Small is beautiful for private equity

Although many institutional investors are keen to add or increase exposure to private equity, the problems in the industry and the high level of fees means the best opportunities may be limited to the smaller end of the market, says Luba Nikulina, New York-based senior investment consultant at Watson Wyatt.

She says investors often underestimate the complications of a multi-year commitment of capital and unpredictable drawdowns. This analysis has become more difficult because market volatility has undermined models used to predict distributions. Many PE funds raised money over the past decade based on a quickening of deployment, and limited partners have committed capital based on assumptions made in the early 2000s.

Big buyout funds have around $1 trillion of cash that they are struggling to commit. If measured at the pace of commitments in 2008, this pile of cash will take up to 10 years to distribute, Nikulina says. But such funds were marketed to LPs as five-year investments. Worse, of the cash that has been deployed, buyout funds often paid high multiples to investee companies, and their positions today are losers. But they continue to charge LPs annual management fees.

Many of these big buyout firms are going to disappear. They will need to return capital to their investors, and over time their positions will be wound up, unless they are able to raise new capital. Meanwhile they risk losing their talented investors. Nikulina says the venture-capital industry has been particularly hard hit. "I hope things don't get as bad for the buyout funds," she says.

Henry Ching, Hong Kong-based consultant at Watson Wyatt, says as many as 40% of PE firms in Asia could face a slow death, particularly those in China, which assumed they could finance quick deals to flip assets -- a strategy that ended abruptly when the IPO market went quiet.

Those funds concentrating on small- and mid-sized investments are in the best shape because they avoided the excesses of the credit bubble. Also, it's in small turnaround stories where private-equity managers can best display their asset management skills, rather than just rely on leverage (or rather, rely on target companies' indebtedness) to make deals happen with relatively little capital.

Nikulina acknowledges there is a lot of interest now in secondary private equity. In 2008, secondary funds raised $26.8 billion. But, perhaps because stock markets have rebounded, there haven't been transactions in the secondary market; PE firms aren't selling, particularly in Asia, in part because managers have slowed down capital calls. Last year, secondary transactions totalled only $13.3 billion.

Sellers are not prepared to sell at steep discounts. In the fourth quarter, bids for buyout funds were submitted with a 60-80% discount to net asset value. Deal activity in the first five months of 2009 has been even slower than last year, Nikulina says. So while there surely are some amazing deals to be had, "it's like digging for small gems inside of nuclear waste", she says. Deals will materialise as markets settle down and it becomes clear who will survive.

Another challenge for LPs is the need to manage more relationships. Two years ago, a $20 billion buyout fund was happy to accept your cheque for $500 million, representing your PE allocation. Today you still may want to invest $500 million in private equity, but fund sizes are much reduced and target returns more modest. Therefore LPs must spread their money around.

The good news for LPs is that fees should come down; or at least investors should feel empowered to insist that interests be better aligned. When PE funds were small, managers needed a 1.5-2.0% annual fee just to pay the bills. But once buyout funds reached into billions, this annual fee became nothing but a gravy train for PE executives.

During the boom years of 2005-07, demand was such that investors had no bargaining power. Now general partners are ready to listen to LP concerns, says Nikulina. She says investors should not stand for "outrageous" carry on AUM, which had risen from 20% to as high as 30%. She says 1.5% management fees should be the norm, with these fees scaled down over the life of the fund. LPs may also be able to negotiate fees just on invested capital, not on committed funds.

Finally they should no longer feel it necessary to pay PE executives transaction fees, such as fees for financing and monitoring each deal done by the fund. Nikulina says PE firms pocketed as much as half of such fees, which were charged to the underlying company -- taking money right out of those companies, and from investors, for no service or extra value.

Watson Wyatt wants to insert itself into the investment process by advising LPs on fee negotiations. Henry Ching notes that fees in Asia tend to be higher than in the US or Europe, partly due to scarcity of product.