Patient capital in haste

How long is long-term? As general partners raise, deploy and return capital faster than ever before, their investors may be in danger of getting used to private equity's new short-termism. Ken MacFadyen reports.

Ever since the start of 2004, private equity has seemingly lost its taste for inhibition. Holding periods have shrunk, deployment windows have tightened and capital is being distributed back to limited partners almost as quickly as it is being collected.

The very idea of a five-year deployment window seems almost passé today. Both Texas Pacific Group and Permira closed multibillion dollar funds during the 2003/2004 timeframe, only to reenter the fundraising market less than three years later with followup vehicles reportedly targeting around $12 billion and €8.5 billion, respectively.

Meanwhile, deals are shuttling in and out of private equity portfolios at a similar pace. In one extraordinary case, US private equity firms Stonebridge Capital and Weston Presidio were able to find an exit for their investment in Alpine Engineered Products literally days after the pair had acquired the business. The firms bought the company in the summer of 2005, and within a week after completing the deal were approached by a strategic buyer. The investors hired an investment bank to formalise the process, and a few months later sold the company to Illinois Tool Works. Talk about a quick flip.

Electra Partners Europe, meanwhile, realised more than £110 million in proceeds in less than a year when it was able to unload UK-based Ashbourne Healthcare to Bank of Scot land Corporat e Banking for £280 million last February. Electra had first invested in the retirement home operator the previous April.

The industry has forever lived under the tag of “patient capital”. The typical private equity fund life ranges from 10 to 13 years, a term considered necessary to nurture the companies acquired and allow them to grow. In a down cycle with limited deal activity, such a window makes obvious sense. But in a bull market such as today's, the ten-year term appears excessive.

Erik Hirsch, the chief investment officer at global asset management firm Hamilton Lane, notes that in recent years, he has seen the traditional delay between investment and return of capital virtually disappear among the industry's elite. “For a lot of the top performing funds today, there has been no J curve,” he says.

To wit, global energy specialist First Reserve raised its latest fund in 2004 and is already showing an IRR of 137 percent for the vehicle, according to the California Public Employees' Retirement System. And First Reserve is not just an anomaly: Canadian firm Onex Corp.'s 2004-vintage Onex Partners LP has put up an IRR of 52 percent, according to the California State Teachers' Retirement System, and many other funds of s imi lar vintage, including vehicles from Permira, Landmark Partners and others, have also posted positive returns in relatively short order.

We're not under any illusion that there has been some kind of permanent change in the investment cycle

Jared Stone

Considering the industry's current swiftness and the queue of new institutional investors ready to march into the asset class, it would seem reasonable to assume that LPs have grown accustomed to the industry's accelerated gallop. And limited partners, quick to commit to the new $10 billion-plus funds now customary in the large LBO space, would appear to be showing little in the way of scepticism regarding the industry's ability to put such sums to work.

In parts of the world less accustomed to private equity, the astonishing pace has even attracted controversy – most notably in Germany, where the oft-cited “locust” depiction was borne partly out of the industry's present leaning toward the overnight flip. In the now famous industry-bashing delivered last year by Franz Müntefering, the then Social Democratic Party chairman was quoted as saying: “They stay anonymous, have no face, fall upon companies like locusts, devour them and move on.”

All this raises an obvious question: are investors getting spoiled by the industry's unprecedented upcycle, and if so, is it time to scrap the very idea of the five-and-10 year time horizons that firms have historically followed?

Institutional investors, for their part, should be credited for taking a somewhat restrained view of the marketplace. Limited partners who have seen similar periods of exuberance before recognise that the industry is taking advantage of exceptional conditions at the moment, conditions that are by no means guaranteed to endure.

“We're not under any illusion that there has been some kind of permanent change in the investment cycle,” says Jared Stone, a managing director at Northern California- and London-based fund of funds Northgate Capital. “From the time the first dollar is called down to the time that we expect the last dollar to be paid out is still a 10 to 12 year proposition.”

There has been a perfect storm of factors playing into private equity's hands. The strength of the leveraged loan marke t was what launched the t rend in 2004, fuelling deal activity and pushing M&A valuations higher. That in turn brought the sellers out of the woodwork, eager to switch back into disposal mode after years spent sitting on their hands. The strategic buyers meanwhile, the boogie men of the buyout industry, remained on the sidelines, essentially giving private equity free reign in the M&A market.

“The general partners are just taking advantage of what the markets are offering,” states Hirsch. “The intent of private equity isn't necessarily to hold on to companies for an extended period of time just for the sake of holding on to the company. From our perspective, we don't see anybody complaining about the shorter holding periods on the exit side.”

While buyout shops have been opportunistic in putting capital to work, they have been just as artful in terms of absorbing the market's largesse. The strong performance and industry's higher public profile has translated into an outpouring of money into the market. Private equity firms in the US raised more than $160 billion of capital last year, according to Thomson Financial, while the EVCA reported at its recent Investors' Forum in Geneva that European firms raised more than €60 billion ($72 billion) in 2005.

And the trend continues unabated. There are currently more firms raising capital than in any preceding period, and many of those groups are marketing significantly larger funds than they had before. This is partly because groups aremoving up the scale in terms of deal size and partly because they want to amass large enough pools of capital so as to not have to be back fundraising in two year's time. One limited partner who did not want to be identified notes that in the cases of TPG and Permira, “their fundraising capability far exceeds what they raised last time around”.

Few would dispute that buyout investors have been relishing their dominance. They are enjoying the roller coaster and in their approach to LPs readily concede that the deployment periods of the current fund could easily fall inside of five years. But one area where firms are content to keep the status quo is when it comes to the fund's statutory life cycle of ten years or more.

“We're seeing more GPs come to us with a three to five year deployment window, as opposed to just five, but the ten years [fund life] is something they stick to,” says André Jaeggi, a managing director at Swiss fund of funds Adveq Management in Zurich.

Managers like the long life cycle because it gives them room for strategic manoeuvre. New York-based Lincolnshire Management, for example, in March sold off its investment in flatbed trailer manufacturer Transcraft, emerging from its nearly seven-year investment in the company with a profit. Despite the fact that the company endured what some have described as the longest downturn that the US trailer manufacturing industry has seen, Lincolnshire was still able to return capital to LPs.

Few if any expect the market to hold its current pattern forever. The mainstream press has formed a chorus of bubble cries, and with fund sizes climbing across the board, the naysayers have begun parroting everyone's favourite song of “too much money, too few deals”.

Neither is the limited partner community pouring money into the space blindly with expectations of an unimpeded ride to pastures even greener. Hirsch, for instance, has seen enough cycles to know that eventually every good thing will come to an end.

“This never lasts,” he says. “Factors will change. You're not going to see the strategic acquirers stay quiet forever, and the debt markets won't always go on like this either. Actually, I'm already starting to see the [deployment pace] slowing down.”

Indeed, while LPs may enjoy the celerity of the market today, secretly many are hoping for a slow-down to occur sooner rather than later.

“There was a period of about 12 to 18 months during 2001 and 2002, when there was virtually no transactions,” says an investor. “As it turned out, this was very prudent. What was perhaps more impressive than any of the recent developments was the discipline that the industry demonstrated during that period of time.”

Also, even as it may sound like heresy in the private equity realm, there is a certain population of institutional investors that prefer the predictability of a slower market.

Mark Wiseman, who heads the private investment activities at the Canada Pension Plan Investment Board in Toronto, counts himself among that group. “You never want to a look a gift horse in the mouth, but forus, we're long-term investors,” he says. “We're funding liabilities that are decades away. Having capital come back to us means we have to re-deploy it. Don't get me wrong, we definitely like the returns. But re-deployment is getting more and more difficult today. Pricing is high and it's harder to find places to put the money.”

To the general partners, the buyout bus in essis essentially about building better companies. It certainly helps to buy during a trough and sell at a peak, but to take the guesswork out, GPs take the position that if they're improving the assets, the returns will come. This is why so many firms have bolstered their operations bench in recent years. But that doesn't mean they will necessarily hold onto a company just to hammer in the last nail themselves.

Gregg Smart, a senior managing director and chief operating officer at New York-based Fenway Partners, points out: “We're looking to build these businesses by fundamentally changing the companies, and that generally takes between three and six years.”

However, he notes that there can be a “disconnect” between building a business and finding an appropriate time to exit, and that is why firms may go into an investment with a five year time horizon and scrap those plans to capitalise on an earlier opportunity that may not present itself again.

It's hard to argue with that logic. But while most LPs contend that their long-term expectations for the asset class have not changed, it remains to be seen if those new to private equity – and there have been many – will be able endure the “typical” five-year time frame once the market returns to normal. And that, ironically, will just take more time to play itself out.