The end of the captive?

While the reasons given by JP Morgan Partners and ISIS for seeking separation are different, they add credence to the belief that the days of the captive may be nearing their end. After all, last spring Dresdner’s sale of a private equity portfolio virtually ended its participation in the sector, while CSFB decided to exit the large cap buyout market.

Other banks quit the market in earlier years, leaving Goldman Sachs as the only Wall Street bank aiming to keep a substantial in-house private equity operation. So, what are the reasons for the exodus?

There are several, including the difficulty for banks of managing volatile private equity earnings and the fact that investors can be put off if they believe it is the parent calling the shots. Another factor, which is thought to have influenced JP Morgan’s decision, is the potential conflicts of interest for the banks. This is because their private equity arms may be competing for deals with other private equity houses that are clients of the same bank’s corporate finance arm. Other factors include the additional capital requirements of the Basel II accord and the new international accounting standards IFRS.

It was IFRS, for example, which contributed to ISIS’s decision to change control to a limited partnership, says Jason Hollands of F&C. Under the new standards that will apply to listed companies from the end of 2005, all of ISIS’s portfolio companies will have to adopt the same IFRS accounting framework as Friends Provident. “We didn’t want the disruption ofn forcing accounting changes onto all the portfolio companies,” says Hollands.

Although part of the reason for the separation was reportedly management’s desire to have a bigger share of the profits, Hollands argues the deal is financially neutral because there is already a revenue- sharing agreement and that, in practice, little will change in running of the operation: “It’s not an earn-out and there’s no consideration. ISIS will be our exclusive supplier and we will continue to provide distribution, clients and marketing to ISIS.”

While much of the operation’s activities will continue as before there will, nevertheless, be a change of control and it is the advantages of this independence that hasve pushed many other captives to seek separation. For example, HgCapital, which was spun out of Merrill Lynch in 2000, found being independent attracted clients.

“Clients are often more comfortable investing in an independent fund than in a captive, where the parent takes a proportion of the remuneration and so there is less available to motivate managers,” says HgCapital partner Frances Jacob.

She adds that after the firm separated from Merrill it was able to offer the kind of remuneration packages that attracted high-flying managers. Jacob says: “As an independent organisation we can take control of our own destiny and choose what to do without the involvement of a parent company. We can also perhaps move faster.”

Despite the vaunted benefits of independence, there are still advantages to being part of a much larger organisation, according to some of the remaining captives. Tom Lamb, co-head of Barclays Private Equity, says: “Every time a captive disappears it makes you feel more like an endangered species and people ask ‘are you next?'” But Lamb argues that the conflict of interest issue does not affect Barclays Private Equity because the bank’s corporate advisory is basically debt -oriented and focuses on large players while the private equity arm is mid-market.

He Lamb says: “We’ve also been able to demonstrate the retention of key staff and in fact some LPs are now favouring institutional private equity management because of uncertainties about what will happen to some independent funds when charismatic founders retire.” Unlike such independent funds, he says, Barclays Private Equity has management structures, governance and succession planning in place that ensure a smooth future for the operation. “If an LP invests in two cycles with us that’s a 15-year relationship and they want to feel confident about the structure of the operation at the end of that period.,” says Lamb.

Unlike semi-captive Barclays Private Equity, which seeks outside investment for more than half its funds, LDC (Lloyds Development Capital) is wholly funded by its parent. This single source of funds can be a significant advantage, argues marketing director Rob Pendleton: “It means we don’t have to get rid of a certain amount of money each year, so we can invest when we feel it’s right. It also means we don’t have to fund raise every few years, which can distract a fund from its investments.”

Pendleton adds that not having a group of outside investors also takes the pressure off exits: “We aim to exit after three to five years but sometimes it’s better to hang on for longer and we have the flexibility to do that rather than being under pressure from outside shareholders demanding their return.”

According to Pendleton, a key issue in all this is the relationship between the private equity operation and the parent organisation and he states the bank does not interfere in LDC’s decision- making. “In fact, the bank is very supportive and if we need extra funds to back a business, which is going places, we can draw down from the Lloyds TSB capital account.”

So, it would seem that even if the number of captives are is decreasing, the concept is not yet dead. HgCapital’s Jacob says: “There will always be people who prefer to work for a very large organisation, so it’s not always true that the best people are at the independents. There’s still room for captives, especially if the parent offers particular benefits such as providing deal flow or access to cheaper capital.”