The second quarter of 2011 witnessed the highest ever level of private equity exits on record. However, the majority were achieved by leveraged buyouts funded by the easy availability of leveraged loans. This brings back uncomfortable memories and does not bode well for the private equity industry. At the same time, in the UK, the business model is in the firing line for its application to care services. Can private equity redeem itself?

A £1.1bn ($1.78bn) financial loss; 31,000 elderly residents left dangling; 44,000 staff fearful for their jobs; the highly leveraged private equity partly fingered as the culprit. UK care home operator Southern Cross is being portrayed as the private equity industry at its worst.

According to a July story in the UK's Daily Mail, “by the time they [private equity] sold out in 2007, they had taken hundreds of millions out of the company, stripped its property assets, and saddled it with crippling long-term rental obligations”. 

Whatever the rights and wrongs of the issue, there is one inescapable fact: the private equity industry again finds itself at the heart of a storm.

I don’t want to get into a debate about whether private equity should own care homes more generally – I will leave that to others from the industry who have commented. In the UK's Guardian newspaper, for example, Jon Moulton of Better Capital said care homes were “uncomfortable assets” in the private sector, pointing out that profit and the care industry can make tricky bedfellows: “Profit-making may be helpful in getting some people to do it but on the other hand somebody who pushes too hard for profit clearly will be down-playing the caring requirements.” 

I do, however, want to make the point that the current leveraged private equity business model fails to put the interests of limited partners [LPs – the investors] over general partners [GPs – the managing partners in a private equity management company] and how it should therefore be amended in favour of a model better aligned with LPs’ interests. 

This model should include: exits that suit the LP rather than the GP; fees that are paid only on capital invested; the wherewithal to source genuinely private, off-market opportunities; and the ability to be patient and not invest badly.

Dangerous territory 

These are the lessons that have to be learnt if the industry is to rise again from the ashes of its former prowess. But we are a long way from that.

Industry figures from the second quarter of 2011 demonstrate just how far away we are. During the quarter, there were 309 exits, worth $121.1bn – the highest ever recorded – and 60% of the aggregate deal value was accounted for by leveraged buyouts, according to research house Preqin.

Why the very high percentage? First, firms are looking to raise significant sums for new funds and are desperate to realise value for investors in previous funds; and second, the increased availability of leveraged loans – data provider Dealogic says that so far this year $351bn of leveraged loans have been issued with expectations of $1000bn by year end. 

What’s more, there has also been an increase in appetite for riskier bonds. Dealogic figures also reveal that almost $37bn of high-yield bonds financing private equity deals were issued globally in the first quarter of 2011, against almost $17bn issued in the same quarter in 2010, and just $1.8bn issued in the first quarter of 2009. 

This does not bode well. We have been here before, more than once – remember the lessons of 1989 when a boom in leveraged buyouts and a boom in junk debt issuance led to a massive bust and the effective death of the private equity industry in the UK for five years. This was epitomised by Isosceles' Gateway deal [in which Isosceles paid over the odds for Gateway supermarket in a highly leveraged transaction, and was hit by soaring debt repayments and multiple debilitating refinancings]. 

Back to basics

What happened to the long-term investment view that private equity is supposed to espouse? The illiquid nature of the investment should make it indifferent to the volatility we have seen over the past few years – and the industry should have taken advantage of the massive buying opportunity that the post-Lehman crash represented, and to a certain extent still represents. Yet opportunities went begging – 2009 private equity-backed European buyout investment activity was a derisory €18bn – the comparable figure for 2007 was €177bn, according to the Centre for Management Buyout research.

Taking advantage of disrupted markets to add real value should be the maxim of the private equity industry. 

Instead, many seem to prefer the pro-cyclical, highly leveraged model, a model which is not best suited to the interests of LPs, but leaves the industry open to the charge that many GPs are putting their own interests first by charging management and transaction fees willy-nilly and then selling for self-interest. 

What other explanation can there be with an estimated $400bn in unspent capital earning commitment fees, and at the same time we see a huge effort by GPs to raise more money, with Preqin data showing that 1676 funds are currently trying to raise a collective $680bn?

While opportunities abounded post-Lehman, the vast majority of the industry was too timid to grasp the nettle; some LP investors therefore acted on their own and made money when markets were utterly disrupted. 

Unfortunately for the private equity industry, these investors, including the Qataris and Warren Buffett, invested directly in a host of opportunities, very effectively disintermediating the private equity people who should have been first out of the blocks.

Shrinking demand 

Having been effective in taking their own opportunities, many LPs increasingly feel they are better able to source investments on their own. Coller Capital's Global Private Equity Report published recently stated that almost 90% of investors expect “to turn down some of the requests by private equity groups to reinvest into their next fund generation”, primarily due to poor performance. 

Poor performance caused by highly leveraged investing at the peak of the market and a refusal to seize opportunities when prices were low.

Is it really in LPs’ interests to commit further huge sums of capital, just to see it sit around, earning fees for the manager, or perhaps worse, invested in a tertiary or fourth time around portfolio company sale? To my mind the savvy LP should not be interested in this type of opportunity. 

There are some signs of recognition of this by the industry, even if they are glacial and marginal. Again, Prequin figures show that global private equity funds worth more than £1bn are reportedly charging slightly less in management fees: 1.71%, rather than the 1.81% they were 12 months ago. 

Notwithstanding the fact that they haven’t been lower since 2005, in my view this is only scratching the surface of the reforms that are needed. Of course the very best managers will be able to raise money, charge fees and have LPs clamouring to invest more money. For the rest, the options are few and far between. And for some, there simply won’t be any – they will fade from view as they enter run-off following failed fundraisings. Of course, we are unlikely to see the wholesale closure of firms; that is not how private equity firms die. 

More likely we will see power struggles and partners forced out, such as with the widely reported Cognetas situation [which has said it will make no more new investments from its current fund following the departure of managing partner Nigel McConnell], a possible symptom of things to come. 

Putting LPs first

For those firms that really want to serve the best interests of LPs – and attract LPs to invest alongside them – a start might be to better align business models with those of the LP, where today they clearly are not. The 10 largest private equity firms have shared $15bn in revenues in the past 15 years; according to the HEC School of Management, 75% of these revenues came from management fees, and despite the fact that investors put $179bn into these funds, they only received $113bn in cash distributions – a $66bn shortfall. 

The lessons of the abysmal efforts of the past few years must be learned for the private equity to thrive again. Fees must only be payable on capital that has been invested; deals that are off-market – and highly profitable – must be sought out; transactions should be done deal by deal; and perhaps most importantly, exits must be effected in the investor’s best interests and not the GPs. 

I for one do not want to see the industry come in for more criticism – justified or unjustified – nor worse, for it to hit the buffers once again, as it did in the early 1990s.

Edmund Truell is the founder of the Pension Corporation. He is the former chief executive of Duke Street Capital and the former chairman of the British Venture Capital Association

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