% respectively.  Average PE returns were -19% for 2009, 14% 2010, and 19% for 2011. Overall returns and PE returns dropped in 2012 to zero and 5% respectively before rebounding again in 2013. 

Allocations to Alternatives have not declined as predicted and with the level of distributions seen over the last 12 months, will this be the year they shift allocations?

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Talent Turnover at GPs is not at all bad for future performance | Private Equity Findings Issue 10


Team Stability
Until the 2008 financial crisis not much was known and less was seen about management turnover within GPs. Of course we all knew about PE’s desire to change the management of portfolio companies to improve performance but being a partner of a private equity firm in 2007 with the increasing fund sizes implying huge management fees and access to carry was every MBAs dream. Exit was for the portfolio companies not themselves. Amazingly, or perhaps not given the alignment mantra,  the LPs felt the same; stable teams were what were needed to derive top performance and so all agreements included the key man clause.

Then the crisis hit and GP relationships, both internal and external, were exposed to a new economic reality. Could GPs, so blessed with the talent to optimise their portfolio companies’ management and generate the best fit for purpose, look in the mirror? Whether they jumped or were pushed the headlines from 2009 were awash with stories of high profile departures. However what was the impact on the respective funds' performance?

Professor Francesca Cornelli, Director of the Coller Institute at London Business School co-authored a paper together with Capital Dynamics; Team Stability and Performance in Private Equity looking at the relationship between talent turnover and performance within PE (GP) firms which is highlighted in the current Private Equity Findings Issue (No. 10).

Key findings
·         30% of senior professionals leave their role at some point
·         Turnover is good for performance – at least for subsequent funds
·         Those with an operational background have the most significant impact on performance


Leavers are therefore considered to be the under performers – is this true? Many of those that left firms post crisis have gone on to create/join new firms and raise funds. And what explains the changes today, such as those executives leaving Apollo, where little succession planning and new compensation plans a midst seemingly better economic conditions are creating new growth pains - will their findings hold?

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SMART BETA or just SMART MARKETING?



Smart Beta
Ok so I have been focussing elsewhere but suddenly even I cannot ignore the wave of coverage given over to "smart beta". 

Just the phrase itself did not initially compute - it's beta or it's alpha isn't it? I did finance . It was a few years ago so have they finally discovered a third way? Is this a better proxy for PE?

Indeed I had to look it up.


Then I discovered the Reuters page which pretty much summed up my thinking

So in the end I finish where I began. As a business developer I congratulate all those who have coined the phrase. Great job. But given the financial industry has been penalised for miss-selling so much recently I hope the small print isn't so small regarding the risk. Or am I wrong; is smart beta the financial equivalent of the Philosopher's Stone?

There is some research which does evaluate the strategy so please give us feedback.

(Reuters) - As is so often true in investments, in the case of smart beta it turns out that if it sounds like an oxymoron, it probably is.Beta - the opposite of alpha, otherwise known as beating the...

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LISTED OR UNLISTED | IS THAT THE QUESTION FOR PRIVATE EQUITY ?

Since the start of the year and no doubt prompted by all the additional exposure heaped on the industry from Mitt Romney's presidential campaign, I have been toying with the idea of writing about why PE contradicts that often cited phrase "all publicity is good publicity".  

Bad news, especially with respect to finance, sells. However there appears to be so many bad aspects relating to the private equity industry that all the positive news on deals securing more investment, facilitating management access to operational expertise,  building jobs and generating real value creation is crowded out by the seemingly abundant negative coverage.

All industries, business models and business people have elements that exhibit shall we say questionable business behaviours but is private equity really the commercial black hole equivalent, sucking in every nuance of bad practice that the media would have everyone believe?

Or is it just envy; the same old adage reconstructed and rehashed to fill the content demand on media channels? I decline to comment but instead ask whether the industry behaves in ways that helps engender a negative view?

Hence my earlier blog on transparency.  If you operate under the cloak of being private then it's best not to be caught with your hands in, or perceived to be in, the cookie jar, such as the siphoning off and allocation of transaction fees. Once trust or commercial integrity is challenged it is difficult to regain. Although neither am I advocating that confession, in this case, transparency completely excuses (nor will indeed eradicate) bad behaviour!  However what I really wanted to pose, by way of an example of questionable behaviour, is the decision of private equity to list, especially when many listings have not performed well subsequently.

I thought I would wait until after the Coller Institute, together with the Corporate Finance Faculty of the ICAEW co-hosted their event on 28th March with a head to head debate between Jon Moulton and Louis Elson. Highlights of the event can be seen in this video.

A very entertaining and informative evening essentially highlighted that one size, or one listing model, does not fit all. Indeed listing seems to have as many varieties as Heinz and Mr Moulton himself was not a proponent of listing per se. His variety, a self-distributing fund with fees that are NOT based on NAV, was designed to address many of the criticisms investors have raged about, namely shares trading at a persistent, and often large, discount to NAV.

True the evening primarily focussed on those companies or funds listed in the UK which tend to be relatively small. (Even 3i no longer reigns within FTSE100). We did not talk of the US behemoths, whose management companies, have listed with varied success. These hybrids, in that listing creates a currency or a founders' praecipium, rather than a new pool of capital to deploy in new or existing portfolio companies, are perhaps what Professor Michael Jensen was referring to where he termed Listed Private Equity as a non sequitur in both English and economic senses.

With Carlyle Group's listing just days away the topic is poignant. Denigrated by some journalists from a governance point of view, most of the clauses limiting shareholder rights are common to listings of other large PE groups. 

Equity is always subordinated capital but here the shareholder, devoid of the usual governance levers, is somehow super subordinated. So what should the shareholder of a PE management company earn in this position of the overall capital structure?

The GPs will of course argue that such constraints on shareholder actions are in keeping with their overall governance model, an alignment of interests, where shareholders with varied interests are considered not to add value. May be that is true but what about LPs who have in the past been central to this theory of alignment. With large funds now comprising several hundred LPs, does the alignment proposition still hold?

Are new listed shareholders being short changed - the Carlyle Roadshow talks of an annual dividend  which including special distributions and based on 2011 earnings could be between a yield of 7.6% and 9.3%? Attractive returns indeed. But remember they are "what if", not real, outcomes and 2012 could be more challenging than last year. Like all shareholders, they will be subject to risks within management's control; such as their ability to ensure the maximisation of distributable funds (essentially fees plus carry less costs) and those beyond their remit; such as the taxation of carry, which has been up for discussion for the last five years. 

However beyond these more obvious risks, and this is where we return to behaviours, there is the risk that management could adopt  "bad" behaviours, counter to shareholders' interests. There are many ways that management could divert distributable earnings if they wanted (see today's news on Actis), special fees and subordinated notes inserted anywhere along the chain of their complex group structures, probably being the easiest.

Let's go back to basics and ask why do large PE companies list their management companies? Is this just another example of opportunism by PE firms so derided by the media? From the performance of earlier listings you might be forgiven for thinking so. However Carlyle are keen to counter this accusation by pricing at a discount to where peers are currently trading thereby leaving something on the table as an incentive.

Alternatively have the dynamics of acquisitions changed whereby having a currency on tap has distinct advantages over 10 year funds? It is quite possible they have. In more uncertain times PE funds may have been more reluctant to bid at certain fixed prices whereas equity will give more of a market hedge.

However perhaps there is another more obvious reason. LPs today remain the key stakeholders, as through their commitments they create the framework from which the GPs can build their portfolios and generate returns. Or do they? Is this public listing a means of recalibrating the balance of power? GPs have, over the last three years, needed to accede to LPs' requests for lower fees, managed accounts, better information and a more equitable split of transaction and other fees. Are these listings one way of redressing these changes?

Finally with all the current focus on remuneration I did want to make one point to demonstrate bad behaviours proliferate in other industries as for some reason media coverage remains siloed with little focus on lateral or comparative analysis. If most of the banks featured in the recent remuneration debacles had adopted pay out policies akin to PE then no bonuses would have been paid in any year since the crisis and would not be paid until the shareholders had earned a cumulative 7-9% hurdle rate (on their original investment). I am also ignoring additional factors such as bonuses being paid out on unrealised gains (versus realised in PE) and that many banks are generating returns from having access to government subsidised funding!

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TRANSPARENCY AND DISCLOSURE - WHO CARES?

Have I missed something or has the latest report produced by BVCA and Ernst & Young on the disclosure of performance KPIs per the Walker Guidelines received little to no commentary in the press?

The rhetoric and coverage afforded to this supposedly much needed reform of the industry was vast in the two years ahead of the code's introduction. But now this 4th report has come and gone without so much as a comment let alone some pithy insight.

Why should this be?

It might be worthwhile at this stage to differentiate the performance report from that produced by the Guidelines Monitoring Group which is reporting on compliance with the disclosure requirements per se at both the level of private equity firm and at the portfolio company. However the fact that sample sizes are not easily reconcilable may incite an immediate level of frustration amongst interested readers.
Materiality:
This years' report aggregates data over 60 portfolio companies from 28 private equity groups representing £87 bln of investment in terms of enterprise value and involving over 370,000 jobs. Whilst in number this is a significant increase over last year (43 portfolio companies for 2010) as the criteria barriers for recognition were lowered, their economic impact  on the overall disclosed group in terms of enterprise value, revenue and employment is less than 20%.
Sector Focus:
The report tackles sector focus in terms of percentage of employment. 62% of all Portfolio Company employees were employed in the consumer services sector (including retail), followed by industrials, financials and consumer goods, collectively a further 24%. This is very different from FTSE.
Performance: Year on Year
This has to be the real focus doesn't it? Year on Year growth in revenue, EBITDA, FTE, productivity and capex is all really modest. But in a difficult environment any increase is welcome, although we know nothing about where this growth is coming from; current or new customers, new versus existing products or whether it is UK, overseas or export led. However what is striking is the aggressive change and efficient pruning of working capital to boost cash flow.

Good news then?

Well not really as in comparison to a sector weighted FTSE the results look different. Growth in revenue and Ebitda is much stronger in the sector weighted benchmark compared with the portfolio companies. But, and this will come as a surprise, employment grew within the portfolio companies versus a decline in the benchmark. So the fears and allegations levelled at private equity companies in terms of reducing employment especially in a downturn have not occurred in 2010 for this sample.
Performance: Longer Term
But Private Equity is all about the long term and the report tracks growth against the respective benchmarks over the last 4 years. Whilst annual revenue growth at 6.2% since acquisition is lower than 7.4% for the sector weighted benchmark, Ebitda growth at 5.3% compares favourably with 1.3% for the benchmark. Employment growth has been lower at 0.4% versus 1.3% which supports other research in this area.
Leverage:
The focus of so much criticism, the leverage ratio (debt/ebitda) at acquisition was 7.9. At the end of 2010 this declined to 7x. Third party debt was £70.6 bln gross and £64 bln net. Over the year net debt declined by £1bln funded through disposals, improved operating capital against minimal equity withdrawals.

The portfolio company average leverage of 62% compares to the sector benchmark of 18% and its impact is seen in the attribution analysis of the returns from those that have exited. These number 21 since 2005 generating a gross return of 3.13x versus that of the FTSE. The basis on which these returns are calculated, relative to FTSE rather than absolute, and the fact they are gross is somewhat confusing and could be argued counteracts the desire for disclosure. The total relative return comprises the market(FTSE) return of 100%, 154% from the leverage amplification with a further 59% coming from strategic and operational improvements.

But despite the impact of leverage we know little about the debt profile, its maturity, to what extent covenants have been met, waived, altered or breached. But there again we don't get this much information for listed companies. However when debt is so central to the capital structure (and returns) should private equity reveal more? As an employee or trade creditor I would find this information useful.

Indeed the Sharman Panel on behalf of the Financial Reporting Council is looking at going concern and liquidity risks faced by companies throughout an economic cycle, suggesting that such information should be routinely reported as part of directors on-going discussion on strategy and risk.

We await the outcome of the consultation period and subsequent report especially in relation to question 3 posed by the panel :

"Should the scope of any final recommendations be applicable only to listed companies or also to other entities? If they should be applicable also to other entities, please indicate whether to all or only some types of other companies and entities and whether any adaptations should be made to the recommendations in doing so."

Are we bored or confused?

So does the current level of disclosure  in this performance report tell us anything; are we, or the stakeholders better informed? The problem of aggregation smoothes out the wide dispersion of outcomes, doing no one other than the poor performers, any favours. Moreover the data points while increasing in number are relatively small; just 52 after companies with incomplete annual data or previous negative numbers are excluded.

The cynics thought this code would be little more than a channel to highlight the best of the industry. This is certainly not the case as in places it creates more questions than it purports to address.

But it was created to deal with a real or perceived issue of non disclosure at great cost. The industry can afford it you cry.  Yet in the past, rightly or erroneously, we have treated the data like an iceberg, ignoring the headlines to worry about what lurks beneath the surface. Have we now just decided to ignore it completely and if so, why?

Whilst  in general I am in favour of transparency because:
  • of the positive behaviours it engenders or by perhaps thwarting negative behaviours and
  • it reduces the potential to earn rents derived from asymmetrical information

I believe it should be useful. By that I mean it should be used and not there for transparency sake. Therefore I would like to hear from those who use this data and how they use it in terms of planning or decision making to  better understand just who is in this community of stakeholders.

Certainly many private equity firms are facing challenging times as they seek investors for their next funds. But I doubt if these reports played a role in sorting the wheat from the chaff!

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COLLER PRIZE EVENING | LESSONS FROM TIM PARKER

  • Masters and PhD Prize Winners 2011 announced at Annual Coller Prize Evening
  • Tim Parker's learnings from an impressive career

Now in its 6th year, last Wednesday was the Annual Coller Prize for the best case study and management report completed by Masters students at London Business School in the field of venture capital or private equity. In 2010 we also introduced a new category - the PhD prize that is open to all PhD students at any academic institution focussing on research theses in this sphere.

Congratulations to all the winners and runners up. You can find out more about them and their work on our website.

However I want to devote this blog more to the introduction given by Tim Parker an alumnus of the School and now an Industrial Partner at CVC Capital Partners. Although not a hagiography, it nevertheless provided some interesting and useful insights to the essential elements or lessons for running a successful business and why these might more readily exist within private equity owned firms.

Having witnessed, changed and imposed governance at a variety of organisations including Plcs, family businesses and pe owned firms these are his take aways from his impressive career.

  • Failure - To fail is good for a career, especially if it occurs early and is not too spectacular.
  • Managing People - For success it is critical to develop sound judgement about people - which to motivate and promote and which to remove. The role of the CEO is to pick and trust the right people. He avoids so named "political" people; those that will put their interest and agenda above that of the company or main mission.
  • Delegating Power - real delegation creates real power to leverage (not in the financial sense) the organsiation to develop a collective responsibilty. This is different from a blurred sense of shared responsibility. It means encouraging disagreement and promoting a direct feedback to the CEO on problems and disagreements.
  • Incentives - They can make the same people have different behaviours. Whilst at least in the financial sector incentives are a bad word, he showed that structured correctly and based on realised results not just valuations they can make those potential recipients to ask tougher, more demanding questions of their and others performance. Most importantly they can make those same same people move at a faster pace to correct and improve imediments to performance.
  • Tempo - The speed of decision making is imperative. Opportunities are often lost to procrastination, analysis paralysis or just down right laziness. With volatility a seemingly constant, the ability to make a decision is key. The art is to know when you have enough of the right information. It is, he said, better to make the wrong decision than no decision - wrong decisions can usually be reversed.   
  • Execution and Knowledge - Great execution is everything and the catalyst for this is specific indepth knowledge to anticipate and avoid pitfalls.
What about the benefit of the MBA at London Business School - why is this not included above? Definitely it was a factor (although it was MSc at that time) as it transitioned him into general management from a 'career' in the Treasury. It also underlined and engendered a more competitive ambience as opposed to his, self confessed, more relaxed undergraduate years. 

Tim closed his candid and engaging talk on a more serious and poignant note; after a comment on succession planning at pe firms he made an observation on the increasing pressures facing everyone running a business today, explicitly that 'the cake' is no longer growing. Although open to interpretation I saw this as implying a flaw in or a warning on capitalism as the mechanism for empowering wealth creation. Whilst there is an increasing return on intellectual capital the middle classes are not just being squeezed but evacuated he stated.



So may be  he rightly earned his albeit ersatz tltle "Prince of Darkness" and we should tune out this blog to Elgar's Nimrod, a sombre melody, the type which Tim had told us is used by the media to signify, as in some theatrical ensemble, "the bad guy". But there again honest should not be confused with bad just because you don't like the message!

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PRIVATE EQUITY | THE MASTERCLASS | AN INVESTMENT OR EXPENSE?

  • Can you really be taught Private Equity or is it, as Oscar Wilde might have suggested, something you have to experience firsthand?
  • Is a Business School able to manage the gap between rigour and resonance?
  • In summary what makes this executive education course an investment rather than just an expense?

I last wrote about the MasterClass in the Private Equity Findings Issue 3 and essentially focused on the participants, their seniority and geographic diversity, and syllabus together with some of the course alumni comments.

However I was prompted to revisit it because :

  • The time of year - the MasterClass is held in London biannually (March and October) and
  • Perhaps more pertinently by an email we received from an US based past participant who wrote to say how directly impactful the course was in (re)viewing and ultimately selling his company
    For someone, who has no links to the School other than a 3-day open Executive course, to do that says more than any advert could so I decided to sit in on the current class to watch and observe.

    I have sat in earlier MasterClasses and must confess at this point, my allegiance. However, this time to create a level of detachment I sat at the back not in the lecture theatre desks.

    It was half way through Day 2 and the sold-out class of 40, divided into 8 groups, were on their current assignment - adopting the role of an LP and deciding whether and in what GPs to invest based on their respective track records. This is a simulation using real, unattributed data.

    On paper, the seniority and diversity of this class were no different than other executive programmes; indeed I had to go and check out a few of the flags on name plates which were not immediately recognisable. What's more and despite the sombre economic mood, well at least in the western world, this class was sold out months in advance.

    It's accepted wisdom that business school enrolments are negatively correlated with the economic cycle - I think it's the same for books on leadership but I don't have the stats, but is it true for Executive Education?

    And this is Private Equity. You might have thought the media coverage and reality of tough fundraising, reduced leverage and barriers to exit may have proved all too much but, no, the interest in the sector remains. Indeed this class is populated with participants from leading GPs and Investors as well as many from corporates and the professional services.

    As the class came in I was struck by the positive ambience; a blend of camaraderie and friendly rivalry amongst the teams. I know it's cliched but there was a real buzz in the room. Each team had been set a slightly different task or question on reviewing the data and each presented their findings, seeking out the hidden DNA of each GP.

    "Making an impact on how we do business"........has always been the genesis of the School's teaching and now it is the current strapline for all our programmes. So how do we convey this in the MasterClass?

    Well what do you get?
    • First Rate Teaching - from Faculty and Practitioners. It's a packed 3 days. You have to participate - this is not for observers! 
    • Case Studies - tackling real situations co -authored by Professor Eli Talmor, Chairman of the Coller Institute with appearances from many of the cases' protagonists. Here you are in situ, sharing examples of responsible ownership (and not so great ownership) - always a hot potato - where it's about evaluating operational risks, opportunities and capturing those option values. It is not all about the leverage and financial wizardry. It's about stories and experiences which are delivered brilliantly.
    • International Private Equity - written by Professors Eli Talmor and Florin Vasvari; the current almanac of the PE industry.
    • Simulations - as described above on investing in GPs.
    • Technical Input - from lawyers on matters such as Fund agreements
    • Networking - a chance to spend time and work with senior professionals from varied business and geographic backgrounds and become part of the Coller Institute network though Linked In connections with current and previous programme participants
    • All the above with first rate administration on campus in London!
    Learning is good but not enough, it's what you do with it that counts. Whether it reinforces or changes behaviours it should provide the confidence and platform to make an impact.

    As I re-joined the class for the concluding remarks and drinks it was clear that lasting connections had been forged. At this level  most of the participants come with a sense of purpose and all were enthusiastic about what they had learned, how the knowledge had been transferred and most importantly how they might use it!

    So we remain true to our ethos and hopeful that we will have more stories from alumni and their experiences of how the School and the MasterClass have made an impact on them and others.

    Oh and if you want to hear the real stories and secrets behind the deals then look out for our next MasterClass in 2012 !

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    PRIVATE EQUITY - A BAD BUSINESS?

    Well according to the FT today that may be the belief of Ed Miliband as he espouses his plans for promoting ethical business behaviour during his inaugural speech as party leader at the Labour Party Conference.

    Good ideal we say. However what about execution. I have grave concerns as all that emotive language such as "wealth creators" versus "asset strippers" comes to the fore again.

    Creating a forum for debate is a fundamental tenet of the Coller Institute but we hope that those we host have protagonists and antagonists, that are both open minded enough to listen to the opposing arguments, and have sufficient integrity and judgement to question their original positions.

    Mr Miliband plans to use tax and regulation to differentiate between "good" and "bad" businesses. Just who will be the arbiter and when in the business' life or cycle will it be decided? Any politician as Dumbeldore with the Sorting Hat is not a good image but worse yet he comes to the debate with a bias for they state that Southern Cross is the definition of a bad company.

    To say Southern Cross is a bad company without a debate as to the why,  what and who exactly made it, if indeed it was, does not augur well for many businesses irrespective of their ownership structure. There may well have been governance and operational issues at Southern Cross that could have been better (I am writing a separate blog on this very topic) but to label private equity as bad with one holistic badge is inappropriate and devoid of any analytical rigour.

    Take Southern Cross for example. The business was publicly listed since 2006; ample time for so many stakeholders to question the business model. Why didn't they - were they conflicted, ignorant or both? 

    Additionally "Sale and Leaseback" the financial tool so heavily criticised for causing the company's demise, is used successfully in many industries such as retail. It is not the tool but the workman in defining the terms of the leaseback that is at fault. In a publicly listed company those workmen are visible and accountable and yet when were they called to account? Some have interpreted Mr Miliband's intention as changing the tax advantage currently enjoyed by debt. What about rentals in sale and leasebacks and payments under PFI?

    This week we learned how poor use of the private finance initiative (PFI) by the past government has exposed parts of the National Health System to potentially excessively high future liabilities. However, many PFIs have proven to deliver value for money for governments around the world in the delivery of social infrastructure. Again it is not the tool per se but at least it has been discovered now, with hopefully enough time to renegotiate and restructure.

    In the past private equity has been likened to locusts - now they are in the same camp as anti-social tenants and like bankers just after a "fast buck"; the antithesis of grafters. But quick flips were the exception not the norm; indeed the holding period (acquisition until exit) is increasing. Furthermore remuneration methodology within PE is based on realised not mark to market gains and probably more objective with an audit trail than in banking. Time for a response? Should we host an event "PE - Grafters or Predators? Let us know.

    Interestingly in his speech the world is divided between "producers" and "predators" the former invest, produce and sell. Okay so you know what to include in your slide pack to the shadow government!

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    LEADERSHIP IN PRIVATE EQUITY : A POSTSCRIPT - SPRING CLEANING

    Is it just me or the changing of seasons? For no sooner than I write something on leadership in private equity and the papers seem awash with stories of management changes. Am I just more attuned to the precarious and transient nature of managing a PE owned firm or is there something going on besides the seasonal cliches of spring cleaning; a clean sweep and a new broom.......?

    It started with the change of guard at the retailer New Look (21st March) and then only a few days later (25th March) Andy Hornby quits as CEO at Alliance Boots after less than two years in the role. So what is behind these changes?

    At New Look both the CEO and Chairman went, the former because of poor performance, the latter because an IPO opportunity had been put on ice, again, for the third time since it was acquired by its PE owners. Indeed for its owners, New Look is not at all new since it was acquired in 2004.

    The CEO had been with company since 2001 having won the battle for the CEO title in 2008. However coupled with the company's declining sales, specific operational and personnel matters, which no doubt exacerbated the management change, the media coverage seems more agitated by the PIK loan and perhaps rightly so.

    In those heady days of 2006 New Look raised £ 359 million of PIK Loan, the largest of its kind arranged in Europe at that time! As you know these are deeply subordinated debt instruments where the interest just rolls up until maturity while the initial proceeds are used to pay out dividends to the PE owners. (As an investment New Look has apparently generated 2.5x its owners' initial outlay). As you would expect this is expensive debt and in the accounts to March 2010 was recorded at £597 million and by now, a year later, is probably around £ 670 million. So what you ask?

    Well any IPO was going to pay down the PIK loan with little if any staying with the company. This generally does not give investors a warm glow. However in this case it is known that one of the PE owners and management bought some of the PIK loan at the height of the credit crisis for as little as 25% of face value. In fact the 2010 accounts show them to own about 20% of the issue meaning:

    • the IPO would pay them out at par thereby creating a second payout
    • they would "cheat" the subordination/ risk element of the note by receiving preferential pay out
    • they would leave the senior debt more expensive as an increased margin was agreed by way of compensation for the change in the capital/ subordination structure and may impact the overall capacity with senior lenders
    • the PE owners would create different returns on this investment  for their respective LPs, depending on whether the PIK was recorded in the same fund - this creates conflicts and inbalances to the PE ethos of alignment
    What about Alliance Boots? Are financial pressures the cause in this case? Under PE ownership since 2007, its revenues are up apparently but what about margins; they are already thin circa 2+% (EBITDA) in the larger pharmaceutical wholesale division? We know it's tough on the high street - you only have to look at the Baker Street store to see it's received no capex for at least 5 years!

    But seriously this is more about fit, purpose and who put him there? The CEO position was left vacant since the departure of the incumbent in 2007 so how needed was it or how easy was it to fill? The group has an Executive Chairman and CEOs for each of its two divisions so defining the role would have been critical. Trying to shape a role in that situation with that framework would have been a challenge!

    One additional aspect linked to leadership that PE may need to start to focus on highlighted by these changes and in light of the longer tenures is the question of "Succession". I am talking about management succession within the portfolio company not the PE Firm itself which is another issue all together! In the past, with holding periods of 3 to 4 years, this had not been the priority or focus. 

    The CEO at New Look had been with the firm since 2001 and when acquired by PE in 2004 there were several internal candidates for the CEO role in 2008. However there are no internal candidates to assume the mantel now. Instead the founder, Tom Singh, has been appointed interim Executive Chairman while they search for a replacement. Likewise at Alliance Boots there are apparently no internal candidates and the Executive Chairman is looking externally.

    Interestingly, Founders resuming the helm is also quite topical at the moment. In addition to Tom Singh, Tim Waterstone is considering bidding back the bookstore from troubled HMV and Jimmy Choo is considering repurchasing his brand. This may have worked for Apple and Steve Jobs but the circumstances were very different! However to go back to spring cleaning they do say - a new broom sweeps clean but an old broom knows all the corners!

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    LEADERSHIP IN PRIVATE EQUITY

    Last week the Coller Institute hosted an event entitled "Leadership Risk in Private Equity".

    Rain forests have been destroyed and a significant volume of CO2 exhaled by the weight of literature and numerous speeches given on the general topic of leadership.

    Business School students are bombarded with theoretical and empirical studies on both leadership impact and styles. Yet leadership, good and bad, outside a short list of stereo typing adjectives,  or at least the execution of it remains elusive. Moreover it is often an ex post rationalisation, requiring a crisis or significant event, for the defining assessment. So one size does not fit all but what if anything is special about Private Equity?

    Perhaps it is best to start as the event did with a framework espoused by Professor Nigel Nicholson. Professor Nicholson is Professor of Organisational Behaviour at London Business School. He said, at the start of his talk, that he knew little about PE. However the fact that he has written books on family business (Family Wars) and behavioural risk in finance (Traders), he was the perfect choice to start the debate.

    His framework for leadership acknowledges the importance of the dynamic interaction and connectivity between the classical studies and comprises:

    • Situations - This is the context in which the leader operates, the business environment, the people around him/her - their capabilities and state of mind and the challenges he or she faces. This context is not a constant but a dynamic and, according to the second law of thermodynamics, a chaos seeking variable. Does the situation shape the leader? This depends on:
    • Qualities - This is the leader's character; the will, the skill. These are often difficult to change. Does he/she accept or question the context. Does he/she shape the world around them?
    • Processes - These are the styles, tactics and strategies a leader deploys in dealing with "Situations" or how the "Situations" make a leader react.
    Like all frameworks it doesn't tell you what to do or when to do it, therein lies the art of leadership! Shaping a world to fit you my be irrelevant if that world doesnt fit in a macro sense. However changing, letting the world shape you, is difficult. It involves self discipline and a catalyst to know when and what to change. Leaders that surround themselves with challengers and trusted sounding boards exist (Warren Buffet and Charlie Munger come immediately to mind) but are rare. If I am wrong then let me know!

    So we have arrived at the conundrum; the duality of leadership - shape but adapt! but is it useful or applicable to private equity.

    As I listened I thought it might explain why private equity is so often linked to increased turnover at the portfolio companies in CEOs and even more prevalent the poor CFOs.

    A company or the "Situation" is very different pre and post buy out especially when significant amounts of leverage are involved. Debt brings new stresses, such as redefining resource allocation, new controls and potentially new relationships with the lenders.

    • The shareholders are different  - more active, demanding and with greater access to data and management
    • The information required by those shareholders is often narrower but considerably more in depth and more frequent
    • The Leadership balance changes as shareholders have a major impact on strategy and often add/insert new members to management team
    • The communication between management and shareholders changes becoming more frequent and often less formal.
    Therefore it seems astonishing that management teams survive at all in this post PE owner world! Yet so many private equity firms state within their investment philosophy that they 'back management teams'. Is this borne out by the data? Well data is sparce or to be precise data available to academia is sparce (so if any LP or GP would like to work with us please do get in touch)!

    I refer back to Professor Cornelli's, our Academic Director, speech given at last years Global Leadership Summit, held at the School and written up in her blog.

    In her paper 'Is the Corporate Governance of LBOs Effective' she finds evidence that CEO turnover is  actually lower post an LBO especially where the original CEO is retained and also where the PE involvement on a Board is high. But wait, when she distinguishes according to the level of PE involvement she sees again the best performing deals have the highest levels of engagement, such as those deals where the CEO is changed! What does this reveal about the role or effectiveness of incentives at portfolio companies in terms of leadership? Which type of CEO in this Darwinian world survive - adapters or shapers or something else? For one view read this.

    So GPs appear on the face of it to be adopt a directive approach to leadership at least with respect to their portfolio companies and so long as it results in higher returns great as this is what LPs are paying for. But what about leadership within the GP itself. Here there is no research as yet but Professor Cornelli is currently working on such a project. The recent financial crisis revealed some well publicised schisms but the true drivers and full extent of turnover is yet to be analysed. Just how adaptive were GPs to a fundamental change in the 'Situation' ?

    At the recent PE Conference hosted by the PE/VC Club at the School, one speaker revealed that GPs were slow to adapt, to cut operational costs at the GP level. Indeed using the framework above the new situation now shaped how GPs operated whereas pre crisis they had shaped the PE world (I am reminded of the 80s adage 'Masters of their Universe')

    • more equity/less leverage (although this is now creeping back)
    • focus on the portfolio rather than new additions
    • greater focus on downside risk vs 100% on returns
    • greater responsiveness to LP concerns
    Private Equity is an illiquid asset but the recent crisis appears to have created limited LP suffering, well below some of the apocalyptic predictions. However to what extent do LPs specifically value leadership in their GPs and respective funds and perhaps more importantly how can LPs themselves exert leadership with respect to GPs?

    Looking at the second version of ILPA principles published in January this year, LPs can amend key man clauses(simple majority), halt the investment period (2/3 majority) and using the 'no fault' clause even remove the GP(75% majority). They may even have access to partnership expenses. However to determine whether these principles confer effective leadership we need a test.

    Indeed leadership impact is more acute in times of greater uncertainty and rapid change. Whilst PE has recovered from its recent woes as it did when tested in 1990/91 and 2001/02, it continues to face uncertainty in the form regulation, middle east tensions and doubts about a sustained economic recovery in addition to its specific problems of fund raising and succession planning.

    Will the leaders of the next vintage be different from today?





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    PRIVATE EQUITY CAPTIVES – ANOTHER REASON WHY THE VOLCKER RULE MAKES SENSE

    I’m hoping you’ve had a chance to dip into the latest issue of Private Equity Findings. It’s all interesting but perhaps this issue’s “Beyond the Abstract” entitled The End of the Captive is worthy of an extra mention here.

    Why?


    Academics are often criticised for having their heads either in the sand or stratosphere not on what’s happening right now. Not in this case though! The research paper “Unstable Equity? Combining Banking with Private Equity” by L Fang, V Ivashina and J Lerner is spot on given the resurgent wave of criticism levelled at banking models, bankers and their worth.

    I should say upfront that these are my opinions, not those of the Coller Institute. However as an Institute focused on Private Equity such criticism provides an interesting distraction. Indeed many in PE would side with those that argue bankers, on average, are richly paid in relation to what they earn for their investors. But that’s not my point here.

    Although focused on captives, what this paper is really examining and accumulating evidence on is the much broader and evocative question - the extent to which banking activities are cyclical and whether specific types of activity promote cyclicality within the financial system? This in essence is what the Volcker rule is all about and its sceptics should look at the authors’ findings at least as it relates to bank affiliated private equity businesses.

    • The findings are based on a sample of 7,902 unique US private equity transactions between 1978 and 2009. 
    • The 14 captives identified during the period 1983 – 2009 were involved in over 25% of all the deals done. Significant as this is, the real issue is that their involvement was pro-cyclical, peaking at over 45% of dollar volume at the height of the market (2006). 
    • Overall the amount invested equalled 9.4% of the parents’ total equity (not just Tier 1 !) during this period although it peaked at 23% at the top of the cycle (2005-2006). 
    • It is the concentration of exposure amongst the affiliated group that should at least raise a regulator’s eyebrow if not their blood pressure – the top 5 account for 80% of the total dollar value transacted by this entire group and the leading captive – Goldman Sachs Capital Partners alone accounts for 36%! In the non-affiliated group KKR accounts for 15% of the dollar volume and the top 5 transacted 50%.
    So what drove the banks to get involved and to such a great extent? Go beyond the immediate knee jerk Gordon Gecko response and think about this strategically. The whole economic study of comparative and competitive advantage in terms of how it might apply to banks and specialised GPs is all really very interesting. However the paper looks at two initial factors; superior knowledge and access to capital, especially debt.

    The former if prevalent would be demonstrated by the affiliated deals selecting financially stronger ex ante targets. This they do find but when the parent bank is a lender in the syndicate the targets are weaker.

    Who is driving this? – the leveraged loan group, knowing that they can record the fees today, syndicate or securitise most of their residual exposure and book the loan at cost with no mark to market, brings in the prized equity of the captive in order to earn a league table lending position or is the captive in the driving seat? No longer able to find the growth equity transactions it changes focus, wanting exposure to the larger deals to improve their future potential deal flow and so persuades the leveraged loan group. Or is it simply evidence of opportunistic behaviour deployed by banks during boom times. Those appearing in front of the Treasury Select Committee have and will no doubt continue to deny such a stance!

    So with no comparative advantage on sourcing better deals, what about access to capital? Here is the edge, bank affiliated deals enjoy much better terms when the parent is in the lending syndicate with the greatest advantage concentrated during the boom years.

    • The amount of the loan is increased by US$ 557 million – almost double the average loan size,
    • the maturity is extended by 4.3 years - two thirds increase above the average 6 years and
    • the spread is reduced 33 basis points – a 10% reduction to the average spread.
    But what about the returns? Can average to weaker targets be transformed by significantly cheaper capital? Overall, bank affiliated deals are only slightly worse. However whilst it is accepted that transactions done at market peaks are more prone to distress, this outcome is more pronounced for transactions done by mixed groups - a bank affiliated together with a non-affiliated group.

    Whether pushed or pulled apart by regulatory or management pressure is it any wonder then that the incidence of banks shedding their captives has increased. The promise of cross selling revenues from exit IPOs and future lending cannot make up for the increased cost of capital let alone the new regulatory stance.

    The evidence provided in this paper does indicate that banks’ private equity in house groups added to the overall cyclicality within private equity and that one of the key factors was the parent bank’s involvement as provider of debt capital. The positive impact of cheaper and longer term financing has not allowed their affiliates to generate superior returns but has created additional and detrimental repercussions as part of the credit expansion.

    If this is the case relating to private equity activities one may ask what other businesses have banks created, that a crisis and regulatory shift is required to force a management rethink.

    Whether a comparative advantage for banks operating within private equity existed is unclear – they certainly have not been able to exploit it. Indeed the corollary is that non-banks have an advantage; perhaps created by the shift in talent, a more aligned remuneration structure, better information and until now, lighter regulation. However comparative advantage is not static and regulators should be vigilant to ensure that such advantages, comparative or absolute, are not being driven by regulatory and fiscal differences.

    Which brings me back to the bankers and one last question - does the absolute advantage conferred by being too big to fail warrant the bonus payments currently under consideration?

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    WELCOME TO OUR NEW WEBSITE

    COLLER INSTITUTE LAUNCHES A NEW WEBSITE


    On behalf of the Coller Institute of Private Equity I'd like to welcome you all to our new website. Here you will be able to

    • sign up for our events
    • search for and download articles and research on private equity
    • see the latest content and archive copies of our Private Equity Findings
    • submit your papers for the Annual Coller Prize
    • comment on our blogs
    • or just learn more about us.
    The search function, found under the Reasearch tab, is multi layered to either select papers and articles housed on the site or to search more broadly.

    To get all this just register your details under log in



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    About me

    Ann Iveson

    BSc (Econ, LSE), MSc Sloan Fellow (London Business School); ACA

    Senior Advisor

    Ann was Executive Director at the Coller Institute of Private Equity for the past two years (2008-2009) playing a key role in defining and implementing many of the strategic initiatives and projects. She has extensive banking experience within the fields of credit, fixed income sales, derivatives and capital markets. She headed credit at CSFB and European Corporate Origination at BNP Paribas. She qualified as a Chartered Accountant with PriceWaterhouse Coopers and holds a BSc (Econ) from LSE and is a London Business School Sloan Fellow. Ann is a member of the Advisory Board.

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