Bottom of the Pile

By Vicky Meek, September 4, 2002

Predictions of a mass consolidation in the private equity market might lead some to assume that there will be a clear-out of all the market’s worst performers. Some bottom quartile funds will certainly disappear from the scene; others, however, are likely to be more enduring.

Ask any investor what they believe to be the most well worn phrase in private equity and the likely answer will be, ‘We are a top quartile fund’. In an asset class in which the difference in returns between the best and worst performers is so marked and in which it is possible to interpret that performance in any number of ways, it’s pretty inevitable that firms attempt to flatter their achievements when they are out fundraising. As one investor says: ‘We always take the “top quartile” claim with a huge pinch of salt.’

But while everyone recognizes that it is statistically impossible for every private equity firm to be a top quartile performer and while the phrase has become something of a cliché in the industry, very little attention seems to be paid to the other end of the scale – the bottom quartile. What of the poorest performers in the asset class? They must exist and, with overall lower returns across the private equity fund universe over recent quarters, their performance will have plummeted still further

Tourists returning home
There is wide-scale agreement that some of the worst performance over recent years will have come from the US venture capital sector, particularly from the type of funds set up by those with no previous experience. Many of these are already falling by the wayside. ‘These guys were tourists,’ says Jesse Reyes of Thomson Venture Economics. ‘They didn’t know what they were doing. They jumped into the market when it was hot, invested their capital in 1999 and 2000 when prices were at their highest, and are now suffering from the pain of rock-bottom valuations. They will be washed out pretty easily. They are just about out of business now.’
Many of these firms will have raised a first fund in 1999, when the going was good. They will have invested that fund quickly and then gone on to raise their second fund in 2000. Even without any exits, and therefore an indication of a track record, these funds are unlikely to have struggled to raise capital back then. As a result, they will probably have invested their second fund with equal speed at a time of what appear to have been, with hindsight, ludicrously high valuations. The value of these investments will now be shot to pieces and the subsequent write-downs will have left the funds looking very sick indeed. Without the skills needed to recognise which investments to continue working with, without the experience of nurturing promising companies in a downturn and, importantly, without cash reserves to provide follow-on financing to those companies, the value of their portfolios is plummeting further. In one example quoted by a secondaries player, a fund wrote down its portfolio by a staggering 91 per cent for the six months to June 2002. And, as a fund’s management fee is dependent on net asset value, the general partners will be generating little or no income for their firms. It’s the classic death spiral scenario.

As a result of this, it’s hardly surprising that those who thought it was easy to make a quick buck in private equity are now looking for other options. ‘There are a lot of these new firms going quietly out of business now. They are not getting an adequate management fee and they are unable to raise new funds, so they’re shutting up shop and finding buyers for their portfolios,’ says Matthew Cherry president of US due diligence specialists Intelex.

In some cases, limited partners are stepping in to speed up the process. Most fund terms and conditions contain provisions stating that if the net asset value of a fund falls below a certain level, then limited partners are able to take some form of action. They may be able to liquidate a fund or replace the manager, for example. In one instance the limited partners of a US fund have simply refused to honour any future drawdowns, taking the view that to do so would simply be throwing good money after bad.

In some respects this clear-out is no different from what might happen to some poorly performing firms in a less extreme market – the process has simply accelerated as valuations have plummeted and investors have become more wary. ‘It’s often said that it’s relatively easy to raise your first fund and second funds,’ says Reyes. ‘It’s the third one that is hardest. If you raise a first fund, you can usually raise a second within a few years because it is still too early to tell exactly how the first one has done – there are few realisations. The third one is always much harder because by then, you’d better have some results to show investors.’

The end of the road
So we are seeing some clear-out of the least experienced teams with some of the poorest performance. This is providing opportunities for other, more established players to buy up some or all of the ailing portfolios. ‘In some cases, private equity firms are able to buy portfolios with one or two decent companies very cheaply,’ says Cherry. ‘It’s the same kind of thing as the guy who asks someone to take his Ferrari off his hands because he can no longer afford the repayments.’

The problem is, though, that not all the poorest performers will be anywhere near as severely hit. In almost any other market, in which performance information is freely available or easily assessed, you would expect the inevitable to happen. Those providing the poorest customer service, shoddiest goods, worst returns to investors, etc, would soon find that their clients abandoned them and their business would go to the wall. In private equity, however, you find a curious set of circumstances that means that in many instances this sequence of events may not happen as quickly as for those firms now quietly disappearing. Indeed, for some it may not even happen at all.

One of these circumstances is the fee structures employed by private equity firms. As mentioned, firms charge a management fee based on the net asset value of a portfolio. As a result, there is little incentive for firms to write down their portfolios, especially in the current environment. ‘Firms know that it is difficult to raise funds at the moment and some of them will be tempted to delay writing off their investments,’ says Jan Faber of Henderson Private Capital. ‘There are definitely some poor performers out there attempting to hang on to their management fees by not writing down their investments. That is just plain bad practice.’ Reyes agrees: ‘I think the clear-out process may well be prolonged in some instances because there are firms who do not want to take write-downs as quickly as they should.’

The high volume of money that poured into the industry over recent years is another factor in delaying the inevitable for some firms. Much of it was invested quickly. But there is still a large overhang of capital in the market – $200bn of uninvested private equity capital in the US alone. Much of that dry powder remains in the hands of the larger players. But there are still firms hanging in there because they have some capital left – albeit a small amount. Again, this is likely to prolong the lives of some bottom quartile funds. ‘Given the amount of capital raised in the last few years, the clear-out process could take a while because some firms that should shut up shop will be able to hold out if they have been tightening their purse strings,’ says Cherry.

The establishment
But it would be wrong to assume that some of the newer entrants to the private equity market are the only poor performers. There is anecdotal evidence to suggest that many of the established players are regretting their more recent investments, the performance of which may well position them in the bottom quartile camp. These are the ‘guys who knew what they were doing and jumped in anyway’, according to Reyes. These funds will be able to survive on the back of management fees earned on previous funds. ‘Those who knew what they were doing and didn’t invest everything but have a high exposure to technology will survive,’ says Reyes. ‘If they have six or seven funds under their belt they won’t do too badly. You may see some of the senior partners leaving the younger blood to take over and you are already seeing limited partners pressing for better terms, but you won’t see any catastrophic failures – unless there is some malfeasance involved.’ John Porter of Hamburgische Landesbank agrees. ‘There is poor performance among some of the more established players. But a few bad investments will not ruin a management company entirely,’ he says.

These firms are also likely to be saved by a judicious piece of forward-thinking. They may well have raised before the bad news on their recent portfolios came out. Many investors have been complaining about the fact that many firms have been coming back to the market before they have realised any investments on their previous fund. ‘I think the timing of many firms’ fundraising efforts has been important,’ says Faber. ‘There has been a lot of fundraising activity over the last few years that has been instigated for the wrong reasons. These funds, particularly venture funds, knew that their previous two funds would be losers early on and so they sought to raise their next fund quickly. A lot of funds over the last two years have been sold on the performance of their 1995 or 1997 vintages – and a lot of investors have bought into them.’ And for many of these funds the amount raised, together with the current slow pace of investment, mean that they will not need to be in the market again for a few years yet. By which time, the market should no longer look quite so ugly.

Current market conditions aside, however, there are also circumstances under which bottom quartile funds will continue to get funding and will survive at any time in the cycle. These are the funds that, for whatever reason, have a very loyal investor base. ‘What amazed me, especially throughout the 1990s, was the fact that there were quite a few poorly performing funds that stayed in the market, regardless of how little they returned to their investors,’ says Catherine Lewis of Proventure. Some of these are likely to be funds with strategic investors involved. ‘Some investors are not purely driven by return objectives in their private equity investments,’ she says. ‘They may be happy to continue supporting teams that may be of strategic value to them. There may be synergies to be gained or they may be wanting to access the knowledge of portfolio companies, such as in the case of corporate venturing, for example.’

On the other hand, there are some poorly performing firms that will continue to raise capital, well beyond any reasonable expectations. This comes as a result of what Capvent’s Varun Sood describes as ‘the mistaken belief that private equity is a relationship business’. The industry is viewed very much as a people business in which knowing fund managers features high up on the vast majority of limited partners’ list of priorities. Private equity is a long-term business and people on the LP and GP side need to work with each other for at least ten years. It’s unsurprising that marriage and divorce metaphors are often used in the context of private equity fund investment. But it’s this idea of relationships that, Sood argues, allows poorer performing firms to continue receiving funding. ‘Private equity is an investment, not a relationship,’ he says. ‘If you believe that you have a relationship with your fund managers you are going to be less inclined to pass on future investments. Look at recent history. It’s the re-ups that have really hurt investors.’

Wary investors
The fact that many of the less experienced funds are going out of business, however, indicates that investors are becoming more wary and discerning. Many investors are looking much harder these days at performance data and increasingly pass on those that cannot provide evidence of exits on their recent funds. Cherry, who has seen a dramatic increase in the number of limited partners hiring him to conduct due diligence on fund managers, says there is a lot more attention paid to rigorous checking these days. ‘Many poorly performing funds are currently focusing on their potential when presenting to investors,’ he says. ‘Limited partners don’t care about potential now. They want to know what GPs are doing today. Are they maintaining their focus? Are they building companies to exit?’ If investors maintain this rigour, it’s likely that fewer poor performers will continue to get funding.

The other point to bear in mind is that fundraising cycles are reverting to more normal time periods. This means that investors will have more information at their disposal about a firm’s predecessor fund. ‘The problem has been that over the last three to four years, the fundraising cycle has been shortened to one year to 18 months,’ says Faber. ‘Investors have often backed funds knowing little about what the firm’s recent performance has been like. My hope is that the cycle goes back to at least four or five years. That’s where it should be.’

If there is a top quartile, there will obviously always be a bottom quartile of relative poor performers. But should these current trends continue to develop, it will at least mean that those at the bottom of the pile fall out of the market – if not quickly, then at least before raising yet another fund.

Vicky Meek is managing editor of AltAssets