Top names in private equity, participating in an exclusive roundtable

Cover Photograph by ICT_Photo / Flickr / Getty Images
Roundtable
Sponsored by
022_MAJAug11 1
7/7/2011 9:04:27 PM
Cover Photograph by ICT_Photo / Flickr / Getty Images
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Pantheon Ventures
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Benesch
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New Mountain Capital
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Perseus, LLC
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Thoma Bravo
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Guardian Life Insurance
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747 Capital
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Mergers & Acquisitions
Top names in private equity, participating in an exclusive
roundtable, warn that those who don’t evolve will be
left behind
Photographs by Dan Nelken
August 2011
023_MAJAug11 2
MERGERS & ACQUISITIONS
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7/7/2011 9:05:10 PM
Roundtable
4
ince Lehman Brothers fell, participants in private equity
have known changes to the asset class would be forthcoming.
What has slowly developed has been a transformative status quo, in which sponsors aren’t necessarily being forced to change
their stripes, but they are expected to make good on all past promises
— whether it’s proprietary dealflow, operational capabilities, capital
structure expertise, or any other value add that made it’s way onto a
private placement memorandum. The downturn hasn’t only tested
the mettle of the asset class, it has forced groups to build out and
refine their processes around channeling dealflow, improving acquired assets, optimizing capital structures
and establishing and maintaining relationships. This
transformation, though, is occurring against a backdrop in which the economics are shrinking for GPs,
who are facing pressure not only from their limited
partners or the new competitive dynamics of the deal
market, but also from regulators who have ratcheted
up compliance efforts and a political discourse that
presages foreboding changes to the tax structure.
Mergers & Acquisitions brought together top
names in the space, including both general partners
and limited partners, who shared their expectations
as to how the asset class will continue to evolve and
what factors will drive the evolution for the fore-
24
MERGERS & ACQUISITIONS
024_MAJAug11 3
seeable future. Sponsored by law firm Benesch, the
roundtable included GPs such as Steven Klinsky, the
managing director, founder and CEO of New Mountain Capital, and Carl Thoma, managing partner and
co-founder of Thoma Bravo. Representing the LPs
were Gijs F.J. van Thiel, co-founder of PE fund-offunds 747 Capital, and David Turner, the head of
private equity for the Guardian Life Insurance Co.
of America and a veteran of WestLB and the State
of Michigan Retirement Systems. Perseus LLC senior
managing director Sheryl Schwartz, the former head
of TIAA-CREF’s alternative fund investment team,
and Pantheon Ventures global head of business development Kevin Albert, who joined the fund of funds
last year from Elevation Partners, each brought a com-
August 2011
7/7/2011 9:04:38 PM
posite perspective incorporating their experiences on
both the GP and LP sides of the business. Meanwhile
Benesch partner and executive chairman James Hill,
who also chairs the law firm’s private equity practice,
shared his ground-level view from working on behalf
of clients involved in all areas of private equity. What
emerged was a provocative picture of where the asset
class is and where it is headed. The following is an edited version of the discussion.
Mergers & Acquisitions: As we look at
the future of private equity, it probably
makes sense to consider the current
state of the market. Here we are almost
three years since the credit crisis really
took hold, and it’s still difficult to gauge
whether the predictions for the great
shakeout will actually occur. There is
still a $376 billion overhang, according
to Cambridge Associates, suggesting
that sponsors are slowly chipping away
at their dry powder but still have a long
way to go. Meanwhile, mega-deals have
largely been pushed to the side, while
financing in the small and micro-cap market is still
tight, channeling most activity toward the middle. As
a jumping off point, I’d like to get everyone’s take
on the current environment for private equity as you
see it and maybe touch upon some of the notable
changes you’ve experienced since the dislocation.
Albert: What I’ve witnessed and what I think we
will continue to see is just a maturation of this market. In the 1980s and 1990s, most institutional investors were effectively new to the asset class. Since then,
they’ve become very sophisticated. That has translated into more specialization, as limited partners really hone in on the value GPs are adding, whether
it’s through operations or a sector focus. You’re also
seeing a lot of limited partners culling their GP relationships down to a more manageable size.
Van Thiel: The private equity market is cyclical and
will always remain that way. As it relates to whether
or not a shakeout will actually take place, I’d point
to the VC market, which was hit pretty hard in the
late 1990s. It didn’t happen in venture capital. What
you saw was that a bunch of firms that managed to
August 2011
025_MAJAug11 4
stick around and operate among the ‘living dead’ for
the following decade. Now, we’re starting to see those
groups re-emerge and think about raising their next
funds. The point is that it’s pretty hard to kill off a
private equity fund and managers have no incentive
to dissolve voluntarily.
At the same time, as Kevin alluded to, I think in-
“
The key to any
model is the
structure of the
economics.
Sheryl Schwartz
Perseus, LLC
”
stitutional money is going to gravitate to managers
who can set themselves apart — be it through operational excellence, proprietary dealflow, industry focus
or something else. The question investors should be
asking, however, is whether or not these advertised
distinctions are real.
Klinsky: If you look at the period from 1981 to
2000, the market maintained an upward trajectory,
and it led to certain practices that I think people consider to be inherent to private equity. The use of leverage, for instance, made perfect sense during that
time. In 1981, debt did create returns because you
were operating in an environment with very high inflation, with interest rates that only moved lower for
the next 10 years. In a sense, you could buy a business
with absolutely no unit growth, lever it with 95 parts
debt, watch inflation grow by 10%, and then triple
your money in the first year. That was the story of
the 1980s.
In the 1990s, you essentially had the greatest bull
market of all time. From January 1990 to the end of
1999, you could leverage just about anything and post
an attractive return. If you just levered the stock mar-
MERGERS & ACQUISITIONS
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7/7/2011 9:04:58 PM
Roundtable
ket, for example, you would have looked very smart.
Going into this past decade, it has really been characterized by a choppy, up-and-down market. You can’t
just count on an upcycle to bail you out anymore.
When we launched New Mountain 11 years ago,
we didn’t want to count on bull markets or bear markets, so we made it part of our fundamental thesis
to concentrate on defensive growth industries and
work to build businesses within these sectors. Generally speaking, I think private equity is evolving to be
a form of business as opposed to merely a form of
finance.
Hill: I would just echo some of the points that have
already been made. Private equity today is fundamentally different than it was 30 years ago, and it has also
undergone some significant changes over the past five
years. I’m sure we’ll hear more from the limited part-
“
The move from
valuing investments at cost to
mark to market
motivates GPs
to put points on
the board early.
Gijs F.J. van Thiel
747 Capital
”
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ners here today, but I get the sense that there is much
more of a focus to find GPs who have been together
for a period of time and have established a cohesive
and proven team. I also think that they’re very much
aware of the processes of their GPs. For instance, they
wouldn’t be enamored with certain funds if they discovered that most of their dealflow emanated solely
from wide-ranging, broadly focused auctions. And
this scrutiny, beyond serving to raise the bar for many
sponsors, has lengthened the fundraising process. It
takes a lot longer for LPs to either say “yes” or “no” to
a potential fund investment.
Turner: My own personal opinion is that the more
things change, the more they stay the same. With that
said, there are some remarkable differences when considering the PE market today versus five years ago.
The coordinated activism of the institutional limited
partners, for instance, has gained a lot of traction, but
there has been a movement afoot to standardize terms
and conditions between GPs and LPs for years now. I
think the progress could be considered somewhat of
a watershed event, but it’s not necessarily a new effort
on the part of limiteds.
Thoma: I think I’m most pleased about the way
the industry has stood tall compared to some of the
other asset classes. People talk about the banks being
stress tested, but I think the past few years have served
to stress test private equity, and notwithstanding how
the asset class may be portrayed in the press, the industry came through strong. As Steve said, the asset
class has really evolved into a form of business. It’s
about better corporate governance, and I believe private equity does that better than the public sector.
Schwartz: As Gijs mentioned, we’re seeing all of
the normal cycles that have played out in private equity since the asset class has been around. This time,
though, changes to the regulatory regime and new
accounting doctrine are exacerbating the cyclicality.
The move to more of a mark-to-market accounting
basis has had implications felt by both LPs and GPs.
There’s more transparency, increased governance and
a trend toward significantly more regulation, which
together have made the asset class seem more volatile
than past eras, at least on the surface. It’s always been
cyclical, it’s just that the market values weren’t going
up and down in real time.
Mergers & Acquisitions: I think what David said
makes sense, in terms of the more things change,
the more they stay the same. The three legs to the
private equity stool, for instance, remain buying
right, generating earnings growth, and then selling at a higher multiple, while the leverage gooses
August 2011
7/7/2011 9:05:05 PM
Roundtable
“
Private equity
is evolving to
be a form of
business as
opposed to
merely a form
of finance.
the returns. What seems to have changed, however,
are the processes involved, as Jim alluded to. From
what I can tell, the GPs that are generating enthusiasm among institutional investors seem to have
a blueprint in place that helps them source deals
outside of a traditional auction; they have a proven
ability to generate consistent growth across their
portfolios, whether it’s through rollups, a specialist
approach or some other strategy. And as a result,
Steve Klinsky
New Mountain Capital
”
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exit, worry about the operations of the business. Of
course, throughout all this, they were expected to be
out finding their next deal. As a result, the pipeline for
each particular partner wasn’t particularly deep at any
given moment. There was no real division of labor.
What we’ve seen over time is that the asset class has
really adopted a set of best practices around organizational infrastructure. You’ll see partners brought in
to specialize on business development and sourcing;
other partners may handle the bulk of
deal financing and relationships with
lenders; of course, operational executives have become more prominent;
and as PE registration looms, more
and more firms are bringing in specialists to deal with compliance or investor relations. It’s more of a business
and less of this independent, shootfrom-the-hip gunslinger mentality,
in which partners hop on planes and
hunt for deals.
they’ve been able to line up profitable exits across
multiple cycles. Increasingly rare is the shop made
up of a handful of rainmakers and nothing else. I
guess what I’m getting at is that a bifurcation seems
to be taking place, in which those shops that have
institutionalized their processes have really separated themselves from those boutique groups that
are maybe stuck in 1994, and believe that one great
deal will beget others?
Mergers & Acquisitions: The evolution seems to be taking many forms.
For instance, among the GPs here
with us today, Thoma Bravo represents the continued refinement
around a strategy that began with the
buy and build; Sheryl’s appointment
at Perseus underscores the renewed attention and
sense of partnership GPs have with their limiteds;
and the business Steve has built at New Mountain
seems to encapsulate all of the characteristics Jim
just described in terms of the institutionalization of
the PE business. Steve, let me ask, when you set out
to launch New Mountain after leaving Forstmann Little, what were some of the considerations you made
in building the firm and creating a culture?
Hill: I think you are seeing a bifurcation. At the
same time there is a bit of a conundrum, especially for
smaller funds, because these processes, not to mention the increasing demands of regulators and limited
partners, all require an infrastructure.
When I was young in this business, the predominant models were these funds in which everybody was
a partner and each one was expected to go find their
own deals. They would negotiate the transaction,
close the deal, take a board seat and then, until the
Klinsky: It was never about trying to differentiate
ourselves. We just began with the mindset that risk
doesn’t create returns; good business practices create
returns. Our goal was to build an organization that
could execute on that thesis. Over time, it has continued to evolve. Eleven years ago it was basically myself
in a rented office, and now we have 800 people on
our staff, and 50 investment professionals. But it’s a
dynamic process and we’re continually trying to improve it by asking questions around all of the points
August 2011
7/7/2011 9:05:24 PM
we’ve alluded to. How do you find great companies
outside of an auction? And how do you build those
companies and take care of them?
There is no set model, but we try to add people
who make the whole organization stronger. And we
try to avoid any silos, where an individual might
think, “I have to find a deal, but what happens afterward doesn’t really concern me.”
Mergers & Acquisitions: Are limited partners really
aware of the processes in place or the expertise a GP
builds out in a given market? Or, alternatively, is it
really only about returns, and whether a GP can be
considered a top-quartile or top-decile performer?
Also, are limiteds more forgiving if there are processes in place, but perhaps a GP just missed on
some bets?
Schwartz: You really have to consider the different types of limited partners too. Gijs and David, for
instance, have the in-house expertise to really analyze
the smaller managers. They can dig in and pick out
the upper-quartile players in a given segment. But
on the other hand, the larger LPs, such as the state
pensions, may not have the staff in place to evaluate
the specialist funds and they tend to deal with a lot
of turnover. That’s why these LPs prefer larger funds,
because they’re also putting larger chunks of capital
to work. There are other considerations too. The state
pension funds, for instance, have to deal with FOIA
issues; the insurance companies may have certain accounting requirements; while the endowments could
have certain liquidity needs.
Albert: I actually think limited partners would
rank track record as No. 2 or No. 3 in terms of the
criteria they’re using to select fund investments. The
cohesiveness and culture of the firm, as well as the
transparency they’re afforded into the operations are
probably more important. Limited partners don’t
want to be surprised. They don’t want to see style drift
if it’s not something that was discussed as part of the
strategy. That is the best way to blow up a relationship
for a general partner.
One thing that I’m not sure a lot of GPs really understand — a point that has really been driven home
since I joined Pantheon — is this concept of portfolio
construction. It’s not just about lining up all of the
top-quartile funds. Limited partners are trying to assemble a fairly diversified portfolio, and if they’re successful, that will ensure that in any given market, at
any given point in time, they’ll be backing a fund that
is knocking the ball out of the park.
Turner: Portfolio construction has always been
part of LPs’ approach to private equity. I may be telling a tale out of school, but the truth is that in periods of oversupply, when the LP is spending 75% of
their time just sifting through very good, competitive
funds, you actually have less time to think about all of
this. Also, FAS 157 has changed the game a bit. From
an aggregate standpoint, when we’re looking at the
performance numbers that come out of all the various
groups we’re backing, you have to footnote the fact
that these are all based on post FAS 157 valuations.
August 2011
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“
Private equity firms are
modeling out
returns at 17%
to 18%, which
is just a little bit
above mezzanine, because
they want to put
the money out.
James Hill
Across the board, though, all LPs clearly want
more information, and they want it in a more timely
manner. It’s up to the GPs to be responsive to not
only their largest LPs, but basically all of their limiteds
in order to have a diverse and reliable funding base.
Van Thiel: If you step back a bit, we’re talking about
the evolution of private equity. At it’s core, it’s about
Benesch
”
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7/7/2011 9:05:28 PM
Roundtable
“
Negotiating a
limited partner
agreement is
not an end in
and of itself;
it’s not a
bloodsport.
buying businesses and executing a transformation.
There was a period of time when the “transformation” part of the equation was less and less important,
as leverage and access to the capital markets allowed
people to get their money back really fast and generate attractive IRRs. I think what Sheryl was saying
rings true, about the various motivations of LPs. For
one group, an 8% IRR might be considered a fabulous outcome, whereas another group requires returns
to be in the low 20% range.
Having said that, at this point everyone should
know that private equity is not about playing the capital markets; it’s about transforming companies and
bringing together expertise and knowledge. In the
early days, one partner could have this kind of impact.
Today, it’s much more difficult, because everything is
faster paced. The move from valuing investments at
cost to mark to market motivates GPs to put points
on the board early. That didn’t exist five years ago,
David Turner
Guardian Life Insurance
”
MERGERS & ACQUISITIONS
030_MAJAug11 8
Mergers & Acquisitions: That’s a perfect segue into
how GPs have refined their approach in terms of
‘buying right’ — be it through proprietary deal flow,
finding unique angles that allow for a premium, or
just having a flawless operational plan in place from
the start. From the LP perspective, do you even get
into how investors are sourcing deals or the multiple
paid on entry?
Turner: I can’t tell you how many dozens of GPs
come through our door every year with the same
story, which is: “We have a differentiated strategy, we
produce proprietary dealflow, and we offer some level
of value add.” I usually have to stop nine out of every 10 within the first five minutes. I think it speaks
to two different factors today. One goes back to the
point I was making earlier regarding how much noise
is out there for LPs to sift through. The other thing,
which I think is important, is that it all goes back to
execution. The fundamentals of the business haven’t
changed. There are many different iterations and various models that have evolved. It’s an asset class that is
constantly striving to take advantage of inefficiencies.
It’s the groups that have been able to translate that into
a process in which their performance is replicable that
are able to distinguish themselves from their peers.
Schwartz: It’s not that difficult to determine
whether a GP truly has proprietary dealflow. At Perseus, the firm is only focusing on certain sectors, and
the deals come naturally because they have a network
in place. Industry expertise also provides an angle
that’s different, so sponsors can come at deals almost
like a strategic and base the valuation on what they
can do with the assets that others can’t.
when GPs could slowly build an asset, and even drag
it into negative territory for a period of time, without
having any impact on the books of their LPs. That’s a
big change. Some limiteds are even somewhat blinded
30
by the accounting treatment because they prefer that
GPs are coming out of the J-curve that much quicker.
But while the whole business is accelerating, the end
game is still the same: it’s about how much did you
buy the company for versus how much you received
on the sale.
Thoma: Sometimes this means that you actually
work backwards. You can model out, for instance,
that you want to make three times your money and
a 25% IRR over four years, so what can I pay and
what operational assumptions are necessary to get to
that goal. We might pay $100 million for an asset,
August 2011
7/7/2011 9:05:55 PM
which seems like a lot if somebody else only wants to
pay $80 million, but we believe we can get more cash
flow out of the assets than other buyers; that’s going to
influence our pricing. I think too many people in our
business focus on the entry multiple instead of what
they’re going to do with the assets post close.
so we’re better able to convince sellers to work with
us on the side.
Hill: There’s also a certain level of emotional intelligence that seems to come through. I have been
on both sides of management presentations, and the
Hill: It’s interesting, because it’s not
always easy to distinguish those buyers
from the firms that may have lowered
their internal goals. In some of the auctions we’ve seen, private equity firms are
modeling out returns at 17% to 18%,
which is just a little bit above mezzanine,
because they want to put the money
out. Maybe they’ve had some strong realizations over the past 12 months, and
they’re trying to put capital to work or
they’re just facing the end of their fund
lives. Without naming names, you get
the sense that this happening based on
where a particular sponsor is in their
fund life.
Mergers & Acquisitions: And I imagine
there is one of these groups in every auction, which makes proprietary dealflow — whether
it’s actual deals outside of auctions or pre-emptive
efforts — so important. Does anyone want to provide
an example of how they’ve gone about sidestepping
an auction?
Klinsky: We have a process every year where we’ll
devise a list of particular industries we’re going to focus
on and then we’ll dedicate a team to each of these segments. Two years ago, after Rohm & Haas was sold to
Dow, the former CEO of Rohm [Raj Gupta] joined
us and around him we built out a specialty chemicals
team. A year later, that effort yielded an acquisition
of a Covidien division that sells laboratory chemicals.
It didn’t come through an auction; it wasn’t for sale;
and it wasn’t something that was hatched on the golf
course. It came about because we identified the sector,
staffed up around it, and then found a business that
matched what we were looking for. It’s what we try to
do consistently.
That’s not to say that investments we make won’t
sometimes start off through an auction. But we’re going to pick the space first, and lay the groundwork,
August 2011
031_MAJAug11 9
“
Limited partners would rank
track record as
No. 2 or No. 3
in terms of the
criteria they’re
using.
Kevin Albert
connection that develops between the executives and
the bidders can be critical, especially if you’re talking
about a property that is not a sponsor-owned business and management is staying on board. You’ll see
some groups who are really good at establishing these
connections and they will win deals in auctions when
they’re not even close to the highest price.
Pantheon Ventures
”
Mergers & Acquisitions: And for the limiteds here,
are you actually tracking the purchase price multiples and referencing comparables?
Van Thiel: I think “proprietary deal flow” is one of
the most over-used themes we’ll hear in presentations
— there is no such thing, really. First of all, you need
to have a willing seller, and the seller is always your
biggest competition. Even if it’s negotiated outside of
an auction, there’s a line of others who have looked
at the asset in the past, not to mention friends of the
CEO, whispering in their ears about what the company is worth. So proprietary dealflow doesn’t mean that
you are the only buyer. I take it to mean that a private
equity firm is “the buyer of choice,” which is a much
MERGERS & ACQUISITIONS
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7/7/2011 9:05:44 PM
Roundtable
“
Too many
people in our
business focus
on the entry
multiple instead of what
they’re going
to do with the
assets post
close.
better way for a firm to distinguish itself. It doesn’t
just mean they’re willing to pay the highest price. It’s
about what they can bring in terms of understanding
the industry dynamics; it’s about a strategic vision for
a particular company.
With all that said, we do look at the multiples and
we do track comparable transactions and try to figure
out if the GP overpaid. But it’s hard when you’re sit-
Albert: Operations is a pretty universal theme. I
mean, Clayton, Dubilier & Rice has been at it since
its inception. They’ll bring on operating partners as
a full partner at the firm. Then there are others that
will put together a bench of executives, and maybe
they will be paid on retainer. At some firms, the operators might be involved in the due diligence, and
the funds will have them buy into the deal before they
even make the investment. There are all kinds of different models, and they can all work. What makes
it difficult to project is that ultimately private equity
is a people business and you can’t always figure out
why something works and something doesn’t on the
surface.
Carl Thoma
Thoma Bravo
”
ting in the LP chair, and not at the negotiating table
where the sellers and management teams hammer out
what an asset is worth.
Mergers & Acquisitions: What about operations?
How do LPs really track what works and what doesn’t
for GPs?
Hill: It’s a generic phrase, actually. Everybody
knows now that GPs have to improve operations, but
the approach is different at every firm. Some firms,
certainly, have processes in place. It is evident that the
operating talent is getting involved as early on as the
deal sourcing stage, where they’re strategizing about
how to generate growth and how that plays into the
32
MERGERS & ACQUISITIONS
032_MAJAug11 10
valuation. At the same time, you’ll see these situations in which there are operating partners on staff
or as part of an advisory board and it’s made up of
executives who have been out of an industry for 10
or 20 years. They may have served as a chairman of
a Fortune 500 company, but if I’m an LP, I’m not
sure I’d be too excited about relying on that person to
perform due diligence or expect them to really roll up
their sleeves and get engaged after the deal.
Schwartz: I think the key to any model is the structure of the economics. GPs have to make sure that
there is an alignment of interest, which from a limited
partners’ perspective can often be very difficult to ascertain. I remember one time, at TIAA-CREF, I met
an operating partner and he was working for another
one of our GPs at the same time. He had an arrangement with both of them, but you wouldn’t know that
if you were just doing your due diligence on one of
the firms he was with.
You have to ask whether their industry expertise
is truly aligned with the goal of maximizing the value
of the company for the GP. Are they paid out of the
profits? Do they invest their own money? Do they
also get paid from the other activities of the GP? I
think the economic terms, and particularly the capital
they, themselves, are investing, are the most important factors. The problem is that this can often be one
of the hardest areas to dig into. The GPs will map out
the carry of the various partners, but they’ll just group
everyone else together in some other vague category.
Van Thiel: It’s important to note that nowhere in
our process of screening GPs do we ask: “Who are
August 2011
7/7/2011 9:05:59 PM
your operating partners?” We want to see how GPs
add value, and there is nothing set in stone that sponsors need operating partners to generate returns.
Maybe they’re really savvy with buy-and-build strategies; maybe their knowledge set is on the financing
and balance sheet side of the business and that’s what
drives value. It’s funny, because I think most teams
believe that they should have an operating bench to
point to as part of their presentation, but that’s not
necessarily the value-add LPs are looking for.
Hill: Sometimes you’ll see it serve as a double edged
sword in a process too. Most industries are pretty fraternal to the point that everybody knows everyone
else. Occasionally, you’ll see situations in which it
can be threatening to the sellers’ management team.
They’ll always want to know: “What exactly is this
guy’s role?”
Investors just have to play it very carefully, because
there’s the risk that the current management team
feels threatened and it turns them off from the start.
Thoma: The whole debate about operating partners, at least as far as I’m concerned, is pretty easy:
just show us the results before and after they got involved, and if growth accelerates and margins climb,
then you can attribute that to the operating team. But
our operating partners have one mandate and that is
to make the CEO of the company look good. Their
job is to be a coach.
We target rollups, and when you’re starting with a
company that posts $10 million in earnings, and four
years later they’re doing $70 million, you need somebody that can help management along and identify
what’s going to happen next as the company grows.
But they’re behind the scenes.
Klinsky: All of this goes back to being a “buyer
of choice.” Sellers want to know how you can bring
value, and sometimes it might be experts who can
help with a sourcing strategy or maybe they have
some insight into the customer base that a company
is targeting. Other times it might be a situation in
which the seller is looking to keep a quarter or 30%
of the business. We prefer these investments, because
it removes us from a situation in which someone is
selling 100% and whichever duck quacks the loudest
or whoever puts forward the craziest offer is going to
get the prize.
August 2011
033_MAJAug11 11
Ultimately, I don’t think ‘operations’ is about relying on this one genius who is going to be parachute
into a situation and fix everything. We come from a
family business background, and I think that serves as
a backdrop to our efforts in creating a flat culture in
which the entire team seeks to add value.
Turner: Just to add one quick thought, I think it’s
absolutely critical for GPs to include their LPs in this
process. Most limiteds want to truly understand how
GPs built value in a particular company. So as opposed to the perfunctory five minute call with an exCEO, which isn’t at all revealing, it would be much
more valuable to go spend half a day with the portfolio company. I think the more LPs involve themselves,
and the more accommodating the GPs are, you’ll see a
higher level of confidence that develops, which would
become a fundamental part of the GP/LP partnership.
Mergers & Acquisitions: Switching gears here, it
makes sense to discuss leverage. Steve alluded to
it earlier, but how has the approach to debt changed
for private equity post credit crisis?
Klinsky: I think if you had interviewed people
eight years ago, they would have told you that private
equity investors create returns by taking on more risk,
which equates to piling on more debt. Today, leverage
is viewed as a corporate finance decision. We figure
out the fundamental value of a business and take it
from there. It can be a sweetener, but I don’t think investors simplistically depend on debt the way people
assumed they did. There’s an appreciation that overleverage can kill a company or restrain growth.
Albert: I think limited partners have become more
sophisticated in how they look at debt too. They used
to believe, like everyone else, that debt is good. The
financial shocks that occurred in 2008 were terrifying, as you saw all of these mega buyouts that were
highly leveraged and effectively on their way to going
bankrupt. It didn’t happen because the Federal Reserve drove interest rates down and those companies
were able to recapitalize, but the upshot is that people
have a much healthier attitude toward leverage and
risk management. For instance, there is a difference
between operating risk and financial risk, and taking
on both is probably a bad combination. Firms like
“
Most limiteds
want to truly
understand how
GPs built value
in a particular
company.
David Turner
Guardian Life
”
MERGERS & ACQUISITIONS
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Roundtable
Silver Lake, that operate in the tech space, tend to use
very little leverage because they’re taking on a lot of
operating risk.
“
When you recap, it actually
requires more
attention from
the GPs.
Gijs F.J. van Thiel
747 Capital
”
Schwartz: One of the key components of the alpha equation is whether or not the GP really knows
how to use the debt markets to maximize the value
of their portfolio companies. Do they know when to
refinance, for instance, or alternatively, when it’s not
appropriate.
During the heyday, three years ago, GPs were going in, refinancing, swapping in covenant lite loans
and really preparing their companies with a capital
structure that offered more flexibility. During the
downturn, you also saw GPs work with the banks
to refinance, amend and extend, and get allowances
that the companies most likely wouldn’t have been
able to get from the banks on their own. Today, the
smart GPs recognize that we’re in a low interest rate
environment, so while inflation is increasing, let’s lock
down long-term, low-cost debt. They’re adding value,
because they’re thinking two, three years out about
where interest rates will be and how they can re-jigger
the capital structure to maximize value, liquidity and
options.
Hill: Just to add a contrarian point, debt is so
cheap, in a lot of situations it seems like leverage has
come back to 2007 levels. I’ve seen some companies
sold in the past six months that fetched more than
they would have received four years ago.
Of course, the lower interest rates mean it’s cheap,
but I think it underscores that institutional memory is
short, from the standpoint of both lenders and GPs.
Mergers & Acquisitions: I’d be curious about how
some of the LPs here feel about dividend recaps.
They don’t necessarily imply that a company is being
overleveraged, but does your stance on debt change
at all when it leads to a distribution and you’re getting money back?
Albert: There was actually a Coller Capital survey
that came out yesterday suggesting that limiteds are
actually very excited about the ability to execute dividend recaps again. I think it depends on the progress
that has been made with the company in terms of its
growth, but it’s also a function of the fact that debt is
so cheap.
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Van Thiel: Leverage is always going to have its
positives and negatives. What’s a dirty word for some
can be great for others. With small funds, which
are our focus, you generally need the flexibility of a
strong balance sheet because you’re usually dealing
with high-growth companies. If a buyer wants to
lever these companies up and that translates into a
premium on the exit, fantastic. Because of the debt
markets’ recent strength, we’re actually encouraging
all of our managers to sell and we’re seeing exit multiples escalating.
A recap, though, is right there in the middle. Yes,
it’s nice to get your money back, but while GPs are
holding onto that asset for the foreseeable future,
they’re also exposing it to additional risks. Of course,
it depends on the LP, but we are much more inclined
to tell our managers to sell, and perhaps swallow a
lower multiple on the exit, than to to recap and take
on the additional risk. I think people tend to forget
sometimes that when you recap, it actually requires
more attention from the GPs, because suddenly the
asset is a higher risk item in their portfolio.
Hill: I think some private equity firms will take the
mindset that once they get their initial investment
back, they’re playing with house money. But I’ve seen
it go awry when you’re dealing with a growth company and sponsors have executed two, maybe three
recaps. It can put the management under tremendous
pressure because they may not have the working capital line that is necessary, and ultimately it can have an
impact on the value of the ongoing asset. It has to be
something that management feels good about.
Klinsky: There are different flavors of recaps. You
can have an asset that started off at four times debt to
Ebitda. As the business grew, the debt gets paid down,
and after a certain period of time, you lever it back up
to four times and reward investors with a dividend. I
think that’s a pretty good outcome.
Thoma: When we acquire a business we’ll never
have the optimal amount of leverage. Operational improvements and synergies from tuck-in acquisitions
will bring the leverage down pretty quickly, so we will
probably refinance the vast majority of our companies
within 18 months. We will always look at the sale versus recap opportunity, but the alternative isn’t always
as attractive as the recap.
August 2011
7/8/2011 10:52:51 AM
Mergers & Acquisitions: To switch gears again,
we’ve been discussing the refined processes of GPs,
and alluding to things that require more resources.
At the same time, I know we’ve mentioned the ILPA
Principles at least a few times, but we haven’t really
touched upon how the compression of fee income
— assuming it is inevitable — is going to impact
how general partners put capital to work. Beyond
just smaller management and transaction fees, the
trend line seems to suggest smaller fund sizes, and
this is all before we even consider the cost of Dodd
Frank’s registration requirements or the prospect
that legislators could rewrite the tax code to reverse
the capital gains treatment for carry.
Thoma: All those issues you just mentioned, you
obviously don’t like them as a GP, but we got into this
business to build companies. Are we going to make a
little less money as a result of the changing dynamics?
August 2011
035_MAJAug11 13
Yes. But you have to get up in the morning and do
what what you enjoy doing and quit worrying about
things that are beyond your control.
Turner: Just to address the ILPA Principles, I would
say that negotiating a limited partner agreement is not
an end in and of itself; it’s not a bloodsport. Neither
GPs nor LPs are approaching it as if there is going to
be a winner and a loser. The idea is to craft a partnership agreement and define how you’re going to live
together over the span of what will be a 10- or 12-year
fund life.
I guess the codification of the ILPA Principles is
certainly a very strong statement. So what’s the real
implication of that? It means that there was probably
an imbalance in the LP/GP relationship, and that the
power pendulum is moving back in the direction of
the limited partners. The goal, though, is to align interests, so that when things are going well, all parties
“
There’s an appreciation that
overleverage
can kill a
company.
Steven Klinsky
New Mountain Capital
”
MERGERS & ACQUISITIONS
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Roundtable
are making money.
Schwartz: There’s also a huge movement in which
the larger investors are opting for separately managed
accounts, where they have customized terms with
the GPs. Like we mentioned earlier, there are different types of LPs with different priorities and objectives. So some are focused on fees and expenses, some
might be seeking co-investment opportunities, and
others might be trying to structure in liquidity options or opt outs because they have a CSR mandate
that makes blind pools difficult. Among the larger
LPs, though, I expect more to move toward separately
managed account structures, in which there is a closer
relationship between LPs and GPs, and a greater flow
of information. I think this will be more of a permanent thing.
“
The funds that
are probably
the most impacted are the
smaller groups.
James Hill
Benesch
”
Hill: It’s important to note that ILPA isn’t being
adopted word for word on either the GP or LP side.
With that said, the funds that are probably the most
impacted are the smaller groups; those managing
$300 million to $750 million, and of course smaller
funds too. These firms are relying not only on their
2% management fee, but they were also leaning on
the transaction fees and ongoing portfolio management fees. As that pendulum swings pretty dramatically in the other direction, it’s harder to add all of
the back-office resources that limited partners now
expect.
Many of the large state pension funds, perhaps
rightly so, were becoming concerned — with respect
to the multi-billion dollar funds — that the carry was
becoming secondary as a profit driver to the various
streams of fee income. The problem is that this doesn’t
translate down to the much smaller entities, which
don’t have the benefit of a $20 billion fund from
which to draw a management fee. So that’s something
that’s creating a lot of tension in the small and middle
market.
Schwartz: I’d also add that the disclosure of fees
when companies go public has also exacerbated the
issue, because LPs weren’t necessarily aware of how
much income GPs were generating from this. Now
all you have to do is read the public documents.
Turner: To go back to the economics for a moment, I’d just cite one example. When we’re putting
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together an LPA, we’ll have a discussion with the GPs
about their costs. It’s probably not much different
than the type of due diligence a sponsor performs
as part of an investment. We’ll discuss in detail how
much it costs a fully resourced firm to go out and
source deals, the sunken costs of broken transactions,
and the absolute essentials to run a private equity firm
on a day-in and day-out basis. In one particular case,
we were having conversations with a small partnership raising their first fund. And we determined that
it would cost more than the 2% management fee on
the targeted fundraise to cover their costs. So sometimes this argument can turn around and bite you.
Hill: So did you give them three percent?
Turner: They actually raised more money. I think
it goes back to the goal of finding full alignment,
though.
Klinsky: Fortunately, I’m not fundraising for a few
years, so I don’t have to think about terms every day. I
would say, though, that I don’t think the private equity industry gets enough credit when it comes to how
good and proper the terms really are. Just imagine, for
a second, that if the CEO of a public company sold
his stock options at a profit and then eight years later,
after the stock tanked, he signed a personal guarantee
to return all of the gains that were made on the sale.
Concepts like the clawback, for instance, don’t exist
anywhere except in private equity.
Mergers & Acquisitions: How does it all affect buying
behavior? If you ratchet back the fee income, all of a
sudden private equity shifts back to becoming more
of a lumpier business model. So does it change the
mindset of GPs to become singles and doubles hitters or, alternatively, do they take on more risks in
the pursuit of home runs and bigger paydays?
Albert: Limited partners, amid all of this, are
equally focused on having sponsors invest their own
capital, ideally outside of a fee waiver. Ironically, the
popularity of fee waivers underscored the fact that
management fees were so plentiful, they weren’t even
needed to actually operate the business. But I agree
with Jim. If you’re below $750 million in terms of
fund size, it’s going to be a pinch. If you’re investing
your own personal capital, that should modulate your
August 2011
7/7/2011 9:06:30 PM
willingness to try to hit home runs.
Schwartz: I think you raise a good point about LPs seeking out
GP commitments, but at the same time, most of these people are so
wealthy that the amount they’re putting in, while it seems like a lot,
is not that significant in terms of a percentage of their net worth.
Albert: It’s probably harder to figure out what actually motivates
them than whether their commitment is a significant portion of
their net worth. Basically, sponsors have their reputation, their pride
and their money. For most, those three are the motivation.
Van Thiel: To go back to the larger question of what is going to
happen to private equity as the new economic picture takes hold,
this is something that we think about a lot. We haven’t figured out
if it’s going to have a net positive or negative impact, but what I
think it will do is bring higher motivated teams to the forefront.
There was a period where pretty much anybody who had completed
three transactions thought they could raise a buyout fund. You pull
together three partners, three associates, raise $200 million, collect a
$4 million management fee, and that’s a pretty good life. That’s not
going to be so easy to pull together anymore. I can’t speak for the
larger buyout firms, but on the small end, sponsors are using their
funds to lever their own investments. They are not driven by the
economics of fund management; they’re driven by leveraging their
ability to invest really well. We don’t shy away from asking them how
big their commitment is in relation to their net worth, and whether
they’ll miss it if it’s not there tomorrow.
In the small buyout world, we will see changes. There will be
fewer young spinouts, because it’s just too expensive and it becomes
very, very inefficient if you can’t get to a certain fund size pretty fast.
But getting to a certain fund size is not a recipe for success. I think
we will see more experienced people coming into the market, who
are comfortable and have a track record with small funds.
CUSTOM MEDIA GROUP
August 2011
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