Sunday, 21 September 2014
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Mar 15 2013 | 10:00am ET
Private equity has a problem, says NewGlobe Capital Partners founder and CEO Andrew Hawkins: A growing number of funds have reached the end of their lives in a market not conducive to exits.
The situation is not without precedent
“If you cast your mind back to the middle of last decade,” Hawkins, a former managing partner of Vision Capital and founder of Palamon Capital Partners, told FINalternatives, “there were still substantial numbers of funds that went beyond the end of their 12-year life. In fact, there was this wonderful statistic produced by Adams Street: If you take all the buyout funds in history, the maximum life of any of them is 12 years and the average is 17, which is a piece of alchemy that you can only wonder at, but it's because a lot of these funds continued on with relatively tiny and stubbornly unsaleable pieces of assets in them.”
According to Hawkins, that pot of assets is now worth $75 billion and growing every year as “the 10-12 year look-back goes into vintages, when the funds raised were simply far, far bigger.”
Masood Sohaili, a lawyer in DLA Piper's corporate and finance group, agrees.
“I think 2013 is going to be a year where a lot of the private equity companies are going to be looking to exit from investments they made in 2006, 2007 and early 2008, in more optimistic investment environments. And the market, while it's getting stronger, has not really facilitated exiting for those companies."
“You're left with a large group of portfolio companies, good operating businesses, that are doing okay, maybe not in hot industries or hot markets, that are not going to be able to do the expected, traditional exit that was the investment thesis when the investment was made.”
Hawkins lists two main factors contributing to the current inhospitable exit environment. One is the buyout boom from 2005 to 2008 during which, he said, “a lot of mistakes were made."
"Evaluations were, frankly, crazy in many cases, financed by high amounts of leverage and huge volumes of deals being done," he said.
The second was the Lehman crisis which left the LP market “increasingly unwilling to invest in a large number of GPs, that looks with suspicion on the way that funds have performed and questions just how competent the managers are.”
The result, said Hawkins, is today's “uniquely unpleasant combination” of GPs who have underperformed their peer groups and LPs loath to invest more money. But Hawkins and his partner Christophe Browne see opportunity—they intend to “use new capital to unlock” the value in these end-of-life funds.
NewGlobe, in partnership with Vanterra and Hamilton Lane, will target older p.e. funds—with no successor fund and no chance of the GP raising another vehicle—run by managers who “may have made one or two investment misjudgments” or who were “clobbered by the market which just went against them,” said Hawkins.
NewGlobe will offer to buy out all or a substantial minority of the fund's LPs. The former, the “simple” option, would see them offer LPs liquidity or the chance to roll into the new vehicle. “We then share those new economics in a way to be determined, deal by deal, with the incumbent GP. So by doing this we essentially re-capitalize the fund and re-energize the GP."
NewGlobe will take a supervisory role in the new fund—the “intensity” of its involvement dependent upon circumstances, such as “how many people have they got left in that old GP." In Hawkins' view, the GPs, although they must give up “a degree of independence,” win because, rather than enduring “a short period of pretty lowly fees as a manager of a self-liquidating trust, earning increasing opprobrium from their LPs for not having liquidated and now giving them worse returns than they might have otherwise because these kind of fire sales and forced sales and liquidating trusts never attract anything but bottom prices,” they get “a piece of the fees and a piece of the top side, so they're re-incentivized to make these assets more valuable.”
MLPs & ESOPs
Re-capitalization is one method of dealing with a troubled exit environment, but Sohaili said he's been hearing a lot lately about two others—master limited partnerships and employee stock-option plans.
MLPs, traditionally, are structured as limited partnerships, trade on public exchanges and earn 90% of their returns from natural resources. But according to Sohaili, the Internal Revenue Service and practitioners have recently expanded the definition of qualified income, making MLPs an option for a somewhat broader, although still limited, range of companies.
DLA Piper has seen “a couple of instances” of private equity funds finding within their portfolios companies, or significant portions of companies, whose revenues qualify for an MLP, even though when they bought the company “they had no idea what an MLP was and they never anticipated exiting using an MLP."
For a company that “is not the size to go public and/or would not get the kind of multiple on IBITDA that you would get if you were going in the public markets, going out as an MLP potentially can get you a higher multiple and allow for a smaller-sized deal.” As for the mechanics of such an exit, Sohaili said you'd sell the assets to a newly-formed partnership which would then raise money by going public. “For the investors, it would be just like any other exit.”
Sohaili said ESOPs offer another option. They won't earn you a higher-than-market return—ESOP rules stipulate that the company be sold to employees at fair market value. But it can allow disposal of companies “that are not hot assets,” he said.
“You've got some company in the Midwest that has a narrow manufacturing product that has a narrow application; they make decent revenues and if you were just to look at the revenues it would be a valuable company, but it's not something that the people who are buying companies are interested in."
“There's an opportunity to sell the company to an ESOP, which is basically by the employees, and the employees can borrow money to buy the ESOP. The private equity fund may have to retain subordinate debt to make the numbers work, but at least they've managed to get a big chunk of the asset off their books, and while there is a lot of heartache in terms of regulatory and administrative issues with an ESOP and running an ESOP, from the perspective of the management, if they're now owning the company when they otherwise couldn't own it, it becomes desirable.”
ESOPs also offer tax advantages, said Sohaili. If you structure it properly, “you don't get taxed on it until there's distributions, and principal payments on your debt are deductable. You're going to get greater free cash-flow because of the tax situation to service and pay down debt over time.”
The ESOP option is only for companies where management wants to buy and “it's not a desirable asset except to them, who know and understand the business. But, you know, there's a surprisingly large number of such companies being held by private equity funds.”
But where ESOPs and MLPs just won't do, there is always Andrew Hawkins and his venture, funded chiefly by Hamilton Lane, an independent investment advisor with $171 billion in assets under management. Hawkins says Vanterra, a global private equity firm, will co-invest, and he and his partner also putting up money.
Vanterra's Shad Azimi told FINalternatives that his firm's interest in end-of-life private equity funds pre-dates the current project:
“We build very specialized platforms and we had been looking at this opportunity independently for quite some time," he said. "We were considering doing this in-house, but with Christophe's and Andrew's expertise, it made perfect sense for us to partner in this specific platform with them and with Hamilton Lane. The other advantage is the ability to fast-track the process and not go through an 18-month fund-raising process.”
In addition to providing strategic support and working capital, Vanterra has given NewGlobe space in its New York offices, with access to back-office staff and investment personnel. Most importantly, said Hawkins, Vanterra, which helped spin-out private equity assets from the Lehman Brothers estate, “can help us analyze, think about, approach and execute deals in a very complicated space.”
'We See Ourselves As A Hybrid'
Finding target funds “turns out to be not such a difficult science,” according to Hawkins. They've searched Europe and the U.S. for funds with more than $50 million sitting in old portfolios with no successor funds. From this opportunity set, they look for likely investments.
“We don't want to buy portfolios of trouble; we're not turnaround guys, we're not trying to deal with toxic situations," Hawkins said. "What we do want is good-quality managers who've got stuck; we want decent-sized portfolios—ideally $100 million or more, but we'll look a bit lower—reasonable concentration in assets—you haven't got to do a lot of work on a huge number of companies for little reward—and engagement with the GP."
“We see ourselves as a hybrid between a GP and an LP. In other words, going into these situations, we become the LP, or at least a substantial minority of the LP, but because our experience is actually in managing underlying portfolio companies as investors, we actually bring something to the table in terms of experience and strategic thinking about how you deal with these underlying investments. So we are, if you will, both a supplement to and a supervisor of the incumbent GP.”
Hawkins envisions a holding period of three-to-five years for portfolio assets.
“It may take some time to optimize the value in selling these things, but that allows you to build the businesses and to pick your time to exit.”
And who knows? In five years, maybe exits won't have to be quite so creative.
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