Even the most inveterate partygoers of the private equity (PE) world concede that the industry’s days of living high on the hog are behind it.
However, that hasn’t stopped firms – the latest being Los Angeles-based alternative asset manager Oaktree Capital and buy-out goliath Carlyle Group – trying their luck to convince new investors that PE remains a potent asset class in the initial public offering (IPO) market.
Despite weak performance from Blackstone Group (down more than 50% from its offer price in 2007), Fortress Investment (down more than 80% since 2007) and many others, Oaktree believed it could convince investors of its merits. Its April debut told a different story.
Oaktree traded poorly, even though the deal size was cut from 11.25 million shares to 8.84 million and pricing was at the bottom of the $43-$46 range to raise $380 million before the greenshoe.
After four trading days, Oaktree was down 7.67% against a 1.61% gain for the S&P 500 during the same period. Sources close to the deal said Oaktree – as a high beta-stock – was a victim of renewed concerns about the European debt crisis.
Unsurprisingly, Carlyle, which launched its IPO of 30.5 million shares at $23-$25 each, to raise $732 million, in mid-April (as Euromoney went to press), also believes it is offering something unique. Dan D’Aniello, founder and chairman, describes Carlyle as “a compelling public company investment with high prospects for growth”.
Moreover, D’Aniello notes that Carlyle is, by many measures, the largest and most diversified alternative asset manager in the world, with 1,300 professionals in 33 offices on six continents.
“We live and invest in both developed and developing markets and, in both, local market presence really matters in accessing opportunities,” he says. “We have over 1,400 investors and €147 billion in assets under management.”
Carlyle is large and diversified. Nevertheless, concerns about PE firms’ ability to deliver consistent returns in an environment starkly different to their pre-2008 heyday persist. Moreover, questions about why PE firms should be listed and how best to do so have yet to be convincingly answered.
The post-crisis financial environment has impacted many PE houses’ business models. “Before the 2008 crisis, firms generated huge returns but were leveraged to the hilt on bank debt,” says Chris Searle, corporate finance partner at corporate finance advisory firm BDO. “Returns have proved harder to generate in the absence of that debt and will continue to be for the foreseeable future.”
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| Ross Butler, LPEQ |
However, Ross Butler, a director at LPEQ, an industry association of listed PE companies, notes that PE has held up better than expected. “It has benefited from prevailing low interest rates,” he says. “And while restricted credit has been an issue, the level of reliance on leverage and financial engineering across the industry varies significantly. There is clear investor interest in gaining exposure to the profit streams created by PE.” Institutional investors have always been able to invest directly in PE funds, so why consider listed firms? “Listing gives institutional investors a potentially more attractive [and liquid] way to gain exposure to PE,” says Butler.
The shift to defined contribution pension schemes, which require a daily share price, and changes in regulation, such as the Pensions Fund Directive and Solvency II, mean that PE vehicles with 10-year lock-ups, for example, could end up with punitive risk weightings. “The obvious alternative is to gain PE exposure through a listed share that attracts a lower risk weighting,” says Butler.
A distinction must be made between listed PE funds, which offer a stake in a portfolio, and listed PE management companies, such as Carlyle. “Big firms list their management companies, which derive fee income from managing their funds,” says Butler. “There is a link with the PE assets’ performance but the exposure is different and could be subject to other factors. Performance fees can be quite volatile.”
Listing a PE management company rather than a fund creates challenges. Firstly, valuation is tricky. Historically, PE management companies have been valued like other asset managers as around 1%-1.5% of funds under management. Consequently, there’s potential for a disconnect between the share price and portfolio value, according to Searle at BDO.
“An additional problem is valuing assets under management, given that these can be extremely illiquid,” he says.
Secondly, the paramount problem in a PE management company listing comes from understanding the rationale for such a move. “It is difficult to see a motivation for listing a private equity management company other than to provide an exit for partners,” says Searle. “Carlyle has said partners will not sell shares in the IPO but its founders must be close to retirement and the ability to cash out easily is undoubtedly an incentive to list.”
Given that PE companies’ success is usually based on the founders’ prowess, investors can be forgiven for worrying about what they are buying. Moreover, the reputation of PE firms for selling their investments at the most opportune time inevitably gives rise to fears that the smart money is selling out. Furthermore, partners usually continue to hold a controlling stake post-IPO, giving shareholders little say in how the enterprise is run.
No one doubts that PE – regardless of curtailed access to bank or bond debt – has a role to play in the post-crisis landscape. However, it seems the market has yet to decide how to value that role.
“Methods for valuing private equity firms’ management companies are still in their infancy,” says Butler. “Like any new asset class, it takes time to build up trust among investors.”