Friday Letter: Call me

This week PEI was talking to a managing partner of a private equity group based in one of the world’s key growth markets. Like many they had raised a sizeable first fund pre-Lehman and then set about deploying it at pace. Hindsight would say this was their undoing: paying too much for companies that promised plenty but turned out delivering far less as world markets slowed.

Hindsight would also say that it is at this point that a GP has to show its mettle: working with management teams at portfolio companies to deal with the challenges they face. Restructuring, reshaping and, yes, writing off. The end result for this particular fund manager was a downsized portfolio of stressed-tested businesses that had learnt a great deal – but which hadn’t grown top or bottom lines as their owner would have liked.

Today the managing partner has a new thing on his mind: raising a second fund and – no surprise – this has been proving difficult. Besides the reservations many LPs now have about growth markets, it’s the absence of returns that damns many local GPs returning to the fundraising trail.

Remedying this is not impossible but two of the key exit routes remain as yet unreliable in many of these economies: public markets remain sticky with IPO windows opening and closing rapidly, whilst selling to trade remains a protracted process, with many such buyers preferring to follow rather than lead.

Which brings us to the third exit route: selling to another private equity group. Mention such secondary sales to LPs and they often pull a face, wondering how such an acquisition can deliver the growth and hence the returns they are expecting. Won’t the exiting GP have pushed the business as hard and as far as it can go? And isn’t part of the upside created by buying from a vendor for whom maximising return is of secondary importance? When’s a selling GP going to accept that?

When they are looking to raise a new fund perhaps.

Our managing partner agreed that realising some exits was going to be vital if his fundraise was not going to stall. But he then also pointed out that there were other factors shaping secondary transactions today that made the thesis far more compelling for all concerned.

2014 saw another sizeable influx of fresh capital arriving ($370 billion globally), with LPs celebrating the record distributions being made by the international private equity groups in particular by allocating huge amounts anew to the asset class. And it’s those global GPs who have been the prime beneficiaries. A related factor is the low interest rate environment that has not only encouraged investors to allocate to alternative asset classes but also has enabled GPs to make less aggressively geared acquisitions.

Next there is the undeniable point that it often takes local knowledge to successfully invest private equity in growth markets. The fly-in-fly-out model attempted by some non-domestic GPs rarely works and even building a local team can be a fraught as well as lengthy process.

Which is where our managing partner can see an opportunity. If he can sell a portfolio company run by a management team accustomed to the protocols of private equity ownership and now ready to take their business to the next level (which can often mean expanding beyond their local market), then surely one of the international GP groups would be interested? The heavy lifting of sourcing the company and developing the internal controls and processes required will have been done. And the acquiring GP will be prepared to pay a fuller price given the reduced gearing they need to apply to hit their exit valuation model.

“I get an exit at a decent price and they get a well-run business in a growth market without all of the hassle.” The managing partner clearly wanted to describe this as a win-win scenario but instead paused: “In private equity you can’t keep hold of a business until everything is aligned. You aren’t going to return anything without an exit.”

Global GP groups freshly freighted with new capital should give him a call.