Earning their keep

A year ago, buyout chiefs were blasé about the thorny issue of management fees and the growing question of whether they blunt private equity ardour: if you’re already getting a 1.5% to 2% management fee slice of a £10bn to £20bn fund total, how incentivised are you to deliver for the performance fee?

With no desire to change the status quo and limited partners jostling to get into their latest funds, the top tier could afford to bat away any concerns as simply not an issue. Now, they must be quietly patting themselves on the back.

With no credit available and big corporates fighting their own fires on the public markets, buyout firms have nothing to buy, no debt to buy it with and no-one to buy their own portfolios. They are facing a long slog to get their returns by focusing on driving portfolio company revenues in a difficult market with no prospect of the kinds of quick wins possible just over a year ago.

Those “luxury” management fees might now be doing just what they were intended to do, providing funds for “housekeeping” during the forthcoming lean period.

The status quo has changed, too. Limited partners have the upper hand and, according to placement agents, are shifting away from buyouts in favour of more apropos investment strategies, such as distressed, turnaround and secondaries.

One solution could be simply to follow the money and adapt, according to PricewaterhouseCoopers’ Global Private Equity Report 2008, entitled “Seeking differentiation at a time of change”.

In addition to increasing growth at investee companies, corporate responsibility, fair value reporting, changes to taxation and investigating alternative strategies including opportunities in the BRIC and emerging markets were also highlighted as an essential part of the opportunities and challenges facing private equity over the next few years.

“What we have clearly seen is the diversification of assets outside of core private equity activities,” says Brendan McMahon, global investment managers and real estate leader at PricewaterhouseCoopers.

“Blackstone’s assets have gone from US$8.4bn in 1998 to about US$120bn today – that is a massive growth in the management of assets but how much of that is core private equity? They have diversified, particularly in the last three to four years, into other classes, such as infrastructure, distressed, mezzanine and real estate.”

McMahon points to similar moves in Europe, such as CVC Capital Partners’ move into debt funds and infrastructure, the latter involving a US$2bn fundraising this year and the appointment of Colonial First State Global Asset Management’s Stephen Vineburg as CEO of CVC Infrastructure last December.

Terra Firma’s chief executive, Guy Hands, dismissed diversification in his quarterly letter earlier this year, suggesting that fund managers should be able to invest at all points of the cycle and not switch to new strategies, or “knee-jerk reactions”.

Mindful of this, McMahon says firms looking to diversify need to be well organised, have strong brand names and strong networks, owing to jurisdictional diversity.

In the traditional buyout space, McMahon notes that while “we are seeing some of the larger firms coming down the food chain and some 100% equity deals are being done”, the lack of divestments from recapitalisations and secondary buyouts – accounting for about 60% of exits last year, says McMahon, citing EVCA – means holding periods will expand to an average of four to six years, “so there is far more need to have operational experience in-house”.

Whereas previously private equity firms have achieved high returns through clever acquisitions, balance-sheet restructuring and rising valuations, the credit crunch has blown away leverage and multiple arbitrage strategies, putting more emphasis on growth improvements, putting business management skills at a premium.

Hiring the right people for portfolio companies will become crucial, especially in buy-and-build strategies, which the report says will become more popular and can provide a less risky route into less well-known emerging markets.

McMahon says there has been no evidence that investors are shying away from buyout funds, but it is clear that in order to adapt and differentiate within the new market climate – and earn that next management fee – funds need to look “primarily across asset classes that are very similar to their core private equity activities” in order to take advantage of the dislocation, while also, as Hands suggested earlier in the year, “sticking to their knitting”.