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     overview

This note considers private equity funds.

It covers -

• this page - the shape of private equity funds and fund management
• participants - comments on where private equity comes from
• snapshots - information about fund managers such as KKR, Cinven, Apax, Candover, Bain Capital, Oaktree, Macquarie and CVC
• Australia - the nation as an exporter and consumer of private equity
• studies - salient works on particular private equity funds, the economics and regulation of LBOs, and fund managers as a target for cultural criticism
• landmarks - highlights of private equity fund deals since the 1980s, with an emphasis on the media sector

It supplements discussion elsewhere on this site regarding Capital, the digital Economy and Hedge Funds.

     introduction

As the e-capital and investment guide elsewhere on this site comments, private equity funds (aka acquisition funds) consist of pools of capital - from a range of sources, including banks, wealthy individuals, insurance companies and pension funds - that are deployed by specialist managers in the acquisition of assets.

Those assets may be an entire enterprise (typically a company that is listed on a stock exchange), a component of such an enterprise (a division, a regional operation or a production facility) or infrastructure (eg an airport, a highway, a collection of broadcast towers or even a waste disposal site).

The expectation is that the fund will generate substantial returns for investors by disposing of the acquisition, whether through piecemeal sale of units, through sale to another fund or a competing enterprise, or through listing on an exchange. That process may involve enhancement of the acquired entity's efficiency through changed work practices; critics sometimes note that 'enhancement' is often cosmetic, centred on slashing product development, facilities maintenance and the workforce.

Most private equity acquisition appears to be opportunistic. Generation of the desired return is dependant on factors such as whether -

• the fund can extract substantial monies through dividends (reflecting the enterprise's normal revenue or its assumption of debt) during the period of ownership
• whether it can unload assets at a premium
• whether market perceptions have changed and it can accordingly float the enterprise, sell it to another fund or sell it to a competitor at a premium.

The lifecycle from acquisition to disposal, discussed below, is typically medium term. Most private equity funds have exited from their investments within five to seven years. Some are out within 12 to 18 months (often at a substantial profit), derided by critics as 'flipping' or 'burn & bye bye'.

In some instances funds have been left 'holding the baby', with enterprises that are over-burdened with debt and are unattractive to competitors or the stock market.

     structure

The shape of funds varies from jurisdiction to jurisdiction, reflecting -

• different tax regimes
• different regulatory regimes (with for example anecdotal evidence that increased corporate compliance costs in the US after Sarbanes-Oxley are encouraging some enterprises to "go dark" through termination of reporting under the Securities Exchange Act once they have fewer than 300 shareholders)
• size and sophistication of the investment community in different nations (eg greater acceptance in the US than in France)
• competition by institutions and
• emulation of peers.

Funds are typically incorporated as 'limited partnerships' (LLP or LLC), with the fund managers as general partners and investors as limited partners. (The following page considers participation by investors, noting the recent trend for managers to align their interests with those of investors by contributing capital to the fund.) Managers are often responsible for multiple consecutive and/or concurrent funds.

Relationships reflect the status of the managers (in particular their track record operating previous funds) and perceptions by potential investors of risk, reward and opportunity. Early subscribers, large scale subscribers or prestigious subscribers may for example get more generous terms than latecomers or smaller peers. That is consistent with traditional bond selling and loan syndication practice.

Typically, ordinary investors as limited partners do not have an active role in management of a fund throughout that fund's life. That potentially raises governance concerns, highlighted below.

     how many funds, how much money?

Statistics regarding PE funds are uncertain.

That uncertainty reflects the private nature of the funds, some of which are not publicly reported and indeed (in the tradition of private banking) emphasise discretion and avoid media coverage.
It also reflects disagreement regarding definitions, with some figures in official, industry association and academic reports for example conflating data about different categories of investment (eg venture finance of high-tech startups, with a hedge fund and with with funding for an LBO of an enterprise that has operated for 30 or 100 years).

One report suggests that in 2002 there were around 3,000 private equity funds in the US, with some US$150 billion capital, up from US$5.2 billion in 1979. That figure was contrasted with claims of US$1 trillion under management by some 9,000 hedge funds (ie entities where the capital is more liquid and trading more frenetic). Caution is desirable, as a closer examination suggests that the picture is blurred.

Much of the private equity participation is occurring across borders (eg European insurance companies putting money into funds that are managed in the US and that invest globally). The fifty largest funds appear to account for around 70% of aggregate investment and for the highest profile deals, particularly acquisition of major publicly-listed enterprises.

     lifecycles

Typically private equity fund management has three basic stages -

• fund raising (and new fund raising)
• investment
• exit

Fund raising, as the term suggests, involves soliciting investment from several participants. Where the manager has a succession of funds that solicitation is often undertaken during the exit stage of a current fund.

Fund raising may take a year or more, although most commitments appear to be made within six months. The process reflects traditional large scale loan syndication and bond marketing: a mix of informal contact between peers, formal one on one presentations and 'road shows' to collections of potential participants (eg a meeting of invited representatives of major financial institutions in a particular jurisdiction).

In most instances solicitation is for an unallocated pool of money rather than for a specific acquisition. Major funds typically seek enough capital to fund several acquisitions. Returns from asset sales may be redeployed for further acquisitions, rather than being immediately distributed to participants.

Fund raising reflects perceptions of likely outcomes and the balance of power between participants and PE fund managers.

Managers for example may choose to cancel the fund raising if circumstances become adverse (eg macroeconomic forecasts are bad or regulatory regimes change) or solicitation does not secure sufficient commitments. Investors similarly may choose not to participate, or not to participate on a particular scale, if there are concerns about past performance by managers, assessment that the fund is overly dependent on debt rather than equity (some major acquisitions in 2005 and 2006 involved up to 80% debt), perceptions that the managers have been overly generous to themselves at the expense of the limited partners, or even disquiet about community criticism of asset stripping and job destruction.

Investment involves acquisition of one or more assets. Those assets could range from a multinational enterprise to an individual facility or item of infrastructure, such as an airport or highway. Some funds have aggregated several acquisitions in the same industry, whether in an attempt to achieve economies of scale or merely because the managers have expertise and contacts in a particular sector. Acquisition may be frustrated by regulators, for example on the basis of competition policy when a fund or consortium gains dominance in a sector, even though the new owners will presumably shed the asset within a few years.

Investment activity has attracted the interest of academic observers and some of the more independent financial analysts and journalists, who have suggested that there is an innate tendency for managers to optimise their rewards as managers rather than as owners. That is consistent with laments about conflicts between the interests of managers (and directors) and shareholders in ordinary corporations. It is a concern because the fund participants have committed their resources and can only intervene in management of the fund with difficulty.

In some instances the fund will inject capital into an enterprise (or spend money on infrastructure) after acquisition. There are few coherent statistics on such support and overall it appears that most funds either forgo dividends or take money out of the acquisition during the period of ownership rather than strengthening that acquisition with new resources. Some of the more egregious instances of abuse have seen an enterprise starved of investment, loaded with debt and then flicked to a gullible public ... only to expire shortly thereafter or surrender to a takeover by a competitor.

Ultimately, private equity funds are about the successful (ie speedy, trouble-free and lucrative) exit. They do not purport to be long-term owners, although some will retain minority stakes beyond the exit stage.

Exits take a variety of forms -

• sale of specific units or facilities from an acquisition
• sale of the overall acquisition to a competitor
• listing of the enterprise on a stock exchange through an IPO (ie mums, dads and institutional investors take the acquisition off the private equity fund's hands) and even
• listing a fund on a stock exchange, a mechanism used by Macquarie for example.

Some deals can be deliciously profitable. CVC Asia Pacific and Catalyst Investment Management appear to have made a profit of 73% on a four year investment in Australia's Pacific Brands group; peers have made profits of 80% or more after flipping an acquisition onto the market within two years, having recouped their initial investment through a special dividend in the first year.

     alliances

The 1980s LBO boom saw major fund managers, such as Kohlberg Kravis Roberts (KKR), seek sole ownership of their acquisitions. That remains the case with many small and medium scale acquisitions.

The past decade has seen a shift to alliances, with funds joining together to take over large enterprises or fund the acquisition of major infrastructure. The following pages thus refer to consortia that have devoured groups such as BertelsmannSpringer (purchased by Candover and Cinven).

Use of consortia reflects the size of acquisitions (often too big for a single fund to absorb without difficulty) and reluctance to place too many eggs in a single acquisition basket. It has however provoked criticisms that a handful of major funds have colluded to bring down the price paid for particular acquisitions.

     managers

Managers get paid for managing funds: garnering the capital from participants, identifying potential acquisitions, buying the enterprise or infrastructure, choosing and supervising executives to run the enterprise, handling the exit.

Their interests are aligned with but not necessarily identical to those of participants in the funds.

Typically equity fund managers are rewarded for all stages of the lifecycle, with a service fee attributable to each stage and a success fee on exit. The scale of fees varies but it is common to encounter managers charging 2% of the fund capital per year plus a percentage of the premium at exit (ie between acquisition cost and sale price or IPO). That premium varies from between 2% to 20% or more. SEC filings in the 2006 private equity acquisition of US health giant HCA revealed that fund managers KKR, Bain Capital and Merrill Lynch received a US$175 million transaction fee, to be followed by an annual US$15 million management fee (with an additional termination fee if the management agreement is cancelled prior to 2016 plus a fee equal to 1% of the gross transaction value of a future IPO or sale of HCA.

Critics unsurprisingly comment that the manager is the only entity certain to win. Some discipline is provided where managers seek new capital or conduct consecutive funds, with existing investors or potential new investors who identified the manager's past performance having scope to avoid investing at that time.

In some instances that has been little consolation for fund participants, who were unable to fully exit during an IPO and experienced a decline in the price of the enterprise after listing but found that the manager was rewarded for getting the asset onto the market.

     governance and regulation

The partnership agreement is central to governance of a private equity fund. Australia's corporations legislation differentiates between ordinary investors in public companies (with for example obligations for disclosure by promoters) and institutions or individuals taken to have expertise and a capacity for handling risk through private investment. Participants in equity funds thus rely on features of the specific agreement and how it is described rather than on standard securities law aimed at 'mums and dads'.

The expectation is that the agreement will embody the relationship between managers and participants, including articulation of constraints on the power of the fund manager, disclosure and reporting requirements, and compensation.

Managers are however subject to common law and statute law regarding fraud. In the US for example the SEC has used anti-fraud provisions of the Advisers Act in relation to the thoroughness and accuracy of disclosure of performance reporting in a private placement memorandum.

Funds are not exempt from competition policy law and foreign investment law or from money laundering (MLR or AML). In takeovers or property purchases they thus receive the same treatment from regulators (such as Australia's FIRB and the European Commission) as is received by corporations.

As the following page notes, some entities in particular jurisdictions face restrictions regarding participation (ie cannot participate per se or are only permitted to invest a certain percentage of their assets in private equity funds).

     hedge funds

Traditional distinctions between private equity, venture capital and hedge funds (ie entities that generate revenue for investors through a large number of short term transactions) have blurred since 2003.

That blurring reflects perceptions of opportunity, the availability of capital and increased competition in the three sectors. Some hedge funds for example have expanded into private equity to achieve better returns. A handful are active in the US$1bn+ end of the buyout market, unsurprising given the resources available to the largest funds.

Private equity managers have also set up VC arms or participated in venture capital deals and established hedge funds (eg Blackstone, Texas Pacific, KKR, Carlyle and Bain).

     terminology

A concise glossary of some venture capital and private equity terminology is here.





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