Risk guide: LBO fund—fund-level risk considerations

John Barber of Bridgepoint examines the team risk issues pertaining to private equity investing. An excerpt from PEI Media's new book: The Definitive Guide to Risk Management in Private Equity: A comprehensive intelligence source for investors, fund managers and professionals who need to manage risk.

Private equity investing involves consciously taking risks. It is expected that, over time, the investments scrutinised by its investment managers and those that attract their capital will produce compelling performance that exceeds traditional asset classes’ returns. In the buyouts context, greater rewards are often generated because private equity backed businesses typically set more ambitious goals for growth and profitability than their public corporate peers. These businesses often make longer-term, sometimes bolder decisions to commit capital expenditures or to restructure operations (as they stand outside the sphere of listed companies required to report short-term results each quarter) or are more leveraged financially than comparable quoted companies. On occasion, private equity investment managers can also generate exceptional returns when they defy conventional wisdom by acquiring fundamentally sound businesses at knock-down prices when they are out-of-favour or overlooked.

It may be a platitude to state that a private equity firm’s most valuable asset is its skilled personnel, but it is a statement that will always be true. Without a talented, motivated, creative, well-rounded and diligent team, a private equity firm could not accomplish its mission at the best of times, not to mention at the worst. To succeed in the buyout world, a firm must be accomplished in finding, understanding, winning, pricing, financing, managing, and at times rescuing and eventually exiting its investments; each stage is undoubtedly a complex assignment. Collectively, they are usually conducted against pressure from competition, timing (in the sense of deal deadlines as well as compounding IRR thresholds) and market cycles.

Although not guaranteed, private equity professionals’ rewards for successfully meeting all of the required demands can be exceptional. With respect to carried interest, however, much more has to go right than wrong over several years in managing financially leveraged assets with ambitious business plans in order for serious capital gains to be generated for a general partner’s team.

The principal team risk – ensuring sufficient team quality to handle the many daily challenges – is largely mitigated by the potential for very compelling rewards. Highly capable, ambitious, hard-working and skilled professionals are attracted to the private equity arena not just because of the quantity of rewards on offer but also because it is a multi-faceted, fast-moving business. Newcomers to the industry are also inclined to hold out for longerterm, larger financial rewards. In so doing they opt out of the more predictable, shorterterm remuneration available through annual bonus pools in other professions where their investment execution, research or strategic talents could be applied, such as in investment banking, consulting or quoted asset management.

The flip-side of private equity’s capacity to attract outstanding personnel is that managing such first class professionals in a fluid yet relentless business is highly challenging in itself. Sometimes with very little notice a deal can fail or succeed despite months of intensive effort; completed investments can produce binary outcomes over time, with sometimes a seemingly unfair 5x gain on a middling asset benefitting from an improving market, or just a 0.5x gain on a thoroughly decent company trading in tough market conditions, despite years of hard effort to resuscitate it. Star private equity players can fall down if they rely on an over-inflated perception of their own abilities, based on an earlier triumph, but lack the requisite experience to master a fresh, particularly demanding challenge.

They may need support in maintaining equilibrium after striking out in trying to win a series of new transactions, when facing unexpected competition from younger, rising colleagues or when investments for which they are responsible go into reverse after having had only forward momentum for years.

A first generation of type-A or often type-A+ entrepreneurs founded most private equity firms, as the great majority of today’s players (including a number with tens of billions under management) began life as start-up outfits as opposed to corporate captives. As such, most firms ten or 20 years after foundation usually face succession issues that are textbook entrepreneurial challenges – quite often the founders (however successful they have been professionally and financially, so notionally in a position to retire) find it difficult to yield control.

Equally, the second generation can either be too hungry or not hungry enough to succeed them. In the former situation, the conflict (however subtle and masked by shared economic incentives) between a first generation unwilling to let go and a second one a little too ready to assume command can lead to fracturing of firms, senior departures and spin-outs as the younger talent seeks to prove that it is every much as skilled, driven and ready to excel as its former superiors. In the latter case, a firm can drift strategically and managerially for too long as the founders wait for the next generation to mature, sometimes in vain, while often becoming more convinced of their own indispensability as time goes on and the leadership vacuum is not filled.

There can also be other causes of inter-generational inequity leading to tensions within firms, some of which have become more pronounced in tougher economic times when performance at the portfolio-company and fund levels have both suffered. ‘Name’ or senior partners, having earned their stripes and fortunes, may have decided to take a back seat just at a point in the cycle when exceptionally hard work is required of a general partner to steer its companies successfully through difficult conditions, or even to prevent them from sinking. It may be that the division of economic rewards – particularly carried interest – reflects earlier days when the senior partners were still pulling their full weight, leading to resentments among their more junior colleagues who feel inadequately compensated, especially so given the exceptional external challenges they are now facing.

At many firms, the split of rewards can be very slow to adjust to the new reality of who is actually now doing the lion’s share of the work, especially if the original partners persist in ‘overweighting’ the value of their contributions in establishing the firm and creating its franchise. In the most extreme cases, the younger partners and professionals – who usually do not have the fruits of the exceptional rewards of the last cycle to fall back on, and may be facing big write-offs of the personal capital invested in troubled transactions – may threaten to depart en masse just at the point when their efforts and energies are most required. The best antidote to such a risk is a readjustment of the levels of relative rewards so that the greatest contributors to value creation and preservation today and in the future are properly recognised and feel well-treated.

Given that investors in funds are unusually committed to general partners through blind pool vehicles with a minimum of ten years’ life, these various forms of organisational instability can be nerve-wracking, especially in light of limited partners’ relative lack of control over succession outcomes. Key-person clauses in existing fund documents can protect their interests to an extent, but only in fairly extreme scenarios and only after the key person has departed. Besides insisting on tighter-term clauses, investors would be well-served to drill-down on such team concerns and details (such as the specifics of relative carried interest shares between old and new generations) when considering committing to a new fund, even a successor vehicle that follows funds that have produced great results and earned the investors’ long-term loyalty in the process. Every effort should be made to understand how key team members interact with their colleagues, what career aspirations they have at that point in the firm’s development, and the degree of contribution they are making to today’s, not yesterday’s, enterprise; in effect, investors should not rely on the comfort of historical performance and stability but rather assess the likelihood of future team disruption.

Private equity firm leaders and investors in their funds need to be fully aware that private equity investing enterprises will always evolve and must not remain stuck in time. A private equity firm’s skill set in 2010 and beyond will be intrinsically different and far broader from the one needed for success just ten or 15 years ago.

For example, in the mid-1990s a prominent and profitable UK-headquartered private equity firm, with aspirations to expand its geographic presence and investment reach, promoted itself as a close group of 13 partners who were all qualified as chartered accountants and British by nationality. The partners must have concluded that these key attributes were crucial to the firm’s financial acumen and cultural cohesion, yet they learnt over time – to achieve their goals as markets evolved – that they needed to alter the team mix by nationality and perspective; to their credit, they successfully adapted in due course.

As geographic borders blur in the electronic age, business plans become more complex to execute in rapidly changing market conditions and as industrial competition intensifies not just from well-known players but also from emerging economies like Brazil, Russia, India and China (the BRICs), private equity teams need to evolve to meet fresh challenges.
If private equity firms are too constrained by investors seeking team stability and constancy almost at all costs, they will be at risk of being left behind, unable to capitalise fully on business opportunities and potentially unable to fulfill their fiduciary responsibilities to manage investors’ capital diligently and professionally.

Firms must have the financial means and the operating flexibility to invest in new talent that is right-sized and skilled for today’s marketplace. In practice, this might mean, from the investors’ perspective, on the one hand affording a general partner some ‘fat’ in its operating budget to expand its team pre-emptively to meet forthcoming needs and challenges or to acquire fresh expertise and perspective, while on the other allowing it more freedom to realign and refresh its team to cope both with emerging opportunities and fresh risks, particularly those that arise when expanding into new and less familiar geographies.

On occasion some investors – with their detailed questionnaire tables addressing a general partner’s turnover between funds and the like – can bring too bureaucratic a mentality to assessing what is an entrepreneurial trade, one that needs new blood for new investment seasons and territories.

This partial chapter is one of 19 in The Definitive Guide to Risk Management in Private Equity: A comprehensive intelligence source for investors, fund managers and professionals who need to manage risk, a new book from PEI Media. Edited by risk management experts Capital Dynamics, this guide provides investors and fund managers with valuable tools and practical guides to risk management scenarios, as well as case studies and best practices. Sample contents and more information on the book are available at www.peimedia.com/risk.