How to Mitigate Against PE GP “Sharp Practice”

Fait ou fiction?

Ahmed Badreldin, Former Head of MENA for The Abraaj Group, has written an interesting article on the above topic for Private Equity International.  

He emphasizes enhanced controls over the GP by LPs and proper due diligence.  

A lot of good common sense suggestions. 

Some quotes that particularly resonated with AA:  

1. “A key element of diligence is maintaining skepticism until the very end.”  
2. “Furthermore, funds shouldn’t have large positive cash balances and alarms should go off if there are drawdown requests from funds that already have large cash balances.“ 

What I found particularly interesting was his focus on a three specific examples of GP “sharp practices”.   

Do you wonder if he witnessed these “sharp practices” first-hand during his career at one of his previous employers? Or is he just applying his theoretical knowledge to identify key risks?  

AA has his own opinion, but what’s yours? 

In his own words:

“A recent case involved a fund that had externalized fund administration, but where drawdowns were made despite the fund having large cash balances.  Monies ultimately went to a bidco SPV where the bank accounts and the SPV were controlled by the GP without external oversight by independent directors or fund administration (despite the actual fund having fully externalized its fund administration).”

“Funds should not have large cash balances for multiple quarters, especially given the risk of fund bank account balances with “quarter end window dressing”, where the cash balances of the fund can be temporarily shored up from external funding sources, which can be difficult to detect, resulting in reported cash in the GP reports not actually existing for the reporting period.”  

He also focused in on valuation of portfolio companies.  Suggesting that these be audited by independent third parties with perhaps the inclusion “simple” metrics such as EV/EBITDA versus comparables as a way of providing a check on the GP's valuation.  

AA would note that selection of “comparables” can allow the GP a great deal of discretion to achieve a desired result.  And there is always the possibility of manipulation.  

Bahrain International Bank valued its investment in Burger King franchises it owned in the Carolinas using a multiple based on an unconsummated offer to buy the Burger King company. Note that is comparing the value of a franchise (part of the chain) to the main company (ex the franchised outlets).  

That’s not to say the DCF produces a more accurate result.  Small changes to assumptions (discount rate, growth rate) can result in big changes to valuation.  

As he notes, valuation is an art not a science.  When the intended result is known, the artist can employ all of his talents to achieve that result.  Or just enough.  One hopes though that the arts employed are not the "black" arts.

Storm Signals in Private Equity

A Severe Warning Flag Given the Amounts Involved

Chris Schelling’s article in Institutional Investor flashes some very clear warning signals about PE.  

“Private equity sponsor-to-sponsor transactions are on the rise. But lately, some firms have begun selling companies to other funds in their stable — a far more worrying development.”  

Chris outlines the risks of both sorts of transactions:  

1. a private equity firm selling a fine investment to another PE firm and 
2. the more worrying one a private equity firm selling a fine investment from one of its own funds to another of its own funds. 

When "exits" aren't via trade sales or IPOs are they really exits?  Or are they symptoms of real problems?  When they represent a large percentage of declared but perhaps not real "exits", are the problems severe?

Let's look at these in order.

First inter sponsor sales.

One-third of all private equity “exits” in 2017 were the first type:  one sponsor selling to another sponsor.  Data for 1 H 2018 show a similar trend. 

There probably are some situations when these transactions can be economically justified in terms of value creation for the limited partner not just for the fund manager/sponsor.  

But such instances are clearly not one-third of all exits.   More likely to be for a fraction of that percentage.  3%? 

Essentially what the fund manager who sells is saying is that he can no longer increase the value of the investment.  What the fund manager who buys is saying is that he can.  

There could be special situations where this is true, e.g., a further increase in value of an investment requires that it be integrated with other companies that the selling fund manager doesn’t own and is unable to buy.  The buying fund manager may own those companies.  

But if the buying fund manager has no special advantage like that and is relying on making traditional operating or financial improvements to generate IRR, then:  

1. The buying fund manager believes he has the skills to make a PE like return on the investment at his higher entry price 
2. If the selling fund manager is realizing a profit that triggers carried interest, then the ultimate return on the investment must be such that two managers will separately and independently be able to generate PE like returns. That would be some investment! 

AA has a hard time believing that the probability of this happening is significant enough to justify one-third of all exits as sponsor to sponsor deals.  

As an aside, through this transaction, one or both of the fund managers may be displaying reasons why they are likely not to be good stewards of your money.

1. If the first manager can't use traditional methods to enhance value but the second can, then an LP might wonder if it's particularly wise to be investing in the first manager's funds
2. If the second manager is wrong and can't generate additional PE-like returns, then he's probably not a wise choice for LPs.

Naturally suspicious folks like AA would want to know if there are reciprocal deals.  Fund managers are helping each other out "exit" less than ideal investments.  Fund Manager A sells “fine” investment #1 to Fund Manager B.  Fund Manager B sells “fine” investment #2 to Fund Manager A.  Each generates an IRR which allows them to sell future funds, to earn carried interest, quiet current investor unease at lack of exits. Hopefully, the purchased investment turns out to generate a decent return or can be buried among other returns if it’s not so decent. 

In other words, are GPs passing around less than stellar investments among themselves?  Investments that they cannot place with a trade buyer or IPO?  That the volume of inter sponsor transactions is at one-third of all "exits" suggests something is not right.  When one factors in the rise intra sponsor sales, the red flag gets even bigger.

Or is the explanation the need to use so-called “dry powder” (uninvested funds) now perhaps as much as some US$1.5 trillion? LPs can't be happy seeing their univested funds earning cash returns that likely don't even cover the 2% management fee.

Fund managers are merrily raising more money.  One might question why any additional money needs to be raised, other than to increase GP's management fees—which as you know or should are independent of fund performance.  I

Interested in more on the topic of “dry powder”?  Check out this article by Melissa Mittleman from Bloomberg.  

An ocean of money looking for investments is more likely than not to be on average an ocean of particularly dumb money.  Overpayment and poor underwriting choices will be the result.  Limited partners’ future returns will be diminished. 

But even if firms have discipline to avoid these mistakes, they will generate lower returns for their LPs because of the earnings drag on the overall portfolio from cash holdings.  

So here's another worry for LPs to add to worries about asset quality, lower returns for a long-term commitment.

Second, intra sponsor sales.

But all this pales when one considers the even more troubling intra-sponsor sales. A sponsor sells a “fine” asset from one of its own funds to another of its own funds.   This is a major red flag.  

As before, there are no doubt excellent reasons why this should be done sometimes, but the incidence of these “sometimes” is likely to be less than observed demonstrations of probity by the political class.  That would take this to much less than the 3% for sales of “fine” investments from one sponsor to another sponsor.  

I’ve mentioned before that we were once approached by a prominent PE firm pitching us on their new fund and touting the return on a predecessor fund.  A closer look at that fund disclosed that its return was almost all generated by a single deal.  A sale of a “fine” investment from that fund to another managed by the same GP.  We, of course, declined the opportunity to invest and struck that firm off our list of “serious” firms.  No further due diligence needed.  When you don’t trust the people, due diligence really isn’t needed at all.  

And finally a shout out to Chris’s first comment:   

“A well-known GP in our portfolio has been known to say that PE performance “isn’t a return until you can buy a beer with it.”

Quite!   

But if your GP is generating beer rather than champagne returns, you might consider interviewing additional fund managers.  "Beer and pretzels" is the lowest stage of FY money among investment bankers.