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P R I V A T E E Q U I T Y

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The private equity industry was suddenly sidelined by the credit crunch, but lenders have recently begun to back leveraged deals, albeit usually ones where the target company has a strong track record and a healthy balance sheet, and where the acquirer is prepared to commit a larger portion of equity than in previous years. The economic downturn has also altered the relationship between fund managers and their investors, with LPs now demanding changes to the way funds are managed and information is released.

P R I V A T E E Q U I T Y

R O U N D T A B L E

P R I VAT E E Q U I T Y


Marta Viegas

Partner, TozziniFreire Advogados

T: +55 (11) 5086 5233

E: [email protected]

www.tozzinifreire.com.br

Marta Viegas is a partner in the Corporate Law practice of TozziniFreire Advogados in

São Paulo, specialising in private equity transactions. She joined the firm in 1997 and

holds a LL.M/K degree at Northwestern University School of Law and Kellogg School of

Management. She has worked in various and complex transactions involving national

and foreign funds, having gained vast experience in structuring deals and negotiating

acquisition contracts.

Timothy Hartnett

Partner, PricewaterhouseCoopers LLP

T: +1 (646) 471 7374


www.pwc.com

Tim Hartnett is a partner in the Transaction Services practice and is the US Private

Equity Sector Leader. In addition, he is a member of PwC’s Global Transaction Services

Leadership Team. Mr Hartnett has specialised in providing a broad range of acquisition

services to financial buyers, including due diligence, valuation, structuring, taxation and

specialist consulting. He holds an MBA from Columbia Business School and a BS from

Boston College.

Johan Terblanche

Senior Associate, Loyens & Loeff

T: +352 466 230 245


www.loyensloeff.lu

Johan Terblanche is a member of the Investment Funds practice. He specialises in

the structuring of investment funds with special focus on alternative funds, including

private equity and hedge funds, and advising their managers and investors. Prior to

joining Loyens & Loeff, he spent five years in the British Virgin Islands, focusing on

investment funds and regulated business.

Kate Downey

Partner, Kirkland & Ellis International LLP

T: +44 (0)20 7469 2214


www.kirkland.com

Kate Downey is a private funds partner in the London office of Kirkland & Ellis

International LLP. She focuses on advising fund managers in relation to the structuring

of domestic and international private equity funds, carried interest and co-investment

schemes. Ms Downey also has experience of a broad range of other private equity

transactions, including a number of secondary portfolio acquisitions, joint ventures and

the restructuring of a number of private equity management houses.

Dhaval Vussonji

Partner, Kanga & Company

T: +91 22 6623 0000


www.kangacompany.com

Dhaval Vussonji is an Advocate & Solicitor with the Bombay High Court. He has been

associated with Kanga & Company for about 10 years. He is also a Chartered Accountant

by qualification. He has been involved in advising private equity deals undertaken by

the firm.

THE PANELLISTS

Jennifer Bellah Maguire

Partner, Gibson, Dunn & Crutcher LLP

T: +1 (213) 229 7986


www.gibsondunn.com

Jennifer Bellah Maguire is a partner in Gibson, Dunn & Crutcher’s Los Angeles office and

leads the firm’s Private Equity Practice Group on the West Coast. Ms Bellah Maguire’s

practice areas emphasise private equity, mergers and acquisitions, financings and

divestitures. She has been selected by Chambers and Partners as a Leading Corporate/

M&A Lawyer for 2005 through 2009.

When there is economic or interest rate instability in the period

between signing and closing, banks and private equity firms have little

interest in absorbing that risk.

TIMOTHY HARTNETT

8

How would you describe buyout activity over the last 12 months? What types of deals are making it through to close?

Terblanche: The number of classic leveraged buyouts has been considerably lower than in recent years and a limited amount of transactions have been making it through to close. These are pri-marily limited to special situations – companies in need of debt restructuring, bolt-on acquisitions to existing portfolio companies and the like, although mid market buyouts are continuing to oc-cur more frequently than larger buyouts. Buyout activity has been significantly lower overall, due to the lack of financing, difficul-ties in raising capital, uncertainty in relation to the prospects of targets and their valuation, and concern about exits in the short and medium term.

Hartnett: In terms of pure buyout activity, it’s been very slow. In the US, it was slow in the summer of 2008 and then fell off a cliff in September that year. Without the banks lending, pure private equity plays took a wait-and-see approach, while funds that had more flexibility built into their investment mandates saw new op-portunities in the market and pursued them aggressively.

Maguire: We would have to segment the last year roughly into two six-month periods. The first six months saw a re-emergence of credit and consequent renewed activity, but very low leverage, very difficult negotiations with banks and still some significant seller financed deals or just all equity if return was defensible. Also, great disparity in seller and buyer valuation models, because of economic uncertainty, made deals tough to get done or even agreed. In the last six months, there was much greater activity, easier credit (though not to ‘good old days’ leverage levels), re-emergence of relatively hotly contested auctions and a few larger club deals. Buyers have once again had to revisit their models to justify multiples that they probably didn’t think they would have to pay – but some are now willing to pay in order to win deals. In terms of industries, healthcare and financial services have been popular, but many mainstream sectors are also returning.

Viegas: 2009 was a difficult year for the entire world. Accord-ing to the Latin America Venture Capital Association, invest-ments fell 29 percent, fundraising dropped 43 percent and IPO exits declined 30 percent in Latin America. However, Brazil was hit by the crisis to a lesser extent than other countries. Economists believe this to be the result of sound economic policies and im-portant reforms implemented by the Brazilian government since the 1990s, which were key for attracting and giving comfort to investors – the recognition of Brazil as ‘investment grade’ in mid-2008 was a result of such efforts. As a consequence, in spite of the crisis, Brazil faced record numbers of private equity deals. The number of overall transactions in Brazil decreased in 2009, but the percentage participation of private equity funds in the Brazil-ian transaction scenario has actually increased, according to re-search by PricewaterhouseCoopers. The funds invested mainly in the sectors of retail, construction, education, information technol-ogy, services, consumer goods, pharmaceuticals, biotechnology, renewable energy and timber.

Vussonji: The buyout activity in India over the last 12 months has been unique in the sense that it has been dominated by distress sales or division sales by larger conglomerates. It has also been marked by certain value buys by private equity funds and cash rich

investors. However, deals which are making it through to close are the deals which are being offered either at an attractive price or where owners are inclined to sell or dispose of their investments at the best price available in the market. Generally, buyouts in India still constitute a small percentage of private equity deals.

Are there signs that bank lending criteria is becoming more open to supporting private equity transactions? What debt-to-equity ratios are common in the market?

Viegas: As opposed to other countries, especially the US and Eu-ropean countries, in Brazil buyouts do not rely heavily on large amounts of bank debt to generate a return. Because of the high interest rates and onerous taxes, as well as large reserve require-ments for banks, loans in Brazil are expensive and discourage companies from leveraging. The Brazilian government controlled banks, such as the National Development Bank – BNDES, Banco do Brasil and Caixa Econômica Federal, are the main sources of financing currently supporting private equity transactions.

Vussonji: Private equity transactions in India are generally not supported by banks as they are prohibited from providing any funding for the acquisition of shares of a listed entity in India. Such transactions are being funded by large corporate and private equity funds from their own resources. Non-banking financial companies are permitted to lend for such acquisitions but are few in number. A debt-to-equity ratio of 1:1 is common and in certain cases we have seen this increase to 4:1, with sufficient collateral.

Terblanche: Although banks in Europe are becoming more re-ceptive to private equity transactions, pricing and debt levels are far off pre-2009 levels and are not showing signs of returning there any time soon. Refinancing offers are generally around 1.5 to 3 times EBIDTA, but we’ve seen debt ratios of 4 or 5 times EBIDTA on premium, high quality assets.

Have you noticed any fundamental changes in the way buy-outs are structured and negotiated?

Hartnett: For companies that can be financed, either because of steady earnings or a simple investment thesis, it’s a seller’s market today. Many PE funds and their significant committed capital have been close to idle for the past two years, so they are keen to make

The number of overall transactions in Brazil decreased in 2009, but the percentage participation of private equity funds in the Brazilian transaction scenario has actually increased.

MARTA VIEGAS


ROUNDtable

acquisitions. But with the seller in control, deals are done differ-ently. Rising prices are driving lower modelled returns. There is also less access to information and the management team. Sellers are also looking for more certainty around pricing and timing. On the flip side are the more complicated deals, which require more effort, more diligence and take longer to close. Those attributes make it very difficult to get a deal done in this market. Banks are rightfully starting with companies that are easy to understand and more stable. Deals that are more complicated to carve out, or that require governmental or workforce approvals, take time to com-plete – and when there is economic or interest rate instability in the period between signing and closing, banks and private equity firms have little interest in absorbing that risk.

Maguire: When a classic buyout occurs, the changes are of de-gree rather than paradigm shifts. We are seeing a return to post-closing buyer protections – surviving representations, escrows and so forth. In addition, the notion of a reverse break fee is losing traction. We are seeing preferred stock deals and mezzanine style debt with equity kickers become more common – outside of the venture arena. In other words, we are seeing private equity buyout funds take a minority interest for 25-45 percent, sometimes less, and a 2-3 times purchase price preferred stock or a debt instru-ment to limit downside. Sometimes these investments are along-side founders who are trying to take some cash off the table (or just recapitalising, in distress or expansion mode), and sometimes alongside another private equity firm that has been in for a while and is doing the same.

Terblanche: It has been noticeable that, due to a combination of the recent credit environment and investors’ focus on risk management, there has generally been significantly less use of leverage.

Vussonji: In the recent structures we have seen, there is less reli-ance on derivative instruments and loan structures, unless such in-struments are being brought in merely for the sake of convenience and the parties have a greater level of comfort. Also, the manner in which such buyouts are being structured is to reduce the reliance

on debt for funding of such investments. In recent times, promot-ers have preferred to place equity with private equity funds (with appropriate call/put options) rather than funding the acquisition through funds borrowed by them. Where continuity of promoters’ involvement is necessary for business growth, the structure most often involves suitable earn-outs for them.

Downey: The financial crisis has required fund managers to take an increasingly opportunistic approach to the market. We have seen a focus on clean-tech and other green energy funds, raising monies from the smaller quasi-retail market and family offices which have been generally less capacity constrained than larger institutions. Smaller, targeted real estate funds with a focus in continental Europe have also been relatively active. We have also seen a gradual return to single deal structures and club deals in order to allow fund managers to bring transaction and capital to-gether without the difficulties and delays associated with a formal blind pool fund structure.

Viegas: The crisis scenario has influenced a few funds to make so-called PIPE investments, or private equity investment in public entities. Although the Brazilian private equity segment has been traditionally associated with investing in private com-panies at many stages of maturity and development, there were interesting transactions involving traded companies last year. One of the advantages of the PIPE investment in a crisis scenar-io is that the market sets out a parameter for prices. The greatest difficulty for the funds last year was to negotiate prices, as the valuation parameters were unclear. In addition, target compa-nies follow more elaborate standards of control and information disclosure, which facilitates making an investment decision and keeping track of it later. Further, although the capital markets are volatile and target companies usually offer a limited trad-ing volume, investing in this manner includes the possibility of exiting via the market.

Can you outline some of the alternative investment strategies and opportunities which fund managers have targeted since the onset of the financial crisis?

Maguire: During 2009, a great many private equity funds pur-chased senior debt instruments of a variety of types which rep-resented in many cases the effective ownership interest in the company. In many cases the discounts were significant and this, combined with the rate of the instrument, created a more equity-like return. In some cases these investments were part of a ‘loan to own’ strategy which either worked well, or became priced out of the market in a relatively happy way for the fund investor, who exited with a nice return (perhaps not all it had hypothesized, but nice) and was able to return very welcome liquidity to its inves-tors in a dry period. We are also seeing the larger buyout firms coming down further and more often into the middle market, be-cause the mega deals and club deals have not yet materialised in great enough volume to allow them to deploy cash – so pricing has gotten more competitive much faster than many expected.

Terblanche: Since the onset of the financial crisis, many funds have focused, first, on their existing portfolio and, second, on as-sets in respect of which the uncertainties are limited. There has been a significant focus on debt restructuring, distressed debt, distressed equity and lending in the last 18 months or so. Most of 8

When there is economic or interest rate instability in the period

between signing and closing, banks and private equity firms have little

interest in absorbing that risk.

TIMOTHY HARTNETT


ROUNDtable

Competitive bids in the Indian market have led to an unreasonable increase in the price paid for target

companies by acquirers.

DHAVAL VUSSONJI

these funds have had impressive results. The debt markets are changing already and a number of managers are either tweak-ing strategy to adapt or considering launching new funds to align with the opportunities. Those that have profited are spe-cial situation and distressed debt specialists, but it is our experi-ence that in order to credibly focus on distressed situations and to sell your capability to investors, one had to be a specialist in the asset class even before the onset of the financial crisis. Investors have also been interested in investments in innova-tive sectors including healthcare, biotech, communications and technology, especially clean tech. In addition, investors and managers alike have been returning to tangible assets includ-ing timber, commodities, agriculture and the like. Another asset class which has made a resurgence is energy, with renewable energy proving to be a particular favourite. Managers have, in certain instances, reacted to the financial crisis by launching sidecar funds to support existing portfolios in need of additional capital. Innovative managers have attempted to take advantage of the financial crisis by executing debt buy backs and even by forming funds to purchase debt issued by portfolio companies of the main buyout funds. In our experience, buyout managers have rarely shifted their focus and neither have venture capital managers, but specialists in the appropriate sectors have been well placed to attract capital and make solid investments.

Vussonji: Fund managers have, in recent times, reduced ex-posures to complete buyouts of assets. Fund managers have concentrated on those assets where they can participate with promoters and experts experienced in the field to ensure good returns in the long run. Increased acquisitions of NPAs and as-set stripping have also been seen.

Viegas: Fund managers have turned to emerging markets for diversification of their portfolio. The BRIC countries, and Bra-zil in particular, attracted many private equity funds, given the comparatively reduced impact of the crisis and the prospects for substantial GDP growth. A recent study of the Emerging Markets Private Equity Association indicates that in 2009, Bra-zil passed India and is only behind China as the preferred inves-tor destination within the BRIC countries. In addition, we noted that funds decided to focus on more tangible assets, including infrastructure, real estate and timber, and a few specialised funds found lucrative opportunities with distressed assets.

Hartnett: The history of private equity has always been one of consistent evolution in deal types and the strategy behind them. Whether it’s carve outs or take privates, operational plays or financial plays, the days of strict covenants or covenant-lites, the deal makers who have prospered throughout these periods are the ones who have the ability to adjust their strategy to cur-rent opportunities. Over the past few years, the most active PE funds are those with a wider investment mandate from their LPs. These funds utilise their flexibility to make non-standard PE investments, most notably buying distressed debt in a loan-to-own play. They bought debt in good companies suffering from an inappropriate capital structure that did not suit the business. In late 2008 and early 2009, many companies fit that model. PE firms took advantage of that by buying discounted debt and are now in a position where either the debt has rebounded to higher valuations, providing a nice return for them, or they managed to restructure the debt and now have an equity stake in a fairly

healthy operating company. But on the other side of the coin, PE funds operating under a stricter mandate during the credit crunch saw fewer opportunities as banks and bond deals were limited.

How would you characterise the recent performance of the private equity industry? Are fund managers under in-creased pressure to generate returns and manage risk?

Downey: Fund managers are unquestionably under increased pressure to return capital to investors. This is partly to de-risk over-leveraged portfolios but also reflects the fund lifecycle: fundmanagers cannot go to market with a new fund until they have generated sufficient returns to their investors on their current fund to encourage them to re-up.

Vussonji: Fund managers are under increased pressure to gen-erate returns and manage risks. The entities employing the fund managers are insisting that the returns of the fund managers be based on the returns that a manager is able to generate for the funds managed. This has led fund managers to be more cau-tious in their evaluation process and investment decisions, as well as in negotiating terms with the target and its promoters.

Terblanche: Whilst it is difficult to estimate recent perfor-mance because of the relative lack of activity, it seems fair to say that, to a large extent, the men have been separated from the boys in the sense that those managers who have built up a solid portfolio have had comparatively less issues than those who were merely riding the considerable groundswell of pri-vate equity before the financial crisis. Performance seems to be returning but investors still expect managers to ensure, as a primary aim, that assets are protected in order to strengthen their relative position to be able to take maximum advantage when the economic climate improves. The focus is definitely on risk management and governance for the moment, but the pendulum is likely to swing back toward generating returns as markets return to normality.

Viegas: Fund managers are indeed under increased pressure to manage risk. Investors are questioning high levels of lever-age and demanding that fund managers diversify the portfolio, looking for new opportunities in the crisis scenario.

The focus is definitely on risk management and governance for the moment, but the pendulum is likely to swing back toward generating returns as markets return to normality.

JOHAN TERBLANCHE

8


ROUNDtable

Maguire: While many fund valuations have rebounded, not many of them have done more than regain lost ground, outside of specialised areas such as distressed debt, and those lucky funds that are above water have very few realisations to show for it as yet. The current realisations we are seeing tend to be for older funds which are more of a mixed bag, due simply to the usual holding period of fund investments. While there is a heightened focus on risk management, there are relatively few instances where it applies to de novo deals these days – the credit markets are taking care of that. And although it is germane in restructur-ings, it is also fair to say that the exigencies of those deals tend to make the risk calculus fairly straightforward. Then there are exit-related risks, such as seller indemnification. In fact, we are seeing more rigorous post-closing obligations being accepted by managers who feel that it is in the fund’s best interest to exit, even with some retained risk. The issue then becomes one of establish-ing appropriate reserves, and we are seeing some funds grapple with that. So the issue of risk management may be greater at the end of the funnel.

In terms of exit routes, are IPOs, trade sales and secondary buyouts viable options at this time? What basic factors are required to achieve an exit in this market?

Vussonji: In terms of exit routes, IPOs are viable options. How-ever, an IPO in India takes anywhere between six to nine months, since the offer document is required to be cleared by the regula-tor: the Securities & Exchange Board of India (SEBI). Therefore, even though IPOs provide an opportunity for exit, they are re-stricted by the rules and regulations framed by SEBI and market factors affecting the launch of such issues. Trade sales and sec-ondary buyouts are more popular. However, in India, acquisition of more than a 15 percent stake in a listed company entails an open offer to buy out public shareholdings of not less than 20 percent. This at times increases the cost of secondary buyouts in listed entitles. Moreover, in recent times, competitive bids in the Indian market have led to an unreasonable increase in the price paid for target companies by acquirers. All these factors need to be considered when planning an exit.

Hartnett: The answer to this seems to be changing weekly as the capital markets continue to shift. What we have seen is a push

by private equity funds to ready their portfolio companies for whatever capital market opportunity becomes available. That includes everything from ensuring they have the appropriate financial statements, be it annual audits or quarterly reports, to building and documenting a controlled accounting environment. In previous cycles, some portfolio companies never managed to organise themselves to access the capital markets. They were good companies with strong cash flow, but they never built the infrastructure to support a public offering and become a public entity. So we have seen a renewed focus by PE funds to inventory their portfolio companies to identify holes in their ability to ac-cess the capital markets. Nothing is more frustrating for a private equity fund than being told by an investment banker that there is an opportunity to raise some capital for a portfolio company, and then realising the portfolio company is not ready. This is not something that can be fixed in a short period of time, and by the time it is, the likelihood is that the window will be closed again and the PE fund will need to wait until the next cycle. Every un-prepared portfolio company represents a missed opportunity, and PE funds want to hit all of them.

Viegas: One of the consequences of the international crisis was volatility in the Brazilian capital markets and a dramatic reduc-tion in the number of IPOs. On the one hand, fewer IPOs meant more opportunities for private equity funds, as companies in need of funds had a hard time obtaining bank credit and no longer saw the capital markets as a viable option. On the other hand, with less business in the capital markets, private equity funds are rely-ing on sales to strategic buyers as exit strategies. To the extent possible, funds are holding sales of their investment until better days. When performing a new investment, funds are negotiating alternative exit strategies, such as put options exercisable against other shareholders or ways to obtain greater profitability if they need to postpone their exit.

Maguire: We are seeing a number of portfolio companies pursu-ing dual track IPO/sale scenarios. However, as widely reported, some recent failed or less than spectacularly successful IPOs have made that less of a hot prospect than it appeared to be three months ago. A recent internal informal survey revealed that al-most all of our domestic buyout firms have at least one company on file for an IPO or are actively pursuing one, and some have two or more on that continuum. Furthermore, there are a number of cash rich companies (as opposed to funds) out there which are strong strategic buyers and are clearly providing some exits and visibility for firms.

Terblanche: Secondary buyouts are probably the exit routes with the most potential for the short to medium term – a number of private equity funds still have significant commitments and they cannot stay on the sidelines for ever. As financing becomes in-creasingly available and rates return toward the reasonable, buy-ers’ returns will start to be attractive and the market will heat up. IPOs are currently viable only for large assets.

To what extent have fund managers refocused their attention on portfolio management and creating value through existing investments?

Hartnett: It’s widely accepted that holding periods are going to be longer but I don’t think a fund manager would say that they 8

Competitive bids in the Indian market have led to an unreasonable increase in the price paid for target

companies by acquirers.

DHAVAL VUSSONJI


ROUNDtable

Fundamentally, the reduced rate of fundraising reflects a contraction across

the board, and more important, the failure of a good many funds to even begin raising their next generation of

fund.

JENNIFER BELLAH MAGUIRE

8

have ‘refocused’ their attention on portfolio management, or that creating value through operational improvements is some-how a new phenomenon. One of the premises of their invest-ment strategy is that they know how to operate companies bet-ter. That said, the model of how to create value has evolved. Historically, the expertise coming down from PE funds was primarily related to a deep understanding of the capital mar-kets, but now most funds have or are building operational capacities allowing them to leverage the expertise of talented people across the whole portfolio. As an example, a portfolio company may not be able to justify hiring a top notch IT direc-tor, but the private equity firm could justify hiring him or her at the fund level and then leveraging those abilities across the entire portfolio. All companies are under extreme pressure to improve the way they operate, but whereas a non private equity owned company needs to rely on itself to work through the downturn, a portfolio company looks not only to itself but also to its private equity backer for help. The PE manager can pro-vide more experienced resources to its investments in a more cost efficient manner.

Maguire: If you are in the middle of a workout, you just have to do it – whether its ‘refocusing’ or just trying to save the company is semantics. Given the re-emergence of credit availability, there is a lot of energy being put into refinancing so the day of reckon-ing is deferred – hopefully to a day when the economy has recov-ered such that the debt can be paid or there is a profitable exit. This is classic preservation of the option value in the equity. In some cases, the lenders are willing to allow the sponsor to retain some of that, even if value has been severely eroded. In terms of situations other than workouts, everybody likes to say they add strategic (not just financial) value. Some funds without a lot of dry powder because they haven’t been able to raise a new fund, are doing more small strategic add-ons or the like with their exist-ing portfolio companies.

Viegas:Fund managers are holding on to their investment for the time being and increasingly demanding to have more influence in the management of the portfolio companies, so as to improve efficiencies, create more value and generate more returns in the future.

Downey: The market conditions have resulted in fund manag-ers taking a more introverted approach, with a greater focus on portfolio management and on internal operational matters. This greater focus on ‘value add’ at an operational level is perhaps both a result of, but also a cause of, the reduced levels of deal activity in the market during 2009. Investors have not been de-ploying capital and leverage is of course severely constrained, making it more difficult to do deals, but management time and resources have also, by necessity, been focused on value preser-vation in troubled existing portfolio companies.

Vussonji: Fund managers have refocused their attention on portfolio management, recognising this as an old and proven method for creating value and delivering consistent returns. They have also focused their attention on creating value through existing investments, by actively advising management on the best course of action in relation to business strategies. In cer-tain cases, funds have invested additional amounts in relation to those investments, where the fund managers feel that such

investments will be productive in the long run.

Terblanche: Holding periods are becoming longer and fund managers are taking a more active ‘hands on’ approach to generate returns. There is a strong feeling that value creation will flow from operational improvements and efficiencies and build-up strategies rather than high leverage or multiple re-rating.

How difficult is it to secure limited partner commitments for private equity funds? To which types of funds are investors allocating their capital?

Vussonji: Limited partner commitments in private equity funds are difficult to secure in the present market scenario and are usually committed only to proven fund managers with teams having proven full cycle deal experience and who have stayed together for at least 4-5 years. In fact, some of the lim-ited partners have, in recent times, sought additional comfort in relation to the investments made by them by insisting on greater participation in management, controlling appointment of advisers, auditors and legal consultants and also insisting on a spate of veto rights. The investors are allocating their capi-tal in infrastructure and real estate assets. Also, the healthcare and pharma sectors have been a popular choice for investors in recent times.

Downey: The biggest challenge for fund managers going to market during 2010 is how to generate the momentum for a first close. Whilst many investors have capital which they need or want to deploy this year, they may prefer to wait un-til the fund has achieved a successful first close before they are prepared to commit. Fund managers need to think care-fully about how to secure a first close, whether by offering preferential terms on fees/carry to first closers, by offering co-investment opportunities in return for a stapled fund com-mitment or seeding a fund with assets to tempt initial inves-tors across the line. In this market, investors are extremely sensitive to any type of strategy drift on the part of the man-ager – the focused funds with clearly defined strategies are

The market conditions have resulted in fund managers taking a more introverted approach, with a greater focus on portfolio management and on internal operational matters.

KATE DOWNEY


ROUNDtable

8

the ones which will be most attractive to LPs.

Maguire: Fundraising in the first quarter of this year is down from the same quarter in 2009, which was also down from prior years. In other words the market remains quite slow in the ag-gregate. We are seeing funds in the market and there are closings, but many targets look like they will miss. And while terms are still in flux it is apparent that some concessions are occurring. Fundamentally, the reduced rate of fundraising reflects a con-traction across the board, and more important, the failure of a good many funds to even begin raising their next generation of fund. New entrants are rare except those focused on specialised niches.

Terblanche: Until recently, raising commitments for new funds has been very difficult indeed. Just like funds, investors who are in the money cannot afford to sit on the sidelines indefinitely. There has been an increase (at least compared to the preceding 12 to 18 months) in capital raising during the first quarter of 2010 and indications are that this will continue and hopefully improve during the second quarter of the year. Investors are supporting established managers who are able to demonstrate stable, long term track records and who have significant experi-ence in specific asset types. Distressed debt and lending funds in particular have been able to raise commitments as investors were keen to capitalise on the opportunities afforded by the fi-nancial crisis.

Viegas: Fundraising fell significantly and fund managers are finding a hard time securing investments. Investors are commit-ting capital only to well established fund managers and funds that have a well defined strategy, particularly one that includes fast growing emerging markets. As an example, Advent International has just raised $1.65bn for the biggest private equity fund in Latin America. The fund was oversubscribed and had to turn away a few investors. The fact that Brazil will host the FIFA World Cup in 2014 and the Olympic Games in 2016, associated with the country’s urgent need for basic infrastructure, will probably fur-ther attract investors to this region.

What changes have you seen in the GP/LP relationship in re-cent months? Has there been a shift in the balance of power and might this affect fund terms and related documentation going forward?

Terblanche: There has been a lot of expectation in terms of shift in balance of power and there certainly is a great deal more focus on fund terms generally and transparency and risk management in particular. While investors are focusing more on investment objectives and investment focus and are demanding the ability to remove managers by means of no fault divorce clauses and the like, the expected fee pressure has not really been brought to bear, particularly not on the more established players to whom inves-tors are allocating the bulk of their commitments. This seems to indicate a maturity at the investor level which is encouraging and which reinforces the long term viability of the industry, amongst others by ensuring that it remains attractive to creative, bright minds.

Maguire: Institutional investors have, through ILPA, made a concerted effort to identify fund terms and documentation areas where they have sought to identify and prescribe best practices. These include many areas in the broad arenas of economics and governance. Examples include a strong effort to make all dis-tributions of carried interest subordinate to the return in full of capital, or the so-called European waterfall approach. This push, coupled with a higher focus on security for the clawback, re-flects a desire to prevent the general partner from getting too far ahead of the investor. Similarly, there is a focus on fee sharing and an attempt to understand better the basis for management fees and internal budgeting, as well as the internal allocation of economics within the general partner.

Downey: The nature of the market has clearly seen a shift in the balance of power in favour of LPs as evidenced by the publica-tion of the ILPA principles and the focus increasingly being giv-en to ILPA compliance in the due diligence process undertaken by larger institutional investors. Many LPs see this as a realign-ment of the interests of the GP and LP, and we can expect such sentiments to continue as an increasing number of funds return to market. In practice however, it is simply too early to tell the extent to which this will actually move the market on fund terms. The relatively low number of funds closing means that there is little market data available which definitively demonstrates any particular trends in terms as yet. Ultimately, those managers who have preserved value in their portfolios, protected their teams and maintained transparency with their LPs through the financial crisis may still be in a position to set terms – it is those who have fared poorly over the last 18 months who will bear the brunt of LP attempts to move the market.

Hartnett: The private equity industry has been marked by higher returns, but over the past two years returns have not been as high. This, combined with a greater focus on current valuations caused by recent accounting rules, has caused some anxiety for LPs. They are scrutinising their PE investments, which are long term by nature, and requesting more information from fund managers. But transparency and providing real time information is new to many PE funds. They are ill equipped to accommodate such requests, largely because they have always been fairly lean organisations. They don’t have an army of back office staff to process informaion. So there is a need to

Fundamentally, the reduced rate of fundraising reflects a contraction across

the board, and more important, the failure of a good many funds to even begin raising their next generation of

fund.

JENNIFER BELLAH MAGUIRE


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build some infrastructure through people and systems to solve this problem because it is not going away. There is an acceptance that this is the new world and an understanding of why LPs want such information. But PE funds also need to consider the qual-ity of that information. A flurry of one-off questions from LPs strains the review process and increases the risk of inconsistent or inaccurate information being released. They need to prepare better information on a more timely basis and implement new processes to achieve that. For many private equity funds, the so-lution to this issue is still in its infancy.

Viegas: Investors are demanding enhanced fund governance and transparency, particularly more information on management fees, investment strategies and diversification. Also, investors are de-manding that GPs have substantial equity interest in the fund, to maintain alignment, and less discretion on investment decisions. These are trends that are likely to survive the crisis and remain in the long term.

Vussonji: Of late, limited partners are no longer satisfied with the limited rights they have in business entities as investors. Such partners now insist upon being given more rights and greater par-ticipation in management. We have seen claims made by limited partners upon the general partners to the effect that the general partners did not make disclosures up to the mark. Though such claims may not be entirely sustainable, since the limited partners do their due diligence prior to making investments, it has cast an additional burden on general partners to make disclosures which previously were not customary. In these circumstances though, there may not be a major shift in the balance of power, there is definitely a change in the privileges being claimed by limited partners. The fund terms and documentation would obviously change to reflect a new set of limited partners, which just ap-pears to be a nomenclature as these limited partners have been insisting on additional participation in the management of funds and entities in which those funds are invested. Limited partners are also exercising a close watch on all advisory fees and how they are being spent. Further, there is pressure for fee reduction and higher carry to align interests.

The fund industry is facing the prospect of increased regula-tion, as part of the fallout from the economic downturn. What are your opinions on this debate and its potential long-term effects on the private equity asset class?

Viegas: In Brazil, the financial markets are strictly regulated as a result of the financial industry reform that followed a sig-nificant crisis in the late 1980s and early 1990s. Therefore, in spite of the crisis, Brazilian financial institutions remain solid. The local fund market is also well regulated by the Brazilian Securities and Exchange Commission. In this regard, we do not expect any major changes in terms of increased regulations for financial institutions or funds. We do expect, nevertheless, more corporate regulations aligning governance with other parts of the world.

Vussonji: It is true that the fund industry is facing the prospect of increased regulation as part of the fallout from the economic downturn. Any increased regulation of private equity funds would protect the interests of the investors but would no longer give suf-

ficient opportunity to the fund manager to maximise returns. The government of India must recognise that private equity is differ-ent from mutual funds and that in order to protect the interests of large investors who invest through private equity, the industry must remain more or less regulation free.

Terblanche: It is almost inevitable that we will see an increase in regulation and a number of steps have already been taken in this respect. The dual questions of how effective increased regulation will be and how it will impact cost and, consequent-ly, returns still need to be answered. There is a strong consen-sus that current proposals are too far-reaching and that they are likely to negatively impact the industry and, ultimately, inves-tors which is, of course, in direct opposition to the stated aims. Industry organisations are lobbying in an attempt to ensure that the impact is not disproportionate, that increased regulation is tempered and effective without being so restrictive as to blunt the industry.

Maguire: In the US, the pending proposals are milder than in Europe and have not given rise to major controversies. To the ex-tent that calls for greater regulation erode or eliminate the existing exemption from registration under the investment adviser rules, although some of these rules are inconvenient, they are already applicable to a great many funds and have not seriously hampered them. The question of whether the structure of transactions – for example, the level of leverage – that can be done should be sub-ject to regulation, or anything similar should be, does not appear to be arising. The expected defaults from highly leveraged deals have not arrived en masse and if they do, can be expected to be attenuated by both time and the improved economy.

Downey: We are moving out of the financial crisis into an envi-ronment which is more highly taxed, more highly regulated and subject to scrutiny by both investors and policy makers. Fund managers operating in this market have these issues at the fore-front of their minds. Arguably, the shift towards greater regula-tion is, at least in part, an indication of the increasing maturity of the asset class. The size and increasingly public nature of many transactions, and the scrutiny to which many LPs are themselves subject (e.g., pension plans, US state plans) means that a greater degree of transparency is inevitable and that private equity will become increasingly less ‘private’. The burden of compliance (largely the costs of increased regulation) falls on both GP and LP. It remains to be seen whether these increased levels of regulation will temper the politically driven anti-private equity sentiments of recent months.

Hartnett: The hope is that increased regulation will not affect investments or the asset class. But it will certainly impact the cost of doing business. PE funds will need to build a back of-fice for communications with LPs, regulators and government agencies. Strong accounting and compliance departments will be necessary. In terms of regulation itself, there has been a no-table increase in the sophistication of regulators around private equity. They know the issues, they know the industry and they know the practices. However it turns out, the expectation is there will be some sort of regulation, and private equity funds are preparing for this. They may not be ready now, but they are preparing.


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