Trouble in Paradise

Private-equity deal flow is nowhere close to what it used to be. But there are glimmers of hope
Trouble in Paradise
Private equity: It is the financial world's equivalent of the promised land. If only all that milk and honey hadn't dried up.

It's impossible to talk to anyone about what's happening today without the conversation drifting back to what things were like five or six years ago. In the mid-2000s, private-equity players with a good track record could raise hundreds of millions of dollars in six months. Large investors jumped through hoops to get in. New funds had no problem making acquisitions, other than potential competition from rival funds. Older funds easily exited their investments before the clock ran out, through sales or initial public offerings.

Deal flow flew. Fund managers made gazillions, advisors made out like bandits and private-equity-fund investors were kept happy — happy, in this case, defined as average total returns north of 25 per cent.

That's private equity, the dream.

Then the global credit crisis hit. Credit markets froze overnight. People got so nervous about where things were headed, they suspended new investments. Fundraising? Forget it. Stock markets were a wreck. Deals couldn't get done because no one could figure out appropriate valuations. Initial public offering? Initial public offal is more like it, if the investing public's appetite was any gauge.

And therein lies your problem. Selling a portfolio company or taking it public are the two standard exit models for private-equity funds. They need to be able to get out of their positions to keep their investors happy and willing to invest in their next fund. In the absence of sufficient public demand, private equity the dream has turned into private equity the faded dream.

There's no starker illustration than this: back in the boom times, if you had asked someone in the private-equity field what a zombie was, they probably would have said either (a) a walking corpse, (b) a cocktail or (c) a member of the band the Zombies.

Not anymore. There are Zombies on the Street and they walk among us. There is trouble in paradise.

For anyone whose involvement in the private-equity world is confined to drooling over fund managers' compensation packages (Henry Kravis of KKR took home US$94 million in 2011), there are a couple of basics you need to know to appreciate what's behind the continuing woes.

Take the way private-equity funds are structured. They can be set up as leveraged-buyout funds, venture funds, mezzanine funds, infrastructure funds, special-situations funds — but each exists in a separate limited partnership.

The person or group behind the fund, known as the general manager, raises capital commitments, not money, from institutional or high-net-worth investors, who become limited partners. The general manager makes capital calls as they need funds to cover management fees or an acquisition. And each limited partnership has a finite lifespan, typically 10 years with two possible one-year extensions.

Limited partnership agreements as thick as phone books lay everything out. The time frame within which the total amount of money must be invested – say, within the first five years – and the time frame within which the portfolio must be unwound so investors can be repaid.

So there are three critical components in a successful private-equity fund: the ability to raise funds; the ability to make acquisitions; and the ability to sell or IPO them within the allotted time frame.

And today there are still challenges on all three fronts.

Faced with a global crisis that brought financial markets to within a blink of a cascading global collapse, many institutional investors sat on their core positions and kept their powder dry as they waited to see how the universe would unfold.

It's been messy. The eurozone slipped back into recession last fall, and the European Union continues to show indications of great strain. Fledgling signs of life keep spluttering out and there has been talk of a double-dip recession.

Central banks around the world have tried to shock industrialized economies back to life with low interest rates, but recovery has remained frustratingly elusive. Stock markets haven't been going up or down for the past five years so much as they've been moving sideways. The effect on private equity? A 90-per-cent reduction in funds raised between 2007 and 2009, according to a 2011 report prepared by Deloitte.

That may be because private-equity fund investors aren't as happy as they were five or six years ago. “At the peak of the market, private-equity funds had projected returns in the mid 20-per-cent range in many cases,” says John Leopold, Co-Chair of the mergers and acquisitions group at Stikeman Elliott LLP. “When you look at the top quartile back at the peak of the market compared to the current environment, returns have come down significantly.”

Define significantly. “It's tough to generalize, but a lot of them are in the high teens today, as opposed to the high 20s before.”

So why are private-equity practitioners like Leopold in Montreal and Ian Palm at McCarthy Tétrault LLP in Toronto busier than they have been in the past few years? It seems the smaller- and mid-market segment of private-equity markets are showing signs of stirring. It turns out crummy stock returns and low interest rates aren't a complete disaster.

Institutional investors and capital pools need to deploy their money eventually; they can't sit on cash for years on end. But public markets have been all over the map since the credit crunch. The S&P/TSX Composite Index has returned on average 2.5 per cent a year since 2008. That makes private-equity returns, even at half of what they were a few years ago, look more attractive.

“People have capital to invest, and various investment advisors will tell you that private equity, invested well, will outperform public-market investments,” says Palm. “So if you look at the pension funds in Canada, despite their challenges in the interest-rate environment and in the public capital-markets environment, they haven't reduced their allocation to private equity. If anything, they've increased it.”

Fundraising is picking up, he says, for funds that have proven successful in the past. “That's a good-news story. The likes of Berkshire, Birch Hill, ONCAP and Onex – the big guys – have all been able to raise additional capital, although in some cases, in smaller amounts.

“If you look at the KKRs or the Providents and some of the other big ones in the US, they're not raising US$10 billion or US$12 billion; they may be raising US$6 billion or US$7 billion or some smaller amounts of money. But they are raising new capital to invest.”

Raising funds in private equity isn't confined to the front end, though. There are also the capital calls on the limited partners as the fund makes acquisitions, sometimes several years into the fund's lifespan. Are funds getting that money? Palm says mid-market, or smaller funds are having challenges. “Private-equity funds, and private-equity managers, die slow deaths. Not everyone has been able to raise new funds, but the ones that have shown good returns have done well.”

In underperforming funds, however, some limited partners are opting to walk away rather than throw good money after bad — especially if they have to use their capital to shore up other holdings.

Patrick Barry, a partner in the private-equity group at Davies Ward Phillips & Vineberg LLP in Toronto, says even the success stories are working harder to raise capital. “Brookfield, in their most recent fund, which just got completed, took 18 months or so,” says Barry. “They were very successful – they raised $1 billion plus – but they did it over the course of 18 months, and they're a group with a long history and a very successful track record. And it still took them extra time to raise the money they wanted to raise.

“Birch Hill completed their fund less than a year ago and, same thing, it was still very successful and it took longer. And without speaking specifically about Brookfield or Birch Hill, it's likely anyone raising money in today's environment is facing more difficult terms.”

Ah, the terms. As if the going weren't tough enough for private-equity funds, the protracted economic contraction has thrown another curveball their way. Some of the biggest capital pools – in better times some of their biggest investors – have grown tired of high management fees and are putting pressure on fund managers to share in the haircut.

Others are bypassing funds completely, giving the private in private equity a whole new meaning.

Fee structures for private-equity funds are labyrinthine, but they usually boil down to the general manager being paid roughly 2 per cent of the portfolio's assets per year, plus 20 per cent of the profit when the assets are sold.

Many investors now, however, are balking at paying the same fees they did when returns were booming. Some of the larger ones have been setting up their own private-investment arms in-house.

“Some of the large pension funds in Canada have said, ‘That's an expensive way to manage our private-equity dollars. We think we can do it in-house,'” says Barry. “OMERS Private Equity has a significant team of in-house managers who manage private-equity investments in Canada, the US and UK, and they've been quite successful. The Ontario Teachers Pension Plan has done this for many years. Arguably they were the first ones to go down this road. PSP Investments in Montreal is another example, and the Canada Pension Plan has been doing this as well.
“That's been a trend for the last five years or so, and it's a very Canadian trend. US pension funds typically don't do this.”

OMERS, which administers over $55 billion in retirement assets for Ontario's municipal workers, made a strategic decision in 2004 to change its asset split from 80 per cent public markets and 20 per cent private investment to 50/50. It also decided to become an active private-equity investor, instead of investing through outside funds.

While the shift away from public markets dates back eight years, “the shift away from investing in funds started around 2009, after the credit crisis,” says Chantal Thibault, Managing Director and General Counsel of OMERS Private Equity.

While Thibault doesn't provide numbers, the fees an investor the size of OMERS paid private-equity fund managers would presumably run well into tens of millions of dollars a year. For each $1 billion invested, the 2-per-cent annual fee alone would be $10 million. Then there is the 20 per cent that goes to the general manager when the assets are sold.

Fees were “definitely part of the thinking, but they were not the sole reason OMERS changed its strategy,” says Thibault. “We wanted to have more control over our investments. If you own and control the businesses, you're more influential and you have a better governance model than if you invest through a fund.”

Another advantage, she says, is that OMERS Private Equity won't be forced to sell acquisitions within a strict timeframe the way private-equity fund managers are forced to. “If it makes sense in terms of return for us to hold the asset for five years, then we'll hold it for five years, but there's really no pressure for us to sell it. That's really a differentiating factor, because if it's better for us to hold it for 10 years, then we can. There's no pressure for us to show returns in order to do fundraising.”

Many of the large pension plans exiting private-equity funds in favour of active investment also have built up good in-house legal departments. And the funds themselves – presumably once fairly insensitive to legal costs – are presumably not quite so much anymore.

Are the pension plans putting the squeeze on their law firms? “To the extent they were ever cost-insensitive, they're not now and for the economic realities we're talking about,” says John Leopold of Stikeman Elliott in Montreal, “everybody's being squeezed on their returns.”

Private-equity firms are doing more work themselves before they go to their lawyers, he says. “What they're doing is, they're staging their work process more systematically than before, focusing on the business universe of issues first. They want to be sure the deal's got a reasonable prospect of getting done before involving their lawyers. Many clients are doing the letters of intent themselves. We don't even see them until somewhere down the road, so clearly that universe has changed from five or six years ago.

“The vast majority of legal work isn't done at that stage, it's just a more efficient way of managing the files, and I think it makes a lot of sense for them to do it that way. So the overall amount of work we're doing hasn't changed; they're just more calculated about when they bring their service providers into the piece.”

How about the amount of work on the deal side? He says that's complicated. Leopold admits he has been surprised by an unexpected amount of private-equity activity. “If you'd asked me at the start of last year what the outlook was for 2012, I'd have said bleak. But our level of activity on the private-equity side was materially greater in 2012 than it was in 2011.”

He credits strong debt markets, calling them “jet fuel” for private-equity deals. As equity markets go down, investors tend to flock to bonds and other debt instruments, driving up prices and driving down yields. That makes it cheaper for anyone borrowing to finance a deal.

Combine strong debt markets with the amount of dry capital that financial sponsors have been sitting on and the weakness of public markets making M&A the only viable exit alternative, and what you've got is a recipe for lots of activity. “A material increase in M&A activity has been coming through our door,” he says, “but not necessarily corresponding to the volume of deals getting closed. That's not even close to where you'd think it would be given the realities of the marketplace.”

Leopold is not the only one to mention problems getting private-equity deals (as opposed to fundraising) across the finish line. Asked what's going on, he mentions an unidentified client who told him last fall his company had signed four letters of intent in the previous quarter, in four different industries. In each case, the transaction fell off the rails. “It's because the target's performance in each case had not met expectations. And that's a recurring theme we see in the marketplace,” he says. “We're seeing a lot of companies missing their numbers, and that creates a lot of challenges for getting deals done.

“Deals also have longer time lines than they did before, and they're less competitive. Not the ‘A' level deals, but the ‘B' level deals don't have the same environment they did five or six years ago, where those kind of deals were driving time lines because there was so much competition for them.”

Joseph Romagnoli of Torys LLP is seeing a similar dynamic in New York. “Even though there are funds out there that need to get their money out because they haven't invested as much as they could have, a proportion of deals are not getting done because the seller is not willing to let go at the price people will pay,” Romagnoli says from his office in Manhattan.

He says that, between strong debt markets and sellers' expectations based on advice from investment bankers, “pricing can get up there. Good deals with no ‘hair' are still very competitive and they're starting to get multiples we saw in the pre-crunch days. We actually saw one recently that went out at 12 or 13 times, and they're still closing. When you go to the next level and they're not as clean, where there's some kind of ‘hair,' either legal or tax or something like that, those deals are much tougher and they're taking much longer to get done.”

Romagnoli says that, when it comes to investing, private-equity players are more disciplined than they were before 2008. “They're not going to bid up the price to where the sellers want it to be, even though there's lots of debt available.”

Still, between the “dry powder” (as Romagnoli calls the unused capital commitments or cash positions not deployed) and the fact that aging funds need to exit their positions to start repaying limited partners, he's convinced, as is Leopold, that pressure is building for a burst of deal activity.

“I think a lot of people thought 2012 would heat up more than it did,” says Romagnoli. “It's been a bit choppy. From what I'm hearing, people are thinking 2013 will pick up a bit because of all these deals in the hopper. Credit's available, there's private-equity money out there and strategics [buyers] with cash on their balance sheets. It's all there.”

Here's the thing about predictions: at some point they may be right. Until then, what happens to funds when their portfolio companies can't be IPOed or sold off in the prescribed time frame? Enter the Zombies, or Zombie funds, to be more exact.

All private-equity limited partnerships approaching the end of their life need an exit strategy. Those that need one now have a problem. IPOs aren't exactly viable, not post-Facebook, and private-equity sellers can't command the multiples they need from a strategic sale to keep their investors happy. So what's happening?

“Some limited partners have been getting letters saying the fund wants to extend the term,” says Romagnoli. “Typically, the limited partners don't like to get that because they're paying management fees, and they don't want to keep paying fees for someone to just hold on to assets. So Zombie funds are funds that have assets left, but are just in kind of extension land or beyond extension land.”

Romagnoli says Zombies have spawned a new phenomenon: structured secondary sales. “What's been happening is, the Zombie looks for a buyer who might want to put more money into this area because they've been on the sidelines and need to invest. But the fund doesn't sell the companies outright; it puts them into a new vehicle that the new investor buys into.

“The general partner then offers the original limited partners – many of whom are tired and want out – the opportunity to either cash out or roll into that new vehicle. That new vehicle is not a traditional fund with a 10- or 12-year term because these assets have been sitting around, so normally it's more like four or five years or whatever makes sense.

“The buyers of these Zombie-fund vehicles generally put in a little extra money to do a follow-on acquisition, a tack-on or financing for these existing entities, working capital, and typically, they get better economics on the management fee or on the carry.”

Are there Zombie funds in Canada? Ask David Hunter, who does private equity work with Bull, Housser & Tupper LLP, and there's a pause. He says he's not familiar with the term. Five seconds into describing what it is, it becomes clear he's very familiar with the phenomenon.

“We've absolutely got them here,” Hunter says from Vancouver. “I've been managing the workout procedure for one fund that found itself with a relatively underperforming portfolio but a few assets with potential where it was in the best interests of everybody to hang on a little bit longer. They weren't asking for new money, just enough of an accommodation to allow them to keep administering and to try to play it out and see if some recovery could be made. It's a pretty dismal business because people aren't particularly excited.

“We're also seeing other situations where people aren't investing new money; they're simply taking a look at their investing portfolio and maybe cutting a couple of investments loose. They may feel they have three winners, so whatever capital they have left is allocated to follow-on investments.”

Hunter is seeing the occasional investor walk away from a capital call. “In the last little while, we have seen a few defaults.” But on a more positive note, he's also seeing more US private-equity money coming into Canada as investors look to deploy capital or capacity they may have been sitting on for years.

“We're just at the tail end of wrapping up a deal here — not huge, just between $20 million and $30 million, and it's a US-funded, private-equity-funded consolidator that's come into our market up here just to pick up a little nugget. They were very aggressive. They saw quality, were prepared to pay for it and to pay very quickly.

There is particular US private-equity interest in resource deals, he says, “but they're usually buying on a project basis, taking a piece of a project under a structured financing, a limited partnership or a joint-venture structure or something like that, with no exposure to the general risks of the business.”

That type of resource deal is increasingly being also shopped into Asian market, he says. “Because the Canadian resources projects are so interesting – coal and uranium and so on – to the Asian market, that's a natural place to go sell. We've been partnering with the large accounting firms, which have enormous reach, bringing them our clients who need financing and are finding public markets aren't the place to get it any more. So we go into Japan, South Korea or China, and say, ‘Do you want a piece of this particular coal mine?'”

At the other end of the country, Colleen Keyes, a partner at McInnes Cooper is also finding resources the only area of potential interest, and a faint one even at that. “What we're seeing here within our client group is certainly in the mining, resource and energy sectors,” she says from Halifax. “Investments had been European in the 2008-2009 time frame, and at this stage there may be the need for follow-ons, but those aren't able to happen.”

Keyes says Atlantic Canada may not have felt the chill as early as some other areas of the country, “but we're certainly feeling it now. Deal flow is very slow. A lot of our clients are in what I'll call hunker-down mode. We are seeing some level of private-equity investments, but they're very small- to mid-market.

“It's slow. The message I'd send is it's slow. It's very quiet down here — and we'd welcome some noise.”

Sandra Rubin is a Toronto-based writer and strategic consultant.