Pension Funds Still See Private Equity Managers as Worthwhile

Mega funds like Ontario Teachers have been in the press about side stepping private equity funds and investing directly into companies, taking on the responsibility of board governance to ensure performance. This is a nice thought, but really, the private equity funds, in general, do a very difficult job very well, and I find it hard to see their skills being done by the larger funds. The big fund's time is better suited doing the bigger picture and leaving the PE funds to do the dirty work. 

David Currie at SL Capital has just put out an article explaining the reasoning of this. David says:

"The majority of global pension funds remain open to the idea that the additional layer of fees charged by private equity fund of funds represents a price worth paying to get the requisite access and the assurance over administration and compliance that an experienced manager can bring. Our pension fund clients engage us to provide a complete private equity solution for what is typically only ever up to 5 per cent of their total investment portfolio."

The majority of pension funds do not have the €100m (£83m, $132m) allocation to private equity that has been noted as the level that would allow them to invest directly in a structured long-term way into private equity. For these schemes, the hurdles of minimum allocation, administration of the investments and the risk diversification mean that a fund of funds is the only viable route.

In SL Capital’s fund of funds, the average commitment by a client is €12m, which would normally represent the pension fund’s entire private equity commitment, or at least its entire US or European private equity commitment. It is impossible to get true diversification, across at least 10 private equity funds, with a €12m allocation, as most funds require a minimum commitment of €5m.

It is also worth noting that the larger funds of funds sit on the private equity funds’ advisory boards as a matter of course. These positions are open only to the largest or most sophisticated investors and offer a deeper access and relationship to the manager, enabling added insight, a view on strategic direction and a first look at valuations and performance. This really matters when times are difficult, as the experienced fund of funds investors can deploy their team’s deep knowledge and expertise to help restore confidence in leadership or offer solutions to ensure all investors are protected.

While the world’s largest pension funds operate significant teams globally, we as a fund of funds also work closely with them to deploy capital. In this case we are providing support in a specific area of the European or US markets that they find hard to access, due to their proximity to the market or knowledge of the best managers in that segment. In these terms we are the “eyes and ears” for these larger groups in specific areas, such as smaller, regional or local funds, secondaries and direct co-investments. They recognise the advantages of working with fund of funds that can add value to their overall programme.

Private Equity Funds may phone you, but are you really prepared?

You may get a phone call from private equity, but be aware that only 5% of companies contacted actually get an offer. Shocking as that might be, owner-operators go to private equity thinking they are prepared and then are bitter that their time was wasted.

As a financial advisor to owner-operators, our team is constantly discussing how to show our value-add to potential clients. We help owners access fantastic private equity partners, get their valuation higher than they could on their own and then help them through the five years of partnership. 

Owner operators are getting phone calls from private equity funds and not preparing themselves properly. They think they can just show up with out knowing how a Private Equity partner works, what they want and their hot buttons. 

Here's a good article in the Globe and Mail about selling a company that I thought you may find interesting and thanks to Winnie Chou. She picked up this article and has some excellent points. Winnie says,

The interesting part is from the initial prospecting, the Riverside fund sent an introductory letter to 30% of the total list of companies and from that pool, the fund sent an LOI to less than 5% of the companies.

So even though a company may feel like they are being targeted by a big fund, the chances of an actual deal occurring are slim and often, the business owner will not receive an offer without knowing what they did wrong in the meeting.

The management of new costs

There are two concepts not in business owners' heads:
1. Hiring someone new - unless you are OpenText who needs 2,000 new people right now. The American government has introduced changes to business rules, taxes and employee costs. These will need to be digested for a while before owners get optimistic and expand again.
2. Growth. Expanding is not in the plans of many Canadian business owners. In fact, many are reducing their footprint, closing their American manufacturing plants and sticking to Canada. The costs of doing business in America are going up.
I listen to experts and advisors who rattle off these phrases of job creation and growth. Yet, these experts have not been owners themselves. they have not had the stress of meeting payroll and surviving through this past few years.
Having government change your profit and loss ratio by bringing a sudden new law with arbitrary regulations, making your business costs that much more unpredictable, shuts down business joy. For example, Dalton McGuinty's family day holiday was given by the Ontario government the day after he won his elvetion. For business owners, that gift to millions of happy employees meant a loss for 600,000 Ontario business owners. Many of them did not take home a paycheck that month.

The Difference with Entrepreneurs

A Rotman professor of Finance called me last week to speak about running a financial clinic for their business owner program. I hung up the phone understanding why Rotman is such a strong education institution.
The professor told me that they knew that the content of the MBA finance courses would not match with the needs for earlier stage companies - the clinic "students" would all have revenues under $10 million. That delighted me to hear her views as it is easy to clump small business into the same box as even mid-sized companies.
As with every other element of business, finance is a mathematical fit to size of revenues. Skill set requirements change for owners as the business grows. MBA finance is more of a fit for the larger corporates and this Rotman professor wanted her class to get their skill requirements matched, not have MBA cut down. What a concept, a university actually listening to their clients and working hard to deliver the best program.
The different attitude towards business by business owners versus professional CEOs,  reminded me of a favourite quote from a terrific book called The Philosophy of Money by George Simmel.
You do not make great wealth by following the safe paths and the rest of the herd. Simmel says,

"We burn our bridges and step into the mist."

That does sum up the adventure of private equity for business owners and te best private equity experts (not the banker types). You can imagine being back in Roman times, heading off for new fortunes, and it has a good ring of Beowolf to it.

What happens when the Term Sheet has a Put that was not in the LOI?

A great deal can change between the letter of intent (LOI) and the term sheet. Business owners who try to be the expert and manage the relationship with private equity by themselves will discover two things.
1. The private equity team may change terms more if they think you do not have an expert by your side to point out changes.
2. The due diligence charges will become a huge issue if you do not close the deal after the LOI. Clarify who is responsible for picking up the tab. If you have an excellent financial advisor, they should have made sure 75% of due diligence was already done.
Here is a story where the business owner thought they should do the private equity themselves.
A business owner asked me to drop by and as I walked along the street to his offices, enjoying the summer heat, I assumed it was more for social reasons. He did speak about his children's issues but quickly moved the conversation to his business and money. He had been successful at getting the banks to give loans and he told me he now had $10M of his own tied up in the company. He was approaching fifty and did not see the need to sell. He was offered $30M by a private equity group, but turned it away. He also had several Angels wanting to invest, he says.
Last year, a well known private equity group approached him and wanted to invest $5M. He retained a lawyer from a top Bay Street firm to assist. He also hired a finance person to do the analytical work. He tells me that he was fine with the LOI and then the due diligence began. He says it took him a great deal of time and effort but seemed to be worth it.
When the final term sheet arrived, he read that it had a Put, which had not shown up on the LOI. He was shocked that this was now being put on the table and did not want to sign a deal.
He said that his financial person wanted her to sign, but the owner believed it was due to the nature of the finance person's fees. The finance expert was paid the lion’s share of fees only if the deal closed. The owner thought that affected his judgement, and did not trust him to act in his interests. In addition, the owner believed the financial advisor would put his financial needs before hers. So he did not believe he had unbiased expert help.
After all that work, he turned down the PE fund. This respectable private equity group have turned around and decided to sue for $120,000 to cover their costs of due diligence. The Bay Street lawyer says he never saw that coming. He did not have it covered either in the paper work.
It was a surprise to me too. First of all, deciding who pays for the due diligence seems to me to be what gets covered in Law 101, and this lawyer was a top guy charging big fees. If this owner had read the last chapter of Money Magnet, that Bear Trap was laid out clearly, along with his other issues. The lawyer was obviously not experienced in private equity deals. Remember to ASK for past experience. I wish I had a dollar for every deal I have seen papered up by lawyers at great expense, only to have it collapse leaving nothing for the owner. The lawyer then is paid again to clean up the wreckage. Great business, law.
This owner had used the finance expert as a book keeper. If you have an agent of status, the private equity group is not going to play these games as they know they will never see another deal again. Sure, the valuation can drop by 15% from start to end but again, that PE group will become a pariah and EMDs learn pretty quickly who plays these games.
As for transaction fees versus pay for hours worked, raising capital is really tough. I would rather have someone who had the same risk to push the deal along.