There has been a great deal of recent press regarding the gulf between buyers and sellers of private equity interests. The disconnect is usually attributed to some analytic model—the vagaries of FAS 157, a lack of information, uncertain outlooks, etc.
As a buyer of private equity interests, I believe that there is validity to many of the commonly-cited explanations. Nevertheless, focusing on the financial metrics alone imagines a world in which price is the only driving force in markets. It is important to remember that institutions never sell private equity. People within institutions sell private equity. Many of the individuals tasked with managing private equity portfolios have recently suffered through traumatic professional experiences. Buyers of private equity need have patience and understand the personal nature of private equity partnerships.
Today’s sellers of private equity often have often suffered tremendous financial hardship. These are far from paper losses. Universities whose endowments have lost millions are cutting back on construction projects and financial aid. Foundations with similar issues are suspending grants and sometimes shutting down entirely. Losses in some pension plans may jeopardize future retirement and health benefits. The individuals responsible for managing private equity at these institutions have often watched many of their long time friends and colleagues lose their jobs. They are concerned for both their institution’s future and for their personal future.
Financial institutions, most of whom are restructuring to varying degrees, are among the most internally complex sellers. In several recent transactions I’ve been involved with, managers of the private equity portfolios realized that the more assets they sold, the fewer responsibilities they would have and the more likely they were to be downsized. To compound the problem, if they sold the interests at a loss, they risked highlighting a poorly performing investment. As a result, the investors clung to assets which were of little financial or strategic value. In several cases, transactions have collapsed after multiple rounds of bidding.
It is unfair to criticize the private equity managers for acting in their own self interest. It is ultimately the responsibility of the senior management of institutional investors to ensure that private equity managers act in the best interest of the portfolio. These leaders are often under similar pressures. If they allow write-downs, no matter how small, they may need to explain themselves to a board or shareholders or both. In short, there is an overwhelming and intense institutional pressure to do nothing.
The fallacy that today is the worst time to sell private equity has increased this stagnation. Many sellers are highly defensive—they are concerned that they are being preyed upon and perceived as a desperate seller. Only a fool would sell! But today is only the worst time to sell private equity if you expect tomorrow to be better. Indeed, many of the sellers of private equity in the last year were convinced that they were trying to sell at the worst possible point. At the end of 2008, we made offers that sellers rejected as absurdly low. Today those same offers are seen as highly attractive. Given the continuing economic uncertainty it is difficult to call this the bottom with a high degree of confidence.
Is there a way to bridge this gap between buyer and seller expectations? Conventional wisdom suggests that structured transactions can address significant differences in value expectations. Indeed, my firm (VCFA Group) has provided profit sharing structures to sellers as part of the solution. But ultimately the only solution may be time. Institutions will need time to adjust to new realities. Individuals will need time to become more comfortable in their newly defined roles. Until there is some greater institutional stability, there will continue to be a human gulf between buyers and sellers of private equity.