Zombie alert for buyout investors

By Megan Davies and Simon Meads

NEW YORK/LONDON (BestGrowthStock) – A legacy of underperforming and overleveraged deals has left many private equity firms struggling to raise fresh capital while their investors fret they are backing zombie funds limping along on still-lucrative management fees.

As many as half the firms slated to raise new funds over the next 12 months could fail to raise money, observers say, as cash-strapped investors reign in commitments, focus on top performers and funnel more of their investment pot into fast-growing economies in Asia and Latin America.

For the funds that fall below par, returning to investors cap in hand to raise another fund can be agonizing. The alternative is worrying for existing investors: if the management firm does not seek to raise capital for a new fund, it may have little incentive to impress investors by outperforming its peers.

“What is clear is that going forward the industry will be smaller because investors’ capital is lower,” said Steven Kaplan, a finance professor at the University of Chicago.

Investors poured money into the industry throughout the boom years, with funds raised reaching more than $650 billion in 2008, according to consultancy firm Preqin. That fell sharply in 2009 and 2010 with firms raising $230 billion in the four quarters to end-September.

That puts any fund without top performing returns at risk, investors say.

“If you are not a (top) performing fund or you are not focused on one of those high-growth markets where investors might give you another chance, (fund-raising is) not going to happen,” said Mounir Guen, CEO of MVision, which helps firms raise funds.

QUARTILE TRACKING

Investors will be picking through performance data with a fine-tooth comb.

“The bar is higher,” said an investor who declined to be named. “There’s a lot more scrutiny with current fund results.”

Established firms such as Kohlberg Kravis Roberts & Co (KKR.N: ) and Sweden’s EQT are expected to start fund-raising in the next 12 months, but that’s only the tip of the iceberg.

There should be some 1,600 funds worldwide expected to come to market over the next year, said Guen. About half will have a lot of difficulty raising any capital, he said.

Some funds that have question marks over their future fund-raising plans have specific issues other than performance.

For example, media-focused firm Quadrangle, co-founded by Steven Rattner, who was recently sued by New York’s attorney general, is not planning to raise a new fund right now, a source familiar with the matter told Reuters in November. That was not related to performance at the firm, the source said. The firm’s second fund is ranked in the second quartile by Preqin, according to two people who have seen Preqin’s numbers.

British firm Terra Firma (TERA.UL: ), however, has faced performance problems: its investment in music group EMI has not fared well and the firm’s founder recently lost a high profile court case. The firm’s Fund III, a 5.4 billion euro ($8.4 billion) fund, is in the fourth quartile according to Preqin’s numbers, although it still has about two years to invest its remaining fund.

Founder Guy Hands, speaking at a SuperInvestor conference in Paris in November, said: “We can invest the rest of our money well and we can look after the rest of the portfolio. If we do those two things well, we’ll raise another fund. If we do them badly, we won’t. It’s as simple as that.”

Elevation Partners’ head of investor relations jumped ship in September, raising questions about whether the U.S.-based buyout firm would be raising more cash in the near future. Elevation’s 2005 fund was in the fourth quartile at the time, based on Preqin’s numbers.

However, it has a lucrative stake in Facebook, meaning its ranking may rise and it could still come back to the market at some point. For more details [nLDE6871OW]

HARD CHOICE

Facing the stark reality that investors are not going to pony up more capital for another fund, the options for buyout firms are limited.

Some may become “quasi-captive”, MVision’s Guen said, shedding staff and becoming the in-house private equity arm of a sovereign wealth fund or large pension fund.

“It is going to take some time to know who is staying in the space and who will have to leave because it is a long-term game,” said Antoine Drean, chairman of Triago, a company that helps private equity firms raise capital.

British private equity firm Candover (CDI.L: ), which finally said in August it would wind itself up, held talks with Alberta Investment Management Corp earlier in the year about becoming its in-house buyouts division.

From the investor’s perspective, the hope is that struggling firms end the pain by selling their portfolio quickly, and distribute the proceeds.

The fear, however, is they will drag it out in order to collect lucrative management fees for years, leaving investors feeling like little more than ATM machines for posh offices and a skeleton staff.

“There are some horribly frustrating stories from an (investor’s) perspective,” said one investor. That person said there are cases when poorly performing funds can be run longer than needed by people which “just have the perverse incentive to milk the management fees as long as they can.”

“One would hope that moral obligation prevents someone from acting this way,” the person said.

(Editing by Phil Berlowitz)

Zombie alert for buyout investors