The Problem With PE

Posted by Mark on 18th Nov 2009
For most of my adult life any mention of PE, brought back the horrors of Physical Education classes of my youth, in particular a lesson in 1977 after my mother had packed me off to primary school without my kit.  Having to do a class of musical movement in purple paisley M & S "Y-fronts", with green tubing, has scarred me forever and I will never forgive her.

The current problems in the world of Private Equity are more complex, but no less serious.

A recent article in The Independent was one of the first to highlight the seeming reluctance of some banks to engage with major equity players for fear that the buyers might have the temerity to be better at managing out distressed situations than them and might actually make some money!!!

To highlight a bout of insanity that could only be true of an effectively nationalized organization, it references the recent sale of Insight to New York Mellon.  HBoS (nearly 50% owned by you and me), allegedly, sold it at a discount of £15m to the best price bid by a respected PE player, in case they "make huge profit".  Am I missing something, but surely NYM will now make a "huge profit" plus a gratuitous £15m!!!

If this is true, the only losers are the beleaguered HBoS shareholders and the even more beleaguered UK tax payers.

Now PE does have serious structural issues, returns on previous funds may have been illusory, driven by leverage rather than stock picking or asset management, and even worse than that the industry has billions of pounds to invest, sometimes with no real idea of how to get to their desired returns.

Let me explain:

-On the back of Fund I, which made phenomenal returns up to 2005, Gear Lots Over Value Everything (GLOVE) Investment Management looked to raise second fund.\r\n-GLOVE II closed in 2006 with £500m of equity pledges.  It promised its funders a return of 12%, but charges a 2% asset management fee and 30% of the profit over the priority return.  It promised to invest the money within three years and return it within five or six.\r\n-Very excitedly GLOVE announce that they have £2.5bn (geared) to invest, however to make money themselves GLOVE need invest in opportunities that offer a >20% return and this is based on being able to get 80% gearing.

Unfortunately the world as we know it shortly thereafter came to an end.  In 2008 GLOVE looked very clever (if you ignore the returns on Fund I) and couldn't wait to buy loads of distressed kit, but like a surfer on The Serpentine, for them the wave never came and now funds and cash buyers have stoked up the prime market to a level which they couldn't justify, even if they could gear at 80%.

But the clock is ticking , they really need to get that money away shortly or the chance to earn lots of lolly in management fees will have passed, does GLOVE:

a) Spend the money anyway as they otherwise won't get paid and hope the market continues to go up

b) Hand the cash back to prove what jolly good eggs they are; as long as they can have it back at a later date

c) Swallow some pride and buy more secondary assets

d) Explain to their investors that there are fantastic opportunities out there, but in this new environment an 8% hurdle rate is more appropriate and that would give them a chance to compete in the market with target returns of, say 15%

e) Engage in some serious PR, drop all mention of "distress" or "opportunity" from their marketing material and look to cosy up in joint ventures

Clearly a combination of the most pragmatic routes would allow them to engage with banks as credible counter parties with realistic return criteria.

It's one of the many interesting conundrums for next year, after all no one wants to be left shivering at the side of a cold assembly hall being called "Skinny Sick Coloured Pants."

I can assure you.

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