Facing life without leverage

Four leading fund investors tell Philip Borel what the global crisis means for private equity, and what the industry must do now to find the right response

At Geneva's InterContinental Hotel, four of Europe's most senior limited partners skipped breakfast for a no-nonsense exchange of views about their industry with PEI.

George Anson, Wim Borgdorff, Katharina Lichtner and Hanneke Smits were in town along with 400 other professionals for the EVCA Investor Forum, a conference designed to facilitate high-level discussion among GPs and LPs about possible solutions to the difficulties facing the industry. With the stakes as high as they are, there was obviously plenty to talk about, and the four of them had already been engaged until late the day before, the first day of the conference. But they didn't seem to mind the early start.

Not that you would have expected any signs of fatigue: it is hardly a time for lie-ins, and Anson, Borgdorff, Lichtner and Smits aren't the type to get easily tired anyway. All of them arrived on time exuding a sense of purpose, pulled up a chair, pondered the first question – and away they went.

As the discussion gathered pace, it became clear very quickly that here were four fiducaries absolutely determined to deal head-on with the consequences of the market meltdown. No-one talked as though they were looking through rose-tinted glasses; everyone agreed that the problems facing private equity were real and dangerous. But there was also unanimity that a way out of the crisis would eventually be found – and that private equity in general, and the fund of funds business in particular, still have good reason to look forward to a successful long-term future.

PEI: The economic crisis is going from bad to worse, with stark implications for the asset class. As fund investors, are you seeing light at the end of the tunnel?

Smits: You need to differentiate between what's already been invested and what can be invested going forward. There are clearly many groups out there who are still well funded and have capital to deploy, so they should be looking forward to making new investments, albeit of a very different nature. But in terms of seeing the light, I know many GPs are actually pretty shocked about how bad the start to 2009 has been for portfolio companies. Anecdotally, I spoke to a rather large GP in mid-March and he said that trading in the portfolio in January and February had been so poor that the CEOs of the portfolio companies, all pretty sizeable businesses, had had to revise their assumptions about revenue fall-offs for the year, and none of them had been able to finalise budgets. That makes it extremely difficult for GPs to do their own planning and forecast what might happen next.

PEI: Already there have been examples of GPs getting into serious difficulties very quickly, and in some cases quite publicly. Did that surprise you?

Anson: The listed space necessarily confers visibility, and all you have to do is read the available research to conjecture which firms may struggle. The SVG Capital challenges were painful, though I believe Permira did the right thing. Rather than letting uncertainty drag on, they took action and went on the front foot.

Lichtner: The process was transparent, and it was fast.

Anson: But let's be clear, I don't think fund restructuring on that scale presents a trend. Candover was another highprofile example: here you had a dominant shareholder that was part of a new fundraising. I can't recall another situation like that where a very large investor in a fund is having trouble funding their participation. But because Candover is also listed, all of this was playing out in the public domain, which from a private equity point of view was, of course, tough.

PEI: Have all GPs now circulated their 2008 performance reports?

Lichtner: No. I checked yesterday and we had about 20 percent of them in. It's quite delayed this year, they're trickling in. We're now informing our own clients that we will be reporting later because it makes no sense to report numbers that we know do not accurately reflect the situation.

PEI: And are the numbers that have come through already painting a very bleak picture?

Borgdorff: Valuations are of course extremely interesting, but I think it's important to take a step back and talk about where we are exactly at the moment. For most of us in this business, the world we know and in which we have invested up until now can be described as essentially one big upward wave. For the last 15 years we've had gradual, nice, continuous earnings growth with some blips along the way. The last one was in 2001 and we thought that was really a serious event. Today the wave is completely in reverse, and we're in a world we haven't seen before. This all has revived the notion that market cycles are real, despite what economists have been telling us. We've been reminded that extremely serious disruptions can happen.

In private equity, the reminder is that leverage is no free lunch but rather a serious risk factor that has the ability to come back to haunt investments over time, and that liquidity risk is also a very real thing. Suddenly the focus is back on these very textbook aspects, and the interesting thing to me is that the industry really did forget about them during the boom.

PEI: Critics of private equity have long maintained that the industry was using leverage irresponsibly…

This all has revived the notion that market cycles are real, despite what economists have been telling us. We've been reminded that extremely serious disruptions can happen

Wim Borgdoff

Anson: Whether it has or not, the crucial question is whether private equity can still outperform public markets without leverage. Our view, supported by a number of studies, is that it can, indeed that it has. But let's see.

Smits: That really is the question. Even in the late 1980s/early 1990s people saw that leverage was an issue. One of the problems for the industry today is that there aren't many people around who also worked through this period.

Lichtner: I think it's worthwhile looking at the numbers for that particular point. In the late 1980s, average debt-to-equity ratios were much higher than even today, but the returns ultimately weren't great. If you then look at the 2001-03 vintages, these had initially very low leverage and were subsequently refinanced. They turned out to be great vintages in the end. We also looked at leverage levels in private equity-owned businesses versus gearing in public companies, and there were periods when the public market was much more aggressively leveraged than private equity. It's not a consistent picture, and it's just not accurate to generalise that private equity is using excessive leverage, or that the industry cannot generate performance without using large amounts of debt.

Smits: It is true though that the 2001-03 vintages really did benefit from the ability to refinance…

Lichtner: Agreed.

Borgdorff: Given the severity of the market crisis right now, I would expect leverage to disappear for quite some time, and if we are going to enter a long-lasting low-leverage period, the question is whether private equity really does have a claim to out performance in a low-leverage environment.

Lichtner: Again, if you look at the available numbers, you do see that private equity has been relatively good at operational improvements. But if you combine low leverage with a long period of weak growth, that's when it gets very difficult. But then the public market will not perform well in that instance either. And if leverage isn't available for private equity, public markets will probably also have to live with lower leverage ratios. So I don't think the environment hits private equity selectively. It's an environment that will be difficult for value creation full stop. So the question is, does private equity have anything that gives it an advantage over public markets, and there I think the fundamentals of active ownership have not really changed – despite today's economic problems.

Borgdorff: I would add to that compared to what we've seen in the last five years, there will be a movement back to basics and to some of those key drivers that have helped make private equity such a great success, such as effecting better governance and operational improvements to create better companies. But I think we also need to be realistic that the big expansion phase of private equity in the past five years was very much about buying relatively mature, well-performing companies with a lot of leverage, and because of the leverage, even relatively small improvements led to the kind of results we were all looking for. That part is gone, which also means that expansion is going to give way to a period of retreat.

So the question is, does private equity have anything that gives it an advantage over public markets, and there I think the fundamentals of active ownership have not really changed – despite today's economic problems

Katharina Lichtner

Anson: What drove the expansion was years of uninterrupted earnings growth and easy credit – neither of which are available today. Wim's wave analogy is correct, the tide is now going out…

Smits: …and we can see who's been swimming naked.

Lichtner: Private equity is going back to being a skill game. In the past five years, if you had access to deal flow, securing debt was not an issue and you could transact. Now you have to have skills and long-standing relationships with banks to make it work. You need to know how to build banking syndicates to finance purchases, how to drive operational improvement, how to read the exit markets and structure complex exits.

PEI: Are you expecting the buyout funds you recently invested in to return capital?

Borgdorff: The jury on this is out. In asking that question you're asking a macro question. I can see from where these funds are today that there is resilience in their portfolios in terms of their ability to weather the storm. They have financing arrangements that are long term and afford room for manoeuvre; they allow active owners to manage the cash flows aggressively to help companies to survive. So given today's GDP downturn, we do think many of these investments have the ability to get through, making a default rate similar to the early 1990s of about 10-15 percent seem plausible. This would be a significant impairment – but it wouldn't necessarily ruin returns overall. The big question is, where do we go from here from a macro point of view? If there is a second or third round of further deterioration in revenue and profitability, of course then there will be serious difficulties and also much more visibility on the likely outcomes for these funds. All we can do right now is watch closely and hope for the best.

Smits: It's also very hard to generalise. Some funds are already 80 percent invested, others have more in reserve, which in theory should be invested in a more conducive environment. Still others have already returned some of the capital, so it is extremely difficult to make the case right now that the 2007 vintage of buyout funds isn't going to return capital.

Anson: Taking a different tack on this, I also worry a little bit that we're talking ourselves into a doomsday depression. None of us here invest only in large buyouts after all…

Lichtner: Exactly…

Anson: …and to be honest I find it frustrating sometimes coming to conferences and giving interviews where the focus of interest is always the large buyout funds. What we're advocating with our clients, I'm sure all of us do, is the virtue of diversity. We're in venture, in credit, we buy secondary and invest in other private equit y sub-classes. Consequently, the large buyout exposure is a relatively small proportion of what we do. Now that's partly a function of being a fund of funds. You've only got so much capital to invest, and you're not going to increase your allocation to a manager because they increase the fund size; rather you're more likely to respond by balancing the rest of your portfolio accordingly.

Smits: You're not going to double up.

Anson: In effect, it means we become diversified by default, away from large buyout funds, because we have to maintain a balance in our portfolio construction.

Lichtner: And in terms of the large buyout portfolios, one needs to take a careful look at what's actually in them. Typically they're substantially diversified. Large buyout funds do not own only mega-deals with massive amounts of debt.

Anson: And I'm not saying this is a generation of lost buyout funds either. So many of the groups we're investing with have a lot of experience and have been through cycles. One thing that defines private equity is that it attracts a lot of creative talent and smart people, none of whom are going to sit there wringing their hands saying, ‘my God, what do I do now?’. They're the first ones to say, ‘OK, changed circumstances – let's find a way out of this’.

Smits: But are you concerned that some of these funds are not going to get over their hurdle rates? If they don't, the incentives to the teams are going to be gone because the funds aren't going to make carry. So LPs are wondering whether they should be resetting what hedge fund managers call the watermark. I think we would say GPs also have the next fund risk, which in itself should be a hurdle preventing them from walking away. Do you see this as a major issue?

One thing that defines private equity is that it creates a lot of creative talent and smart people, none of whom are going to sit there wringing their hands saying, 'my God, what do I do now?'

George Anson

Borgdorff: I think it's still too early to have a lot of visibility on these kinds of questions. But we all know from previous examples that the alignment of interest, which is one of the strong points of this industry, gets under pressure in difficult times. GPs are aggressive, creative people and they will look for a way out. Investors on the other hand will argue, ‘this is the deal we signed up for, you are in control so you better take us out of here’. So it's still early days, but there could well be more trouble ahead.

PEI: How?

Borgdorff: If there is a scenario of return deterioration, a meaningful number of funds miss their hurdle and the industry as a whole develops a profile of not returning capital – and thus for example impacting the retirement prospects of pensioners – that could create a substantial drawback to the strong investor support the industry has enjoyed for a long time. This is why we are calling on our GPs to say, ‘you better start facing up to the current situation and start dealing with it’. We think for funds that do not get to carry to reset the hurdle would be inappropriate. We would want to push in the other direction and say, ‘what is your contribution to the misery that's been created and can we at least share the pain?’.

Anson: Putting the economic backdrop to one side, one advantage we have as LPs over the buyout GPs is that we have experienced comparatively similar circumstances before. The buyout GPs were on the sidelines during the tech bubble, when the venture funds raised too much money and realised they couldn't invest it. Institutional memory still lingers around this, but the buyout GPs don't have that. Solutions back then were largely about chopping back fund sizes and forgiving management fees coming out of fee holidays.

Smits: It also underlined the next-fund risk. You did see some VCs no longer being able to raise the next fund, and thereafter not much happened in venture for about five years.

Anson: There are definitely some analogies here, even though as Mark Twain said, ‘history doesn't repeat itself – but it does rhyme’. The technology bubble bursting was a difficult situation. The big difference today is of course that we also have a major economic crisis.

Lichtner: Which could have happened back in 2001 as well. After 9/11 in particular there was a lot of fear the world would descend into World War III, and had there been another blow of similar magnitude we could have ended up in a very different place. But even though that didn't happen, George is right – there are definitely analogies. Something that concerns me is that in the buyout space, people during the last 10 years have had a lot of fun. It's been easy, deals were happening, the market was largely going up…

Smits: …just like during the tech bubble…

Lichtner: …and after the tech bubble it did happen that managers simply let companies go because it was too cumbersome to see things through, and I do hope this won't happen in buyouts today, because that could be seriously damaging. I think we can all live with reduced returns if people do their best, but not if key individuals at the firms retreat now on the grounds that given all the money they've made, it doesn't make sense for them to work through all this pain.

Borgdorff: The other interesting comparison with the tech bubble is that if you look at the existing portfolios out there, what you'll find is that there is not necessarily unlimited capital available to support them – especially if they have to be taken through extended periods of difficulty. There will be capital shortfalls. So here the analogy to the 2001 technology situation is that choices will have to be made. GPs will need to be very careful to manage the remaining cash in their funds. Support needs to go to best value and cannot be dished out on a first come, first served basis.

Lichtner: One option here is for GPs to raise top-up funds – which incidentally would have made quite a difference to failing technology companies in 2001. Back then excellent companies were dying simply because of a lack of financing. There could be a learning process here: GPs now may well come back saying, ‘look, we have this portfolio, the companies aren't in a bad position, but the macroeconomic situation does require another year of financing and we do not have the capital anymore’.

Smits: It is happening already!

Lichtner: Yes, it's only starting now but will probably pick up.

Smits: The challenge is LP funding. Top-up funds will create potential conflicts when some LPs in the investor base cannot participate because they're facing challenges of their own. They also create challenges for the managers in terms of valuations. But still, it is happening.

Borgdorff: The interesting part is that already outsiders are stepping into such situations. The advantage compared to venture is of course that buyout portfolios have much more tangible assets and are easier to value. That's why there are already some secondary investors looking into such situations, who have the willingness to provide fresh capital if there is insufficient funding available in the existing ownership structure.

Anson: On that point, it seems very clear to me that there are a lot of other things you can do before you go to the top-up option. Top-ups are probably the last option. You can recycle proceeds. You can also defer management fees, which actually in many funds can amount to a significant amount of capital. And by the way: all you have to do as the LP is ask. Deferring management fees isn't necessarily going to be proposed by the manager, and if you bring it up, they may well say ‘oh – hadn't thought of that’. And then you can actually get a limited credit facility, on a short-term basis, secured against the assets. Failing that, then you can go back to investors with the top-up option. Because you're right: that is painful and really difficult to structure such that everyone feels they're being treated fairly.

Smits: Meanwhile what worries the GPs is that some of them are already trawling around each other's portfolios as well. That should be interesting too: imagine a business with too much debt that needs an equity injection and the current sponsor cannot come in so someone else might.

Lichtner: This would be like staggered club deals. Again we've seen this in venture, when people with available capital came in and squeezed out the existing shareholders.

Borgdorff: Which is of course fair game: from today's perspective, the equity in today's buyouts is in quite a few cases substantially under water.

Lichtner: Absolutely.

PEI: Wim, going back to your point about the message to managers. Are there seriously any GPs out there who are not yet facing up to the crisis?

Borgdorff: Of course there is a massive effort going on to work through the portfolio. It's obvious that everybody is 100 percent focused to protect what is there. My point was when tough decisions need to be made, we think our GPs should not only deal with that, but also deal with it in a way that is true to the relationship with the LPs. George's example that it may well be the LPs rather than the GPs who may suggest a deferral of management fees is a very good one. GPs mustn't game the relationship by looking out for their deal but not worry about the issues facing their partners. If things get tougher still, there will need to be discussions about forms of resetting, reorganising, restructuring, but with willingness for the managers to have skin in this new game, too. That is very important to us.

PEI: In light of all this, how are you now spending your time? How have your pr ior i t ies changed? Are you raising money?

Top-up funds will create potential conflicts when some LPs in the investor base cannot participate because they're facing challenges of their own. They also create challenges for the managers in terms of valuations

Hanneke Smits

Anson: Clearly the fundraising environment is difficult, unless you're raising a secondary or distressed fund. Priorities now are very much about portfolio management, looking after the existing assets and trying to anticipate events. We have a direct co-investment business, a secondary business and a funds business. The co-direct team is spending all its time right now looking at how existing assets are financed and producing rolling 12-month budgets on a monthly basis. The secondary team is run off its feet right now, but deal closing is low because of the big bid-ask spreads; but you've got to be there, you've got to be at the table otherwise you definitely won't get anything.

On the fund of funds side things are very slow. There is a whole inventory of assets that requires care and maintenance. I come back to my point about institutional memory: part of our job is to provide stewardship to fund managers by being significant long-term investors and help them get through things they may not have seen before. I'm beginning to sound like an old man now, but it is true: we can bring a lot of experience and we can say: “here's how we got through last time – have we thought about this or that option?”

Smits: Yes, talking to GPs about their needs is definitely part of it. And on the investment side, I very much concur with what George said. We are also talking more to our LPs than we did, say, 18 months ago. We talk about what are the valuation points likely to be, what do they actually mean and should they be worried.

As a fund of funds, our clients typically have small allocations to private equity and small teams, and they worry. Scandals such as Madoff don't help either, even though we're clearly in a different business. Headlines like that do mean you have to be proactive to explain the differences in terms of how we do our due diligence and the transparency that exists between LPs and GPs. We also talk a lot about performance. In January, we had about one-third of our client base asking about our estimates for the December valuations, to help them with their planning.

PEI: That must be a drag on resources…

Smits: No, because we're set up to do this. We have a dedicated account management team supported by an advanced analytics team that talks with our clients all the time. Also, things are very slow on the primary side in terms of new deals, so the team can concentrate on monitoring, and investment professionals have time to talk to clients as well.

Lichtner: There has been a huge increase among clients in demand for information about what's happening and the context in which it is going on. We're also spending much more time on portfolio monitoring and trying to assess where the risk positions are. Are there funds that may run into problems earlier than others? Which ones are potentially going to need more attention, given where they are in the fundraising cycle and the contents of their portfolios? Are their teams stable? Any really serious problems are unlikely to materialise before the year end, but at that time there will likely be the first real issues.

PEI: From a personal point of view, are you experiencing this period as stressful? Or is it invigorating?

Anson: Look, all of us have been around the block here, though some of the younger guys in our organisations occasionally have this wide-eyed look and are asking what's happening. I tell them this is not the end of the world. One of the great things about private equity is that it has genuinely long-term capital. We don't have windows for capital redemptions in our funds, we can predict, we can plan and hopefully see our way through to the other side where our business remains pretty much intact. Yes, private equity will change and evolve, and 2009 looks like it is going to be primarily about survival. What I think those of us here bring to our organisations is stability and, crucially, confidence. I don't have a silver bullet and won't say, ‘it's all going to work itself out guys, don't worry’. But what I am telling them is, ‘come and ask me; tell me what you think; and let's not be stupid – let's be right’. By this I mean that with every decision now, you have be really, really certain about what you're doing, because you no longer have the wind coming from behind to cover up silly little mistakes. You can't afford to make a mistake.

Smits: This is true for instance on the secondary side.

Lichtner: The Chinese word for crisis is two symbols put together, ‘crisis’ and ‘opportunity’, and drawing younger colleagues' attention to the opportunity element is important. Many of our investors do see this too: they worry about the existing portfolio, but they are also willing to make new commitments because they can see the potential.

Anson: I haven't seen any of our clients saying they're done with private equity. No one wants to just give up. The crisis may be testing their willpower, but with some guidance and handholding, we should all get through it.

Smits: I don't know whether the situation is invigorating, but it's certainly intellectually more interesting. It also provides a good opportunity to improve and enhance the dialogue with GPs. Some of them have got caught up in the wave as well.

Lichtner: Yes. It's not about beating them hard about management fees. But over the last five years we have seen things like transaction fees and other cash streams from the portfolio to the GP that we could usefully get rid of, and now is the time.

PEI: Should we expect lots of LP activism – investors on the barricades?

Anson: We will see politically motivated regulation come down on us, whether we like it or not. It remains to be seen how much of it will actually happen and how much of it is just posturing, but to my mind this is the first time in the history of the business that we should really consider writing to our MEPs to lobby for restraint. What we need to avoid is waking up one morning and saying: “Oops', I didn't pay attention to that.”

PEI: Some people have begun predicting the demise of funds of funds. Are they wrong?

Anson: They couldn't be more wrong.

Smits: We were asked recently whether we would now try to acquire some competitors. But that's of course not so easy. And although there are going to be some casualties, we think our long-standing peer group, including the people around this table, are going to be around in ten years. It also creates opportunities as we are perceived as a relatively stable source of funding for GPs.

Borgdorff: Think about the amount and the quality of work required to limit the damage. This is becoming more and more apparent. I think any investors with ambitions to take out the middle man and do it by themselves will likely think twice now.

Lichtner: Given the challenges in the market today, demand for specialist knowledge is likely to go up – not down.

George Anson, managing director HarbourVest Partners

Having joined the firm in 1990 from Pantheon Ventures, Anson runs HarbourVest's European business. Based in Boston, the firm invests globally in several private equity strategies and has more than $30 billion in assets. Canada-born Anson is one of the most experienced private equity fund investors in Europe.

Katharina Lichtner, managing director Capital Dynamics

Lichtner is Capital Dynamics' head of research and sits on the firm's executive committee. Capital Dynamics, which in March announced the purchase of California-based fund of funds HRJ Capital, oversees more than €20 billion in client money. The firm is based in Zug, Switzerland.

Wim Borgdorff, managing partner AlpInvest Partners

The former real estate specialist joined AlpInvest in 2000 and has responsibility for its primary and secondary fund investment activities. Headquartered in Amsterdam, AlpInvest manages more than €40 billion and invests on behalf of ABP and PFZW, two large Dutch pension funds.

Hanneke Smits, chief investment officer Adams Street Partners

Another Pantheon alumnus, Smits joined Chicago-headquartered Adams Street in 1997. The firm is one of the oldest independent fund investors in private equity and managed $19.5 billion in assets at the end of last year. In addition to setting the firm's investment strategy, Smits currently chairs the investor relations committee at the EVCA.