The last year has undoubtedly been a difficult one for alternative asset fund managers in the UK.
The continued fallout from the credit crunch and the Madoff affair has had serious implications – leaving both managers and investors in UK private equity funds facing an array of problems. This has led to a fair number of funds being restructured, but relatively few new funds being raised. According to the data provider, Preqin, private equity firms globally raised only US$38 billion in Q3 2009, a huge drop from the boom days in Q2 2007 when globally US$208 billion was raised. Looking at the UK private equity fundraising market alone, using the British Private Equity and Venture Capital Association figures, this was at its strongest in Q1 2008 at £141 billion and at its lowest for many years in Q2 2009 at £12 billion.
Over-leverage of private equity transactions has severely affected valuations of many portfolio companies, and the lack of realisations has left both GPs and LPs facing difficulties. Some of the larger funds, particularly those which are listed or associated with listed vehicles, have had rather more public problems and sought to come to arrangements with their investors, for example, Permira (through SVG) and Candover. Others are dealing more privately with their defaulting investors. Other well-known houses have also been in the headlines, notably Terra Firma (in relation to its investment in EMI) and Alchemy (in relation to succession).
Many GPs are changing their teams and looking at overall incentive packages. Some prominent private equity players (notably, Jon Moulton of Alchemy, Guy Hands of Terra Firma, Colin Buffin of Candover and Dominique Mégret/Bertrand Meunier of PAI) have retired or changed their roles. A generational shift is being seen across the board.
Terms are also being scrutinised and, as in every recessionary period, there is a lot of discussion about the change in the balance of power between GPs and LPs.
The anticipated upturn in secondary activity has not yet really shown itself. However the banks seem gradually to be looking more closely at their lending books and as the value gap between potential buyers and sellers appears to narrow, this may be a greater feature of the market in 2010.
PRIVATE EQUITY INVESTORS
Many private equity investors have taken cover and are not making any new commitments to UK funds at present – a position which looks likely to continue well into 2010. Some have been severely affected by losses on other investments and the lack of private equity realisations has resulted in insufficient liquidity. The so-called denominator effect has also inhibited further investing by institutional investors because the value of publicly listed securities has decreased, and so the proportion of monies available to invest in alternative assets has accordingly reduced. Some investors are also suffering as a result of their previous over-commitment strategy in private equity, where they felt that too small a percentage of their commitments were being drawn down for investment (often only 80 per cent or so) over a fairly long period so, relying on previous realisation levels, they committed more cash than they had available. As a result of a combination of these factors, some investors are firmly indicating to their managers that they do not wish to receive draw down notices. This of course raises the issue of conflicts of interest between the different investors in a fund.
Certain investors are frustrated by the 2 and 20 model (i.e. 2 per cent annual management fee and 20 per cent performance fee/carried interest). Traditionally the 2 per cent has been intended to cover the costs of doing business – but the arrival of the mega funds (i.e., US$5 billion plus) has meant that management fees can be far in excess of the expenses bill of some GPs, even though in many of the larger funds the figure is more like 1 per cent. Some investors are trying to negotiate to reduce the 2 (which they are legally committed to pay) despite the lack of activity in the market. Other investors take the view that paying the 2 to remain where they are is far better than losing large chunks of the investments made by certain managers in heavily leveraged pre-credit crunch transactions, and that they want their managers much more focused on portfolio management than on secondary matters, such as changing the level of management fees. Recent headlines cite pressure on private equity groups to cut their fees and one well-known UK investment consultant has recently called for “fairer” terms and a clearer alignment of interests between buyout firms and investors.
This seems to reflect what is happening in the United States where the Institutional Limited Partners Association published a set of guidelines called “Private Equity Principles” in early September 2009. Its 220 or so members, of which about 80 per cent are based in the US (including the prominent Californian Public Employees Retirement Scheme), have together about US$1,000 billion invested in private equity assets. Although the members are predominantly US-based, the guidelines are being carefully looked at in a UK context. They suggest a number of LP-friendly approaches to terms, including whole fund return models rather than calculating performance fees on a deal-by-deal basis – although the latter has been a more US-driven approach and the majority of UK funds are structured on a whole fund return basis. Other issues covered include governance matters (particularly conflicts of interest) and transparency provisions. We anticipate, however, that these issues will be put before UK private equity managers in the coming months.
PRIVATE EQUITY MANAGERS
Most managers are currently considering their options. Many are making more efforts to consult with their investors and supplying far greater levels of information about portfolio companies than has previously been the case. Investor relations is high on most GPs’ agendas. Many are delaying fund-raising until the market improves and relying on the “dry powder” in their existing funds. However, once fund-raising starts again a large number of managers have indicated that they intend to come to the market.
In the last year very few managers have been successful in raising new funds. GPs that are in the market are having to consider reducing their target fund size. Some are trying to attain a first close as soon as possible with a cornerstone investor so that fees will start to flow. Many are negotiating to extend their final closing date beyond the traditional 12-month mark. Some managers are seeking to extend the investment periods of existing funds in a move that is generally welcomed by investors, although some LPs view a legacy portfolio with difficulties as a distinct negative. First-time managers are finding the going very tough and it is likely that many will be unsuccessful in the current climate.
PRIVATE EQUITY FUND TERMS
Whereas a few years ago there was a clear sense that it was a GP’s market and investors were desperately trying to get into certain star funds, there is now a presumption that it is LPs who hold the upper hand. There is an enormous amount of talk about the changes to fund terms – with the expectation that LPs are going to be tough, particularly on management fees, transaction fees, keyman provisions and no-fault divorce rights. However, the reality is that because so few UK funds have closed in the last year (and those that have closed have been largely dependent on strong existing investor support) there is little concrete evidence to support any significant changes. Undoubtedly, the number of fund restructurings has meant that LPs have been spending more time together and discussing issues more openly, so in future they are probably more likely to collaborate and exert greater collective bargaining power. There has also been increased focus on the mechanics of the fund documents. One investor complained recently that a GP had not informed him of a key man event until six months later and, when asked about the delay, responded that the legal documents required him to notify LPs of key man events but did not specify a timeframe. It is likely that this type of loose drafting will change.
Some GPs have troubled portfolios. They have been badly affected by over-leverage and falling valuations and there is an increasing sense that some groups will be unable to raise another fund. Consequently, many executives are “out of the carry” and are looking to move jobs. Rumour has it that there are presently many hundreds of private equity executives’ CVs sitting with recruitment consultants in London. A number of eminent players have decided to retire or announce their departures, leaving younger blood to take up the reins and deal with key man provisions. Even where key man clauses are not triggered, this means that LPs will take a long, hard look at the successors before deciding to commit to new funds raised by these teams.
As a result of this upheaval, many investors are considering what their strategies should be going forward. Some seem less keen to go into blind funds and would prefer to have more say in relation to the assets their money is used to purchase. It seems that co-investment deals and directs, and probably certain types of managed accounts, may be more popular in future.
Some investors are disenchanted with the bigger buyout funds which were heavily reliant on debt – looking instead at the underlying assets – so infrastructure and funds with underlying real estate assets are seemingly going to be in vogue. Green technology and renewable energy funds also appear to be fashionable and there is increased talk about government-sponsored funds of funds investing into venture capital.
The reaction of politicians to the recent crises has been predictable. Politicians are trying to introduce measures to curb what they view as the causes of the turmoil. The draft Alternative Investment Fund Managers Directive, which was published in April 2009, will, if passed in its current form, make it mandatory for almost all alternative investment fund managers to be regulated and contains detailed provisions on the marketing and promotion of alternative funds within the EU. It has caused a furore amongst London-based alternative fund managers and has undoubtedly been a knee-jerk response which needs to be reconsidered. However, the devil is in the detail. A tremendous amount of work has been undertaken at many levels in London, from the government (principally Lord Myners) to the regulators and many trade bodies (including several committees of regulatory and fund lawyers). We are currently expecting a revised draft to be published in mid-October 2009.
The regulators have also toughened their stance – in the form of both the UK Financial Services Authority and in the relevant financial services commissions in the Channel Islands, as well as elsewhere. Applications for authorisation are being scrutinised more heavily and the implementation of the conduct of business rules - in particular the capital adequacy requirements - is being looked at more thoroughly.
Although so far 2009 has been a difficult year, there are signs that both GPs and LPs in UK private equity funds are adjusting to the new climate. We anticipate that the fund-raising environment will remain difficult and there is likely to be continued pressure on fees and more attention to the precise structure and drafting of documentation. It is likely that many GPs will come under pressure as a result of their investor base, key man provisions and portfolio performance or a combination of these factors. Where funds are put into run-off, it will be interesting to see the structure which is chosen by GPs to accommodate their future funds or investor arrangements. Certainly, it remains a challenging time for private equity fund lawyers.