peHUB Wire: Friday, April 23, 2010

Private equity was borne of Wall Street, but that relationship now is under regulatory attack.

As we’ve discussed before, the Dodd financial reform bill’s Volcker Rule would prohibit banks from investing either directly or indirectly on the equity side of private equity deals. Moreover, proposed Basel III language would make PE fund commitments difficult for any G20 bank, given the capital holding requirements for unfunded commitments.

Private equity’s response to all of this has been a claim of systemic impotence: “Hey, we didn’t cause the financial meltdown.” And, to be fair, it’s a legitimate defense. Relatively few big buyouts have gone bust, and many deals (and funds) on life support last year are now breathing on their own. Moreover, most systemic risk posed by private equity relates to poorly-priced leveraged loans – a side of the business that no proposed legislation looks to curb.

So let’s stipulate that the proposed rules to “break up” Wall Street’s bonds with private equity are unnecessary from the point-of-view of future economic cataclysm. Instead, let’s look at a deeper question: Will such regulations save the banks from themselves?

Last week, Harvard Business School professor Josh Lerner sent over a working paper on the economics of bank-affiliated private equity deals. The paper’s co-authors are Lily Fang of INSEAD and Victoria Ivashina of HBS.

It found that around 26% of all private equity deals transacted between 1978 and 2009 included equity participation by a bank or bank-affiliated group (excluding VC and distressed deals). It also found that such deals had significantly higher rates of bankruptcy (7.7% compared to 5.7%) and significantly lower rates of profitable exit (63% compared to 74%). This is particularly striking, given that “targets of bank-affiliated investments have significantly better operating performance than other buyout targets, though their size and other features are similar.”

One explanation, Lerner writes, is that banks are hyper-cyclical when it comes to private equity investments. Buyout deals obviously spike in boom times, but bank-affiliated groups sit atop that spike – participating in over 30% of deals during the recent boom. Conversely, they become particularly shy during down markets, participating in just 10% of deals during the early 1990s recession.

Then there is the whole conflict of interests issue, which helped prompt some banks to abandon direct private equity in the 2000-2002 timeframe (before rushing back in 2006-2008). Lerner finds:

“Bank-affiliated deals are generally associated with lower lending amounts, shorter maturity, and higher yield spreads. However, the situation is dramatically different when the parent bank of the affiliated private equity group is in the lending syndicate. When this is the case, deals done by affiliated private groups enjoy a significantly larger borrowing amount, a longer maturity, and a lower spread.”

Lerner doesn’t go conspiracy theory here, instead believing the explanation to be either increased access to information or cycle-related balance sheet expansion. But the findings do make the aforementioned deal performance stats even more damning, given that many bank-affiliated deals come with particularly-friendly sponsor-friendly terms.

It’s important to note that Lerner is not arguing that banks would be better hiding their money in a mattress, because he does not have cash-on-cash or IRR data for bank-affiliated PE deals. Indeed, such transactions may perform better than T-bills, even if they perform worse than non-bank-affiliated PE deals.

But he is, indeed, arguing that banks are dumb money (my words, not his).

And this isn’t a new conclusion for Lerner. A few years back, he found that banks also under-perform in terms of their LP commitments to private equity funds (all-inclusive). Banks’ mean IRR for PE investments at the time was -3.2%, compared to positive mean IRRs for endowments (20.5%), public pensions (7.6%), corporate pensions (5.1%) and insurance companies (5.5%). The only other “negative” group was advisors, and they still beat banks with a -1.8% mark.

Now there are obviously exceptions to the rule, and plenty of savvy bank-affiliated PE managers with strong performance. But, for the banking industry as a whole, one’s got to wonder if fighting Volcker or Basel III on private equity grounds is a smart financial decision. It may be wiser to let the regulators have their way…

*** You can download both Lerner studies here.

*** Permira seems to have caved on the Hugo Boss plant issue. It will stay open, pending a worker vote. More to come at shortly.

*** Have a great weekend…

Top Three

Lenovo has emerged as the leading candidate to acquire mobile device maker Palm (Nasdaq: PALM), according to Reuters. Plam shareholders include Elevation Partners.

MBK Partners has put cable company China Network Systems up for sale, with hopes of garnering upwards of $2 billion. Morgan Stanley is managing the process. MDK paid $1.5 billion to acquire CNS in 2007.

Christoph Westphal has stepped down as CEO of Sirtris Pharmaceuticals, which was acquired by GlaxoSmithKline for around $720 million two years ago. He now will become head of GSK venture capital arm SR One Ltd. He also is one of three founding principals of Longwood Founders Fund, a new Boston VC firm that has raised over $50 million for its debut fund (reportedly GSK is among the backers). The other Longwood co-founders are former Sirtris execs Michelle Dipp and Rich Aldrich.

VC Deals

Zenverge Inc., a Cupertino, Calif.-based developer of advanced media integrated circuits, has raised $30 million in Series C funding. Battery Ventures led the round, and was joined by return backers DCM, Motorola Ventures and Norwest Venture Partners.

Aragon PharmaceuticalsInc., a San Diego-based developer of treatments for hormonally-driven cancers, has raised $22 million in Series B funding. Aisling Capital was joined on the round by return backers OrbiMed Advisors and The Column Group.. Aragon previously raised around $8 million.

Overture Networks Inc., a Morrisville, N.C.-based maker of high-speed networking equipment, has raised $17.2 million in new VC funding.QuestMark Partners led the round, and was joined by return backers Intel Capital, Intersouth Partners, Morgenthaler Ventures, Tenaya Capital, TDF Fund and Gray Ventures. The company previously raised around $45 million.

Keahole Solar Co., a Honolulu-based cleantech development company that spun out of Sopogy in 2007, has secured nearly $18million of a $21 million funding round, according to a regulatory filing. No investor information was disclosed.

Media Temple Inc., a Los Angeles-based web hosting and virtualization service provider, has raised $15 million in expansion capital funding. Triangle Capital Corp. led the round, and was joined by GMB Mezzanine Capital. Morgan Joseph served as financial advisor to Media Temple.

AutoESL Design Technologies Inc., a Los Angeles-based developer of electronic system level (ESL) synthesis toolsfor EDA of integrated circuits and systems, has secured around $2 million of a $4.5 million funding round, according to a regulatory filing. The company previously raised $4 million from Adams Capital Management and Infotech

Click Forensics Inc., an Austin, Texas-based provider of click-fraud reporting for online advertisers, has raised around $6 million in Series C funding, according to a regulatory filing. The company previously raised $15 million fromSierra Ventures, Austin Ventures and Shasta

OpenCandy, a San Diego-based provider of distribution and revenue solutions for software developers, has raised $5 million in Series B funding, as first reported by TechCrunch. Google Ventures led the round, and was joined by return backers Bessemer Venture Partners and O’Reilly Alpha Tech. The company previously raised $3.5 million.

XOS Digital Inc., a provider of content management solutions and digital media services for collegiate and professional sports organizations, has raised an undisclosed amount of Series B funding. NewSpring Ventures led the round, and was joined by Dublin Capital and return backers Blue Chip Venture Co. and Beechtree Capital.

Buyouts Deals

Endesa (Milan: ELE) has launched a sale process for its Spanish gas distribution and transmission network, which is expected to garner upwards of €760 million. Possible suitors include Macquarie, CVC Capital Partners and Prudential’s M&G Investments.

Francisco Partners has invested an undisclosed amount in T-System Inc., a Dallas-based provider of clinical documentation solutions for hospital emergency departments.

JWI Capital has acquired the WH Smith Hardware Co., a Parkersburg, West Virginia-basedfabricator and assemblerof handling equipment and load securing and material handling hardware. No financial terms were disclosed.

Pacific Equity Partners and CHAMP Private Equity reportedly are among those invited into the second round of bidding for Loscam, an Australian pallet maker being sold by Affinity Equity Partners. The asking price is between A$500 million and A$700 million.

Providence Equity Partners has offered to acquire AcadeMedia AB, Sweden’s largest independent education company with approximately 45,000 students and course attendants at around 150 locations. AcadeMedia is publicly-trade in Stockholm. The proposal would value AcadeMedia at approximately $283 million, with AcadeMedia stockholders to receive SEK165 per share (3% premium to yesterday’s closing price)

PE-Backed IPOs

Mitel Networks Corp., an Ottawa-based provider of telecom services to small and mid-sized businesses, raised $147.4 million via its IPO. The company sold around $10.5 million shares at $14 per share, compared to a planned range of between $18 and $20 per share. It closed its first day of trading on the Nasdaq down at $12.30 per share. Major shareholders include Wesley Clover Corp and an affiliate of Francisco Partners.

PE-Backed M&A

Cornerstone Records Management, a portfolio company of Sterling Partners, has acquired the assets of PageFile Inc. (aka MasterFiles), a Riverside, Calif.-based file storage and management company. No financial terms were disclosed.

Odyssey Logistics & Technology Corp., a Danbury, Conn.-based provider of managed logistics services, has acquired International Forwarders Inc., a Charleston, S.C.-based export freight forwarder and customs house broker. No financial terms were disclosed. Odyssey Logistics has raised over $40 million in VC funding from Boston Millennia Partners, CMEA Capital, RRE Ventures, LogiSpring and Trident Capital.

Pet Valu Canada Inc., a portfolio company of Roark Capital Group, has acquired Bosley’s Pet Food Plus Inc., a Vancouver-based small-format retailer of pet food and supplies. No financial terms were disclosed. Roark took Pet Valu private last August.

Firms & Funds

The Carlyle Group and RPK Capital have formed a $1 billion joint venture to acquire commercial aviation assets, including aircraft and engines. Carlyle’s commitment is up to $600 million.

Human Resources

Paul Wallace has joined SV Life Sciences as a venture partner. He previously was a senior vice president of Healthways Inc., a publicly-listed provider of disease management, wellness and population health support solutions.