Private Eye: LPs are right to applaud a low ‘failure rate’

Investors’ desire to back top-quartile-performing funds sometimes seems exceeded only by their willingness to overlook a real clunker.

Look no further than financial-services specialist J.C. Flowers & Co., which recently informed the SEC that it had reached $628.1 million on J.C. Flowers IV LP.

Just about a decade ago institutional investors committed some $7 billion to the firm’s 2006-vintage second fund. Not a good decision. As of June 30 one of those investors, Oregon Public Employees Retirement Fund, had lost more than half the just over $100 million that it invested in the ill-fated pool.

(Oregon’s performance could improve if the firm were to liquidate its remaining holdings at above NAV. Also noteworthy: J.C. Flowers’s third fund has done well with two of its largest investments, in OneSavings Bank plc and OneWest Bank.)

The fact is, past performance has something to say about future performance in private equity, a phenomenon commonly referred to as persistence. And yet few firms achieve top-quartile returns fund after fund after fund.

There’s quite a lot of jumping around. Recent analysis by Buyouts, for example, finds that 18 percent of the time, buyout and turnaround firms follow a top-quartile performance with a bottom-quartile one; 16 percent of the time they follow a bottom-quartile performance with a top-quartile one.

Such dynamics have investors hunting for metrics to illuminate whether a firm’s recent successes are repeatable, as well as whether a spate of failures has run its course. Chicago fund-of-funds manager RCP Advisors, which has been gaining a reputation for insightful analysis, has shown that a buyout shop’s failure rate — the percentage of portfolio companies that don’t return invested capital on realization — tracks closely with how its funds perform relative to peers.

“If you look across the market as a whole, losing money on deals really hurts a lot,” said Alex Abell, managing director and head of research at RCP, speaking late last year at Buyouts’ PartnerConnect Southwest conference in Dallas. Added Abell in a follow-up interview: “Most buyout strategies don’t underwrite their performance targets to returns that are high enough to make up for having a large percentage of their deals [that don’t] return capital.”

According to Abell, some 80 to 90 percent of funds that keep their failure rate to 10 percent or less make it into the top quartile. Similarly, 75 percent of the funds in the first quartile have failure rates of less than 32 percent.

Looking at bottom-quartile funds, he found that 75 percent had failure rates of 35 percent or higher. The average is around 27 percent for buyout firms. “If you don’t want to be in the fourth quartile, prevent companies from losing money,” said Abell.

Abell and colleague Ross Koenig, senior associate for research, based their analysis on more than 7,000 fully realized deals (mainly buyout, but some growth equity and real assets) in North America entered into from 1990 to the present. The data set included the portfolio companies of some 1,000 funds with an average size of $777 million; some 90 percent were under $1 billion in size, and a good portion had low Roman numerals.

Abell cautioned that the data set’s quality may be compromised by survivorship bias, in which poor-performing funds are underrepresented. He also observed that many underperforming investments remain on the books of buyout shops, which may be reluctant to take a realized loss.

So how can investors take advantage of this correlation? The big takeaway is that a low failure rate is generally a good sign, a high failure rate a bad sign. So what should you make of a top-quartile fund that has a high failure rate?

One possibility: The buyout shop pursues a high-risk strategy in which home-run deals carry the day and make up for losses. But it also may be a red flag suggesting the firm got lucky on a few deals and won’t be able to repeat its performance over the long haul. And what should you make of a bottom-quartile fund with a low failure rate? That could suggest the firm is ready to rebound with its next fund.

Here are few other findings that Koenig and Abell shared about failure rates:

  • Failure rates wax and wane with economic cycles, as you’d expect. Deals entered into in 2000 failed almost half the time while those consummated in 2006 and 2007 had failure rates above 30 percent.
  • Failure rates vary by sector, with IT (35 percent) and consumer discretionary (about 34 percent) toward the high end and financial services (21 percent) and healthcare (22 percent) toward the low end.
  • About 36 percent of growth equity deals don’t return capital, but the failure rate for distressed deals is only about 28 percent — possibly a result of turnaround shops being conservative in how much money they sink into deals, thus reducing the bar for being made whole.

Interestingly, the EBITDA multiples paid for companies don’t significantly affect failure rates in most sectors, with consumer discretionary a notable exception. But RCP Advisors did find especially high failure rates, around 40 percent, when a company’s enterprise value is based not on EBITDA but rather some other metric, such as revenue or book value. These tend to be high-growth companies that may not even be generating positive EBITDA.

Those deals “don’t work out frequently,” said Koenig.

Action Item: Research the J.C. Flowers SEC filing here.