In a recent DealBook column by Andrew Ross Sorkin, Guy Hands of buyout firm Terra Firma provides an unvarnished appraisal of the buyout industry’s bubble-era mistakes and its post-bubble outlook. It will surprise no one if the large majority of buyout deals completed during the credit bubble of 2006 to 2008 turn out to be bad deals. If that was the only issue facing buyout funds, everyone could just take their lumps and move on in a couple of years. The core problem is much more fundamental.
The buyout industry has sized itself based on management fees drawn not only on the record amount of capital invested during the bubble years, but also on the record amount of committed capital for investments yet to be made. The pressure to maintain high management fees and the large amount of undrawn capital commitments conspire to create an environment in which even the deals that get completed after the credit bubble (i.e. from 2009 to 2012) are also likely to produce poor returns in the aggregate. Unless the industry reforms itself, the net returns for vintage year 2006 to 2010 buyout funds are likely to be worse than even Mr. Hands predicts.
I base this assumption on observing what happened to venture capital after the bursting of the dot-com bubble. While the circumstances are different, venture capital and buyout funds are structured the same way. After a fundraising bubble, general partners get addicted to the high management fees that come with larger fund sizes. To protect the fee stream, many managers may (1) continue to fund poor prior investments to avoid taking large write-downs and (2) engage in overly aggressive dealmaking to invest the entire fund prior to the end of the five-year investment period.
- Good money after bad. In theory, there should be no reason to favor a follow-on investment in a troubled portfolio company over a fresh investment in a new company. Each new funding should compete with all available opportunities, yet by propping up prior investments with follow-on investments, general partners can avoid some write-downs that would result in a decline in management fee income.
In the early 2000s VCs made follow-on investments in multiple rounds, creating byzantine capital structures that obscured the true value of their investments in struggling e-commerce and telecom equipment companies. Buyout fund purchases of portfolio company debt and band-aid “amend-and-extend” loan modifications are examples of activity that merely delays the day of reckoning. While human nature is the most likely culprit, the beneficial effect on management fees cannot be ignored.
- Too much money, too little time. After the investment period, a fund can only collect management fees on invested capital. To maintain fees, the huge amount of capital raised during a bubble needs to be deployed before the expiration of the investment period. The competition to deploy capital results in overvaluation and overcapitalization of new portfolio companies. The “echo” venture capital bubble of 2004 to 2006 created a huge number of copycat “Web 2.0” companies with high capitalizations and little revenue. Signs of the same can already be seen in buyout land. Good quality deals are attracting many aggressive bidders offering high prices with little leverage.
Venture capital results speak for themselves
In August 2009 Landmark Partners published “Hope is Not a Strategy”, a study on the results of venture funds raised during the dot-com boom relative to those raised in other periods. The VC industry raised an average of nearly $40 billion per year for the vintage years 1997 to 2003, more than triple the average amount raised from 1992 to 1996. The mean reported return of vintage 1997 to 2003 funds was only 1.01 times invested capital, while vintage 1992 to 1996 funds achieved a return of 3.35 times invested capital.
Additionally, vintage 1997-2003 funds, which are past or near the end of their 10 –year fund lives, have only returned 32 percent of the capital they have called. Unrealized investments represent the bulk of the reported value of these funds. An April 2009 Landmark Partners study, “The Denominator Dilemma”, estimated that the unrealized investments of VC firms are being valued at around twice what they are actually worth. The ultimate return of vintage 1997-2003 venture capital funds will likely be substantially negative.
Venture capital provides the roadmap for buyout investors
Unless buyout firms reform themselves, vintage 2006 to 2010 funds are likely to produce similar returns to those of vintage 1997 to 2003 venture capital funds. Too much capital will chase too few deals in a compressed period of time. The question is whether buyout firms can overcome the short-term incentive to maximize fees and focus on the long-term incentive of protecting the interests of their limited partners.
The key for vintage 2006 to 2010 private equity funds with capital left to deploy will be to focus on their core competencies and maintain price discipline. Buyout funds should expect a longer-than-usual period to deploy capital. Disciplined funds might not be able to deploy their whole fund before the end of the investment period. Like some high-profile VC funds after the dot-com boom, buyout firms may want to consider downsizing the size of their funds to reduce the drag of high fees on net returns. Buyout firms should determine the appropriate staff level to perform reduced deal activity, just as they would for their portfolio companies.
The buyout business will survive the upcoming shakeout, but that does not mean that managers should stick their heads in the sand and hope for the best. I may be naïve, but I believe those firms that are proactive about protecting the interests of their limited partners during this difficult period will be rewarded in the long run.
Tyler Newton is Partner and Research Director at Catalyst Investors, a growth private equity fund based in New York. He blogs about economics and the financial markets at www.tylernewton.com.