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Drifting away

Are GPs overstepping their mandates by buying up cheap debt?

In his 2008 letter to investors, Terra Firma's Guy Hands takes the industry to task for an insidious and widespread strategy drift. ?With the change in return expectations in Europe and the US for large deals, some private equity groups that previously focused on large buyouts have suddenly become distressed debt investors, while other firms with little or no experience beyond their local markets are ?looking to Asia,? he says. Although he admits that successful strategies much evolve over time, some of the more recent evolutions appear to him more like ?knee-jerk reactions to the market rather than well-thought out strategic moves.?

More importantly, Hands believes that firms are overstepping the bounds of their investment mandates with such dramatic shifts in direction. ?If a firm wants to undertake new investment strategies, it should hand back the committed, but undrawn, capital to LPs, and ask for their re-commitment,? he says. ?The firm one chooses to back to do mega-deals may well not be the firm one chooses to back in, for example, the mid-market. The LPs should have the opportunity to decide.?

Asking a mega buyout firm to return capital to its investors before snapping up distressed securities might seem like a dramatic solution, but certainly the issue is a topical one. Cheap debt has not only attracted the likes of Blackstone, Kohlberg Kravis Roberts and Apollo Management in the past year, but smaller middle market firms as well. Sometimes these firms have raised special debt-focused vehicles, but sometimes the investments are made through generalist funds.

Whatever Hands' feelings on the matter may be though, the GPs in these cases are rarely doing anything that violates the terms of the partnership agreement. These contracts have usually built in enough flexibility to allow managers to pursue opportunities where they see them.

Investment mandates will typically be described in broad terms, stating that the fund will seek ?long-term capital appreciation for its investors? by investing in ?equity, equity-related and other securities.? Some restrictions may be specified on how much of a fund may be invested abroad, how much may be invested in a single asset, or how much may be invested in blind pools or open market securities. But rarely do PPMs explicitly exclude a type of assets.

Roger Singer, a partner in Clifford Chance's fund formation group, has reviewed plenty of partnership agreements, and finds few with explicit, exclusionary language. ?The leading players have a lot of leverage, and they tend to write very broad language about what they can and cannot do,? Singer says. ?The idea is that you're hiring them to be your money manager, so you should allow them to manage your money? The more restrictions you put on them, the more you're inhibiting their ability to manage you're money.?

Singer mentions that debt is an unusual case, however. Many PPMs are written in such a way that the inclusion of debt in the investment mandate was meant to signify buying corporate debt as a means to gain control of a company, Singer says. So while buying distressed debt with the goal of selling it when spreads begin to close may not be a violation of the letter of the contract, it is a violation of its spirit.

?You haven't seen in a very long time people looking to scoop up a lot of debt just for the purpose of holding the debt, so I think people weren't thinking about whether this is something they wanted,? he says. ?They weren't as focused on this point as maybe in the next round of funds they will be.?

It might behoove a GP to at least discuss the investment with its advisory committee before committing to the deal, Singer says. While the GP needn't necessarily bring the deal to vote, it's better that your investors don't see the deal for the first time in a capital call.

Investors have rarely sought legal action against a firm that has strayed from its mandate. But one notable case was the state of Connecticut's pension fund's suit against Forstmann Little in 2004. After the firm's disastrous investments in XO Communications and McLeod USA, the pension fund sued the private equity firm for breaching an investment limitation that stipulated that no more than 40 percent of the fund be invested in a single asset (XO Communications). A jury ruled that the investments were improper, and in fact ?grossly negligent.? But the jury did not award any damages to the pension fund because it only objected to the investments after losing money.

But although the risk of investors suing GPs seems to be low, Singer warns that GPs should still think carefully before trodding on relationships with their LPs. Indeed, Three quarters of all LPs surveyed in Coller Capital's latest Global Private Equity Barometer are worried that fund managers will stray into strategies or geographies where they lack expertise. In North America, 84% of LPs see GP strategy drift as a risk to their returns.

?Even if you're an expert in corporate finance, that doesn't mean your investors want to be in a corporate debt fund,? he cautions. ?You want to be sure you're doing what people want you to do, such that if times are different when you do your next fundraising, people are feeling warmly towards you.?

Netherlands tax reform to hit PE
Tax reform proposals were introduced in the Netherlands in May that could have adverse consequences for private equity, according to a recent client memo from the law firm SJ Berwin. The memo explains that the Dutch proposals relate to so-called ?lucrative interests? ? certain types of shares, receivables or rights with similar economic characteristics. These would be taxed as ordinary income if held directly ? at rates of up to 52 percent, or at a flat rate of 25 percent if held through an entity in which the taxpayer holds a substantial interest. The draft law, intended to apply from January 2009 onward, attacks a ?lucrative interest? if, among other things, it is considered to have been granted with the intention to pay for services rendered by the taxpayer, or certain persons related to the taxpayer. The memo states: ?It is clear that this would apply to the shares held by management teams in many buyouts, as well as to carried interest held by private equity executives.? The law firm does clarify that not all shares or similar rights will constitute ?lucrative interests? ? there are various conditions which have to be met. The firm expects that the proposed measures will be approved quickly, and without significant changes, because they form part of a tax bill that includes other measures that have long been political priorities.

Walker Report earns mixed verdict
Six months after the publication of the Walker Report, the private equity industry has offered a mixed verdict on its impact, according to new research by global business and financial adviser Grant Thornton. The survey of 100 senior private equity executives found the majority of these executives (68 percent) view the industry as more transparent, although only half (46 percent) felt there was a greater understanding of the PE industry since the report was published. Only 27 percent believed the private equity industry was viewed in a more positive way. Grant Thornton private equity partner, Mat Bhagrath, said the Walker Report was a natural reaction at a time when both the media and government spotlight was firmly on the behavior of the private equity industry, particularly on the mega-buyout deals of public companies. While a sizeable proportion of private equity executives have noticed a change in the general perception of the industry, nine percent reported that private equity actually faced a more negative perception in the market place. The survey also found there had been limited change of emphasis on ethical standards, with 27 percent now offering a formal ethical code compared with 24 percent prior to the Walker Report. Two thirds (64 percent) follow an informal ethical code, down from 66 percent.

W.J. Bradley names new CFO
Colorado-based W.J. Bradley Company has announced the appointment of Roy Browning as the new CFO for the private equity firm, dedicated to acquiring mid-sized residential lending firms originating between $300 million and $2 Billion. Browning has an extensive financial services based background, most recently serving as Executive vice president and CFO at Collateral Real Estate Capital, and previously as executive vice president and CFO for Aurora Loan Services, LLC, a mortgage banking subsidiary of Lehman Brothers. ?[Browning's] strong financial background, track record of operational success and history of creating value for some of the industry leaders make him an important addition to the company,? commented William Bradley, company CEO.