Lessons learned

Five key lessons learned from 2009:

1) Prepare for SEC compliance

The US House of Representatives recently passed legislation that would require all private equity and hedge fund managers with more than $150 million in assets to register with the Securities and Exchange Commission. Fortunately for many smaller firms, this threshold was increased from an original target of $30 million, while a discussion draft in the Senate – which will take up the bill next – included a carve out for venture fund managers. While it is too early to predict yet what the final bill will look like, the fact that the regulatory tide in Washington is still strong – along with the increased demand for oversight from LPs – will likely mean that many firms will have to become Registered Investment Advisors, possibly in the near future.

Fortunately, while many US private equity firms have long feared the increased cost and headache of SEC registration, several executives say that the SEC audit process – a requirement of all registered firms – has improved considerably from just a few years ago, as auditors have gained more experience about the private equity industry. But in order to make the process go more smoothly, firms should start doing several things in advance. First, organise your practice and be prepared to describe your business model, investment methodologies, ownership structure and participation criteria. Second, study for and take the Investment Advisers Examination. Three, identify your chief compliance officer, someone with a strong background and experience in conducting annual compliance reviews and risk assessments. Finally, conduct a test audit of your practice and consult securities counsel experienced in advisory issues.

While such steps may seem like a hassle now, they could save valuable time in the future.

2) Have a good investor relations team

The need to maintain good relations with investors is always important during tough economic times, and with a possible ban on placement agent-public pension interaction coming up, in-house IR could be even more important in 2010 and beyond. This was especially apparent in firms such as Aureos Capital, Kohlberg Kravis Roberts and Actis, all of which bolstered their IR and communications departments in 2009.

While each firm has its own approach in tailoring communications for specific clients, several IR professionals offered advice in 2009 on the best ways to keep LPs happy. For instance, LPs mainly want more detailed information on portfolio company performance and valuations, as well as expected drawdowns, potential distributions going forward and upcoming capital calls. Firms should try to get ahead of the curve and have all the right materials in place before LPs even request these.

Investor relations professionals also need to make sure that the GPs are all telling the same story, which may require more coaching for GPs and dealmakers before they are put in front of investors. Finally, a good IR team will allow your firm to always be “in fundraising mode”, as the last year or so has taught that the investors once taken for granted can and do fall out of love in between fundraisings.

3) Prepare for departures

The resignation in early 2009 of Steve Rattner from the Quadrangle Group, the media-focused private equity firm he co-founded, was the first of several high-profile departures within the private equity industry during the year, which also included Alchemy Partners founder Jon Moulton and PAI Partners chief executive Dominique Megret. The repercussions that came up as a result – especially in the “key-man” clauses that were triggered in some of these cases – may be felt even more in 2010, as more funds could be dealing with their own such departures.

This means that firms may want to start thinking about succession plans earlier than they expected, as there is a significant risk that some number of teams will find many of their people, key men or otherwise, leaving for a wide array of reasons.

One idea is this – five years before a senior partner is expected to retire, the firm’s principals would do well to start thinking about succession planning and what the key-man provision in their next fund is going to say. These situations are better discussed in advance than on the fly.

4) Accept that LPs have greater power

During the boom times of 2006 to 2007, many GPs could sit back and watch as LPs competed to get access to their funds. But as The Carlyle Group co-founder David Rubenstein said during a conference in February, LPs rather than fund managers will hold the “balance of power” for the next few years, and will have to be heard out more on issues like deal fees and fund sizes. Several events since then have only helped to confirm his prediction.

This was most clearly seen with the release in September of a new set of terms-and-conditions best practices from the Institutional Limited Partners Association (ILPA), whose roughly 220 members control the vast majority of commitments to private equity funds across the world. Among the “best practices” put forth by ILPA were that LPs should be repaid first on all contributed capital plus a preferred return before GPs get carried interest, clawbacks should be gross of taxes paid, management fees should “step down significantly” once a follow-on fund is formed and deal fees should go completely toward the benefit of the fund. Both CalPERS and a group of development finance-focused limited partner, including the Asian Development Bank and the UK’s CDC Group, have publicly endorsed the ILPA guidelines, while the Oregon Investment Council and Utah Retirement Systems earlier released their own set of conditions – including asking GPs to reduce management fees – that they will consider before making investments.

A GP that refuses to budge on issues of importance to LPs may be perceived not a good fit for a long-term partnership.

5) Only hire ‘real’ placement agents

Few individuals had as big an impact on the private equity industry as New York Attorney General Andrew Cuomo, as his pay-to-play investigation has snagged numerous firms and threatened the long-term prosperity of the placement agent business. In addition to Aldus Equity founder Saul Meyer, who pleaded guilty to fraud charges and could face years in prison, several firms including The Carlyle Group, Riverstone Holdings, HM Capital, Falconhead Capital and Access Capital Partners agreed to pay fines to Cuomo’s office to resolve their involvement in the scandal. Together such firms shelled out more than $60 million in fines and agreed to adopt a code of conduct crafted by the attorney general’s office, which among other things prohibits investment firms from using placement agents, lobbyists or other third-party intermediaries to obtain investments from public pension funds.

That code of conduct was just the beginning, however, as the Securities and Exchange Commission has proposed its own ban on investment firms from hiring placement agents, while the Board of the California Public Employees’ Retirement System (CalPERS) recently voted to sponsor state legislation to treat placement agents who solicit public pension funds as lobbyists, which would lead to a ban on success fees. Such proposals have raised more questions than answers, including whether placement agents can legally be paid for work already done on behalf of a fund. How such questions are resolved, and the amount of legal expenses incurred as a result, will be a big part of 2010.

The whole affair has the entire industry wishing a handful of GPs had never met certain dubious middlemen.