Keeping LPs happy: Its a whole new ballgame for private equity

Timely topics in private equity Issue 5

About the author

About the sponsors

Jack DiFranco National Managing Principal, Private Equity Grant Thornton LLP Jack DiFranco is the national managing principal for Grant Thorntons Private Equity Services. He also served as national managing principal for Grant Thorntons Transaction Services Group as well as Grant Thornton Corporate Finance LLC. Jack has assisted clients with business acquisitions, divestitures, recapitalizations, management buyouts, and financing transactions for senior debt, subordinated debt and equity. He specializes in providing M&A advisory services to clients in a variety of manufacturing and service industries. In addition, he has helped companies and their shareholders identify and evaluate their strategic and financial options for increasing shareholder value. Prior to joining Grant Thornton, Jack was a managing director in the Investment Banking Group of Stout Risius Ross, Inc. Preceding his experience with SRR, Jack was a member of the investment banking groups at First of Michigan Corporation and Ernst & Young Corporate Finance LLP. In these positions, he provided M&A, financing and transaction advisory services to corporate acquirers, private equity firms and middle-market companies and their shareholders. Jack has served companies in many industries, including automotive, building products, information technology services, industrial equipment, health care, business services, software, distribution, television and radio, education, insurance, retail, and food processing. Jack earned an MBA in finance and corporate strategy from the University of Michigan and a bachelors degree in finance from Oakland University.

The people in the independent firms of Grant Thornton International Ltd provide personalized attention and the highest quality service to public and private clients in more than 100 countries. Grant Thornton LLP is the U.S. member firm of Grant Thornton International Ltd, one of the six global audit, tax and advisory organizations. Grant Thornton International Ltd and its member firms are not a worldwide partnership, as each member firm is a separate and distinct legal entity. Our vision is to be a firm comprising empowered people providing bold leadership and distinctive client service worldwide. As such, Grant Thornton understands the unique needs and strategies of private equity firms and their professionals. Throughout the life cycle of a fund, we deliver timely value through our audit, tax and other advisory services. Visit Grant Thornton LLP at www.GrantThornton.com.

The Association for Corporate Growth (ACG) is the global community for mergers and acquisitions and corporate growth professionals, helping connect capital with opportunity. ACG provides its members with the research, tools and networking opportunities to grow their businesses and themselves professionally. Founded in 1954, ACG has grown to more than 13,000 members from corporations, and private equity, finance and professional service firms representing Fortune 1000, FTSE 100, and mid-market companies in 56 chapters in North America, Europe and Asia. For more information, visit www.acg.org.

Introduction

To say the last few years in the M&A business have been a roller-coaster ride is an understatement. I know that many of my peers who have been in the business for 20-plus years agree. At the beginning of 2011, we were eager to start the new year and looking forward to a more stable deal-making environment. That said, while transaction market conditions continuously improved during 2010, 2011 has brought on a whole new set of challenges for private equity professionals. Many private equity firms deferred fundraising until market conditions improved. With the slight recovery we have seen, private equity firms were expected to flood the market looking for capital this year. However, with limited partners (LPs) remaining somewhat cautious about investing, many private equity firms are faced with the prospect of not being able to raise a new fund in 2011 or, for some, ever again. Needless to say, the implications of this could be widespread. New regulatory requirements that go into effect in July for private equity firms will also change the landscape. This white paper explores the current fundraising climate, what LPs expect from private equity partnerships going forward, and how regulatory issues will affect private equity firms and the industry in the future. To explore these issues, we spoke with professionals who focus on various elements of the private equity industry. These specialists include LPs, general partners (GPs), regulatory professionals and fund managers. In addition, Grant Thornton LLP searched many data points, including those from PitchBook Data Inc. (PitchBook), Dealogic, Standard & Poors, and Probitas Partners. Through these sources and original reporting Grant Thornton provides readers with the context of the current fundraising and regulatory environment. In addition, we offer a candid view of what LPs can expect going forward and whats on the horizon. In order to preserve confidentiality, we have withheld the names of LPs who agreed to talk with us off the record. This white paper will give readers a better understanding of how new developments may change the industry and how private equity firms can meet the increasing expectations of LPs in the context of the current economic and deal environment.

Contents 1 Introduction 2 Fund performance and the economic environment 5 The regulatory environment 7 Alignment of interest 10 Firms that perform 11 Potential solutions Infrastructure, operational enhancements, transparency and better reporting Industry specialization Alternative investment strategies Value creation 16 Concluding thoughts

With limited partners (LPs) remaining somewhat cautious about investing, many private equity firms are faced with the prospect of not being able to raise a new fund in 2011 or, for some, ever again.
Keeping LPs happy: Its a whole new ballgame for private equity 1

Fund performance and the economic environment

After emerging from one of the most difficult economic environments in history, most private equity professionals had started to feel a little more confident by the middle of 2010 and were looking forward to 2011 and rightfully so. Companies that had held out on selling started to creep back into the market in 2010, and by the end of last year, deal volume had picked up significantly. In 2010, private equity deal volume reached $195.7 billion globally, up 53 percent over 2009s total of $105 billion. The fourth quarter alone saw $57.8 billion worth of private equity deals get completed, according to Dealogic. Whats more, investment banks saw $9.9 billion worth of revenues come from advisory work on behalf of financial sponsors, according to Dealogic. That was more than twice the $4.4 billion generated in 2009. The data leaves no question that private equity activity began rebounding in 2010. Thats the good news. However, regulatory changes and difficulty raising new funds are two obstacles facing dealmakers today.

After aggressively putting money to work during the 2004 through 2007 period, private equity firms that raised capital during that same period now need to raise new funds. According to PitchBook, private equity funds globally raised only $148 billion in 2009, 54 percent less than they did in 2008. 2010 wasnt great either; only $90 billion of capital was raised during the year (see Figure 1). Funds that would normally have raised capital in 2009 and 2010 postponed fundraising in hopes of launching new funds in more favorable market conditions. Now that dealmakers are seeing a marked improvement, 2011 is expected to be a crowded fundraising market. In fact, globally there are about 700 private equity and venture capital funds either already in the market or expected to be in the market to raise funds during 2011. They are all competing for the same dollars to be doled out by LPs.

Figure 1 Private equity fundraising by year

Number of funds closed 300 Capital raised ($B) Number of funds closed Capital raised $ in billions $350 $300 $250 $200 150 $150 100 $100 $50 0

250

Companies that had held out on selling started to creep back into the market in 2010, and by the end of last year, deal volume had picked up significantly.

200

50

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: PitchBook Data Inc.

2 Keeping LPs happy: Its a whole new ballgame for private equity

With all the pent-up demand for new capital, private equity firms are finding that LPs are firmly in control these days; LPs arent quickly forgetting the challenges that arose during the 20052007 time period that left them less than enthusiastic about private equity firms for most of 2009 and 2010. As a result of private equity firms being able to raise a record amount of capital and the wide-open leverage markets, many firms paid aggressively for the companies they purchased. As expected (with the benefit of hindsight), this is already negatively affecting returns. Private equity vintage funds from 2007, for example, are showing an average internal rate of return (IRR) of negative 14 percent. Mezzanine funds from the same year are showing an average IRR of negative 32 percent (see Figure 2).
Figure 2 Average internal rate of return for U.S.-based funds
PE Mezzanine

Its not all bad news, though. In fact, LPs sentiments toward private equity are actually becoming more positive than they have been in recent years, especially toward middle-market funds. According to a survey conducted by Probitas Partners at the end of 2010, Private Equity Market Review and Institutional Investor Trends Survey for 2011, 46 percent of respondents plan to focus their attention in 2011 on investing in middle-market ($500 million to $2.5 billion) buyout funds (see Figure 3).
Figure 3 Private equity sectors of interest During 2011, I plan to focus most of my attention on investing in the following sectors: (choose no more than five)
U.S. middle-market buyouts ($500 MM-$2.5 B) Growth capital funds U.S. small-market buyouts (<$500 MM) European middle-market buyouts (country-focused) Asian country-focused funds Distressesd debt funds European middle-market buyouts (Pan European) Pan-Asian funds Energy funds Restructuring funds Mezzanine/credit-focused funds U.S. venture capital Infrastructure funds Secondary funds Emerging markets (ex-Asia) Cleantech/green-focused funds Other niche sectors U.S. large buyouts ($2.5-$5 B) Fund-of-funds Mega buyout funds (>$5 B) Timber funds European/Israeli venture capital Source: Probitas Partners Keeping LPs happy: Its a whole new ballgame for private equity 3 46 39 37 33 30 27 25 22 19 19 18 17 15 13 13 11 9 9 8 5 4 2

Internal rate of return 25% 20% 15% 10% 5% 0 -5% -10% -15% -20% -25% -30% -35% 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Vintage Source: Pitchbook Data Inc.

Its not surprising that LPs have pulled back on their allocations, as evidenced by the already changed fundraising environment. For example, in 2007, The Blackstone Group raised a $21.7 billion fund, the largest private equity fund ever raised. But its latest fund, Blackstone Capital Partners VI, held a final close of just $13.5 billion in July 2010. Madison Dearborn Partners set out to raise a $10 billion fund in 2008. After 28 months, the firm closed on roughly $4.1 billion, far below its revised target of $7.5 billion set in the summer of 2008.

However, the number of private equity firms that are able to raise capital will likely diminish overall, and there will be a divide between firms that can raise new funds and those that cant. Fundraising will be subjective based on the GP. There will be a growing divide between the haves and havenots. Fundraising will be very easy for some because they have had spectacular track records and a loyal LP base. These firms wont have to make huge concessions either, says Erik Hirsch, chief investment officer for investment adviser and funds-of-funds manager Hamilton Lane, whose clients include MassPRIM, the state of Washington and the United Brotherhood of Carpenters. Then theres another group for which none of this is true. These firms are having serious problems, which will eventually lead to a weeding out in the market. Its important to note that even the firms that cant raise new funds will not go away immediately we wont see the wind-down of those funds for another five years. Its a slow death, warns Kelly DePonte, a senior professional with placement agent Probitas Partners. In the venture capital industry you saw a ton of funds raised in 1999 and 2000 that didnt finally decide to wind down until 2007 or later. I think about 10 percent to 15 percent of private equity firms may disappear, but it will happen slowly.

If a private equity firm raised its most recent fund in 2006, it should be raising its next fund in 2011. Even if a firm cant raise a new fund for three years and isnt making new investments, it will still be managing some portfolio companies bought with its previous fund. It wont be until 2014 or 2015 that these private equity firms will finally cease operations. As an aside, with fewer firms in business and the size of some firms potentially smaller, it only stands to reason that there will be a decrease in investment professionals headcount over time as well. We are expecting fewer professionals to staff the firms, but this isnt necessarily a bad thing. It will help bring down administrative costs associated with being a larger fund which the LPs ultimately pay for, says one LP, referring to the fees they pay private equity firms to manage their assets.

Its important to note that even the firms that cant raise new funds will not go away immediately we wont see the wind-down of those funds for another five years.

4 Keeping LPs happy: Its a whole new ballgame for private equity

The regulatory environment

In addition to dealing with a more difficult fundraising environment, private equity firms must meet the requirements of the Private Fund Investment Advisers Registration Act, which was signed into law on July 21, 2010, as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). The new legislation requires advisers of private equity and hedge funds with more than $150 million of assets under management to register with the SEC by July 21, 2011, which is quickly approaching. (Venture capital funds were given a pass.) The Dodd-Frank Act was put in place to promote the financial stability of the United States by improving accountability and increasing transparency in the financial system. While the largest private equity firms will most likely face greater scrutiny from the SEC, all firms that will be required to register with the SEC should do so and prepare themselves now for SEC inspections. Every registered firm is required to appoint a chief compliance officer (CCO) to maintain the firms books and records, which will be subject to SEC examination as the agency sees fit. Private equity firms will need to have a formal compliance policy, in addition to keeping track of their assets under management, use of leverage, counterparty credit risk exposure, trading and investment positions, valuation policies and practices, types of assets held, side arrangements with LPs, and trading practices, if applicable.

Additionally, there is a required change in sales materials, and more disclosures from private equity firms will be needed. As part of registration, Form ADV Parts 1 and 2 must be filed. We are finding that many private equity firms dont have these things in place, says Steven Goldberg, a principal in Grant Thorntons Business Advisory Services practice. However, as partners came back from the holiday at the beginning of January, they started realizing that they have to take this seriously. We are now getting more and more calls about registering, every day. Some experts estimate the cost associated with registering to be about $250,000 for a smaller firm; however, costs can vary widely depending on how in-depth a firm gets with its registration and how prepared it is when beginning the process. Appointing a CCO is the first step toward satisfying the requirements set forth by the SEC. The CCO can be a fulltime person or someone who is outsourced the cost is expected to be roughly the same regardless of which route a firm takes. The CCO should not be one of the firms partners. It shouldnt be someone who gets paid off the proceeds of the firms investments. That creates a conflict, warns Goldberg. The CCO should be someone who is knowledgeable, competent, empowered by the firm and up to speed on registration requirements.

While the largest private equity firms will most likely face greater scrutiny from the SEC, all firms that will be required to register with the SEC should do so and prepare themselves now for SEC inspections.

Keeping LPs happy: Its a whole new ballgame for private equity 5

Next, the CCO has to have the firm ready for SEC inspection, which is a periodic examination of the firms books and records. The ADV forms are where the initial process really begins. Filling out the first part of the ADV form is easy. It requires general information such as ownership and control, regulatory, disciplinary history, and balance sheet information, along with additional information about the business. The second part is more complex. Private equity firms are required to create a narrative brochure that provides information such as affiliations, conflicts, fees charged, investment strategies, and specifics on the advisers past performance and services. This material needs to be updated annually and delivered to current and potential clients. A lot of firms think the process ends with their newly appointed CCO filling out the ADV form. But thats where the process really begins. The information in the form needs to be accurate, and firms have to live by the information they put in there. Inaccurate, misleading or omitted disclosures could lead to regulatory action, which will not look good on a firms track record, says Michael Patanella, an Audit partner in Grant Thorntons Financial Services practice.

Because there will be several thousand new funds registering, observers are speculating that the SEC will not get to every firm immediately. The SEC will probably look at the larger funds first and the funds with troubled assets or ones that have had regulatory issues in the past, says Goldberg. But that doesnt mean a squeaky-clean smaller firm shouldnt be ready because the SEC could just as easily inspect those firms too. In fact, to deal with the influx of new registrants, the SEC recently asked Congress to form a separate organization that can examine the private equity firms and hedge funds registering. While how the SEC plans to deal with all the new registrants is not yet sorted out, private equity firms that comply early on will be in better standing in the long run, not just with the SEC, but with LPs as well. I dont want to say that a blemish on a private equity firms record with the SEC will cause the firm to close its doors, but it would certainly be looked at negatively by the LPs and could certainly slow money from coming into a fund, says Patanella.

While how the SEC plans to deal with all the new registrants is not yet sorted out, private equity firms that comply early on will be in better standing in the long run, not just with the SEC, but with LPs as well.

6 Keeping LPs happy: Its a whole new ballgame for private equity

Alignment of interest

These three words have been thrown into the private equity discussion for the past several years. And while many believe those words are overused, LPs still care very much about alignment. Alignment of interest really comes down to a feeling that all parties are sharing the risks and benefits of the relationship in a fair and appropriate way. Many LPs believe that GPs gained too much power over them during the boom years, and now they are trying to take back some power and are making their demands clear. At the heart of the issue is fee structure. When raising very large funds, private equity firms were able to charge significant fees to manage LP assets, and the fees were not based on return on investment. Granted, the problem had a greater effect on the larger private equity firms because they generated higherdollar fees, but middle-market firms are coming under scrutiny as well. During the last couple of years, LPs felt their alignment with GPs was out of whack. To deal with the alignment issues, in September 2009 the Institutional Limited Partners Association (ILPA) put out Private Equity Principles, a set of best practices for private equity firms to follow (see page 9). More than 100 LPs have endorsed the principles, which were revised in January 2011 and fall within three guiding tenets: governance, transparency and alignment of interest.1 The goal of the principles is to make sure that the GPs interests are aligned with those of the LPs.

LPs are monitoring their portfolios closely, and so the Private Equity Principles were published in an effort to restore the alignment of interest between GPs and LPs that existed in the original private equity model. When there is more emphasis on carry and less on fees, both LPs and GPs share in the upside of the value added to portfolio companies. says Kathy Jeramaz-Larson, executive director of the ILPA. Its important for the GPs to understand what is important to the LPs as they enter into fundraising. Indeed, according to a survey conducted by Probitas Partners at the end of 2009, 47 percent of LPs believed the management and transaction fees on large funds were destroying the alignment of interest between fund managers and investors, and last year 39 percent still said that these same factors were destroying the alignment of interest between GPs and LPs. Whats more, LPs are focusing more heavily on fund structures, with 53 percent of them saying they are spending more time focusing on the GPs level of financial commitment to the fund.

When raising very large funds, private equity firms were able to charge significant fees to manage LP assets, and the fees were not based on return on investment.
1

Institutional Limited Partners Association, Private Equity Principles, Version 2.0, January 2011

Keeping LPs happy: Its a whole new ballgame for private equity 7

GPs are listening. At the end of January, Kohlberg Kravis Roberts & Co. (KKR) made headlines as it prepared to raise its newest fund, KKR North American XI Fund LP, which is targeted to raise $8 billion to $10 billion. Its most recent fund, which brought in $17.6 billion, was raised in 2006. What is most newsworthy about the firms new fundraising effort is that KKR is offering potential investors concessions to invest. According to The Wall Street Journal, [f]or the first time, KKR is giving investors the choice between a lower management fee and [a] more favorable split on fees charged to the portfolio companies that the buyout firm purchases, including transaction and monitoring fees. The firms predecessor vehicle gave 80 percent of fees charged to portfolio companies to investors, while 20 percent went to KKR itself. Now LPs can opt to receive 100 percent of the fees but must pay a higher management fee, or they can stick with an 80-20 split without an increase in management fees.2 KKR will also include a 7 percent preferred return hurdle before the GP receives any of its share of investment profits, which is something LPs have been pushing for. Still, according to most GPs, the ILPA principles have been a good starting ground for LPs and GPs to engage in dialogue about the alignment issue. And with increased ability to influence fund terms, LPs are increasingly identifying issues that are most important to them, often using those terms as the final filter when choosing among potential opportunities.

Investors are really worried about the alignment of interest, says Probitas Partners DePonte. The large fees have really messed things up. To go to the heart of the matter, GPs can make money even if LPs cant, and it ticks LPs off. Unless your returns have been spectacular, which now about 5 percent of firms can probably claim, LPs are asking for fee reductions and better alignment. Lots of private equity firms have started listening. Many of them have revisited their fee structure, with some even opting to cut their fees to entice LPs to continue investing with them. It is important for private equity firms to listen to what the LPs are asking for and be ready to address management fees as appropriate. The ILPA guidelines are a good starting point for discussion, but in all of our interviews, we never came across any private equity firm that was willing to adopt all of the principles. Unfortunately, because there are about 100 principles, it seems many private equity firms cant endorse them 100 percent. As one GP puts it: If you ask 10 LPs to rank the three principles they care most about, they all say different things, which makes it hard to please all of them and makes the principles seem less important. Also, a GP may comply with 90 percent of the principles, but its the other 10 percent they dont comply with that one LP cares about. The guidelines are a starting point for open and honest conversation and need to be treated as such.

It is important for private equity firms to listen to what the LPs are asking for and be ready to address management fees as appropriate.

Willmer, Sabrina and Dai, Shasha, KKR Sweetens Terms for New Mega Fund, The Wall Street Journal, Jan. 29, 2011

8 Keeping LPs happy: Its a whole new ballgame for private equity

ILPA principles
The list of principles initially published by the ILPA in September 2009 and updated in January 2011 is very comprehensive and includes nearly 100 items. Below is a select list of principles:

Calculation of carried interest Alignment is improved when carried interest is calculated on the basis of net profits (not gross profits) and on an after-tax basis (i.e., foreign or other taxes imposed on the fund are not treated as distributions to the partners). No carry should be taken on current income or recapitalizations until the full amount of invested capital is realized on the investment. Clawbacks Clawbacks should be created so that when they are required, they are fully repaid in a timely manner. The clawback period must extend beyond the term of the fund, including liquidation and any provision for LP giveback of distributions. Management fees and expenses Management fees should be based on reasonable operating expenses and reasonable salaries, as excessive fees create misalignment of interests. During the formation of a new fund, the GP should provide prospective LPs with a fee model to be used as a guide to analyze and set management fees. Management fees should take into account the lower levels of expenses generally incident to the formation of a follow-on fund, at the end of the investment period, or if a funds term is extended. Expenses The management fee should encompass all normal operations of a GP to include, at a minimum, overhead, staff compensation, travel, deal sourcing and other general administrative items as well as interactions with LPs. The economic arrangement of the GP and its placement agents should be fully disclosed as part of the due diligence materials provided to prospective LPs. Placement agent fees are often required by law to be an expense borne entirely by the GP. Term of fund Fund extensions should be permitted in one-year increments only and be approved by a majority of the limited partner advisory committee (LPAC) or LPs. Absent LP consent, the GP must fully liquidate the fund within a one-year period following expiration of the fund term.

GP fee income offsets Transaction, monitoring, directory, advisory [and] exit fees and other considerations charged by the GP should accrue to the benefit of the fund. GP commitment The GP should have a substantial equity interest in the fund, and it should be contributed in cash as opposed to being contributed through the waiver of management fees. GPs should be restricted from transferring their real or economic interest in the GP in order to ensure continuing alignment with the LPs. The GP should not be allowed to co-invest in select underlying deals; rather, its whole equity interest shall be via a pooled fund vehicle. Team The investment team is a critical consideration in making a commitment to a fund. Accordingly, any significant change in that team should allow LPs to reconsider and reaffirm positively their decision to commit. Investment strategy The funds strategy must be well-defined and consistent. The investment purpose clause should clearly and narrowly outline the investment strategy. Any authority to invest in debt instruments, publicly traded securities, and pooled investment vehicles should be explicitly included in the [agreed-upon] strategy for the fund. Fiduciary duty GPs should present all conflicts to the LPAC for review and seek prior approval for any conflicts and/or non-arms-length interactions or transactions. A majority of LPs must be able to remove the GP or terminate the fund for cause. Changes to the fund Given the long-term nature of the private equity partnership, the funds terms and governance must be well-defined upfront but also be flexible enough to adapt to changing circumstances. With appropriate protections for the interests of the GP, LPs should have the option to suspend or terminate the fund.

Management and other fees All fees generated by the GP should be periodically and individually disclosed and classified in each audited financial report and with each capital call and distribution notice. All fees charged to the fund or any portfolio company by an affiliate of the GP should also be disclosed and classified in each audited financial report. Capital calls and distribution notices Capital calls and distributions should provide information consistent with the ILPA Standardized Reporting Format. The GP should also provide estimates of quarterly projections on capital calls and distributions. FINANCIAL INFORMATION Annual reports Funds should provide information consistent with the ILPA Standardized Reporting for Portfolio Companies and Fund information at the end of each year (within 90 days of year-end) to investors. Quarterly reports Funds should provide information consistent with the ILPA Standardized Reporting for Portfolio Companies and Fund information at the end of each quarter (within 45 days of the end of the quarter) to investors. Portfolio company reports A fund should provide a quarterly report on each portfolio company with the following information: Amount initially invested in the portfolio company (including loans and guarantees) Any amounts invested in the portfolio company in follow-on transactions A discussion by the fund manager of recent key events in respect of the portfolio company Selected financial information (quarterly and annually) regarding the portfolio company, including: - valuation (along with a discussion of the methodology of valuation), - revenue (debt terms and maturity), - EBITDA, - profit and loss, - cash position, and - cash burn rate.

Source: Institutional Limited Partners Association

Keeping LPs happy: Its a whole new ballgame for private equity 9

Firms that perform

First and foremost, the private equity firms that have performed well and have a stellar track record will be able to garner attention from their LPs. Top-quartile firms such as TPG Capital, Leonard Green & Partners, and WL Ross will most likely have an easier go at fundraising (see Figure 4). According to a recent Probitas Partners survey, investors are likely to commit slightly more to private equity in 2011 than they did in 2010, but the appetite for new managers is limited; most investors are focused on reviewing current relationships with strong GPs and renewing with only a select few. Coming out of the recession, LPs have realized they simply do not have the time or capacity to monitor an extensive number of GP relationships, so they are placing greater focus on the relationships they value.
Figure 4 Internal rate of return by year 2006 2010 Fund name Walnut Investment Partners I T3 Partners II GCP California Fund Information Technology Ventures WLR Recovery Fund II Providence Equity Partners Permira Europe I Clessidra Capital Partners Fund Platinum Equity Capital Partners DLJ Merchant Banking Partners I Carlyle/Riverstone Global Energy and Power Fund II Carlyle/Riverstone Global Energy and Power Fund II OCM/GFI Power Opportunities Fund II Advent Global Private Equity IV Advent Global Private Equity V First Reserve Fund IX Lincolnshire Equity Fund III OCM Opportunities Fund IVb Source: Pitchbook Data Inc.
10 Keeping LPs happy: Its a whole new ballgame for private equity

A lot of LPs came out of the downturn realizing they have too many fund relationships. They are asking themselves, Do I really need six firms with the same strategy in my portfolio? At the core of the issue is LPs taking a hard look at which firms with good track records are additive. Its not about simply being different, but being different and being able to perform, says Hamilton Lanes Hirsch. Lori Campana, a managing director with fund placement agent Monument Group, agrees. Fundraising is a challenge, but it is improving. LPs are making commitments, but much more selectively. They are only reupping with their best managers and ones that add something really compelling to the mix, like a regional or sector focus, for example, she says.

Investor name The Walnut Group TPG Capital Leonard Green & Partners Information Technology Ventures W.L. Ross & Co Providence Equity Partners Permira Clessidra Capital Partners Platinum Equity DLJ Merchant Banking Partners Riverstone Holdings The Carlyle Group GFI Energy Ventures Advent International Advent International First Reserve Lincolnshire Management Oaktree Capital Management

Vintage 2000 2001 2001 1995 2002 1996 1996 2005 2004 1992 2004 2004 2005 2002 2005 2001 2005 2002

Close date 02-Jan-04 02-Jan-05 02-Jan-05 02-Jan-99 02-Jan-06 02-Jan-00 02-Jan-00 02-Jan-09 02-Jan-08 02-Jan-96 02-Jan-08 02-Jan-08 02-Aug-09 11-Jan-06 26-Apr-09 02-Jan-05 02-Jan-09 02-Jan-06

Fund size ($M) 105.00 378.00 50.00 75.00 400.00 363.00 890.00 1,100.00 700.00 1,000.00 1,100.00 1,100.00 1,020.00 1,768.69 3,235.79 1,375.00 433.00 1,340.00

IRR 120.66% 95.40% 91.00% 89.71% 79.30% 78.50% 74.50% 63.70% 60.59% 58.10% 55.80% 55.14% 55.03% 52.30% 50.80% 48.10% 47.16% 46.50%

Potential solutions

So what will it take to attract new investment and keep LPs happy? Well, not all LPs needs and expectations are alike. Certainly investors will have their own specific combination of concerns and expectations. That said, some common themes and approaches will resonate with most LPs. As previously discussed, better alignment of interest (including addressing concerns about management fees) will be important. In addition, improving infrastructure and operations to reduce costs and heighten transparency will become an area of focus. Differentiation through industry specialization and alternative investment strategies is gaining momentum. And finally, enhancing performance through a more proactive approach to value creation will be required to produce attractive returns in a very competitive marketplace.

Infrastructure, operational enhancements, transparency and better reporting

Better infrastructure and operational enhancements as well as more transparency and faster financial reporting will be key differentiators for private equity firms. Believe it or not, registering with the SEC can be beneficial. While registration may take some time, it will help firms keep better track of their information and in turn help them disseminate it to LPs faster. Firms that register will be more attractive to investors because LPs will be able to invest in them with more confidence, says Grant Thorntons Goldberg. Additionally, outsourcing the CCO function could be an advantage in the long run. As Patanella points out, it takes the possibility of any conflicts out of the equation, which is a positive for the private equity firms. Theres sometimes a negative connotation when firms do their own books. Firms are not thrilled about paying outside administrators to handle this function, but then theres less of a concern of management manipulation of transactions and misappropriate of assets, says Patanella. That said, while many LPs look at the new registration guidelines as bogus because the SEC does not have the resources to enforce them, as a practical matter, registration can add more structure to private equity firms, which they, especially smaller firms, are lacking, says DePonte. DePonte goes on to point out that LPs dont really care about infrastructure per se. They care about getting their hands on data regarding their investments. I am not hearing a lot of LPs saying they want to see more infrastructure, but they are saying they want faster access to information, he says.

While registration (with the SEC) may take some time, it will help firms keep better track of their information and in turn help them disseminate it to LPs faster.
Keeping LPs happy: Its a whole new ballgame for private equity 11

Hamilton Lanes Hirsch agrees. LPs are making a greater push for operational enhancements, he says. LPs are under pressure from their pensioners to know more about how their money is being invested, especially if theres any type of irregularity in the market. Illiquid assets like private equity assets add extra concern. From there, the pressure trickles down. LPs then turn to fund management, demanding accurate information in a timely manner. LPs are under pressure to let their investors know where their assets are and what their exposure is. Right now there is a gap between private equity firms that get this done in an acceptable time frame and those that lag four weeks with the excuse that they dont have a CFO or a back office. LPs are absolutely going to make a distinction and will penalize firms that cant produce this information when it is requested, says Hirsch. For example, before Monument Group allows any of its private equity clients to present funds to LPs, it insists that GPs be prepared to demonstrate their firms infrastructure strength. LPs notice it, comment on it, and are more and more interested in hearing about it, says Campana. We have our GPs talk very specifically about their back office initiatives and how they help the firm better manage its portfolio companies. The next thing LPs want to know is how that translates into returns. Sometimes thats hard to answer. Some value additions can actually cost money, but GPs should then be able to demonstrate how having better reporting technology or providing more purchasing power to the portfolio companies has turned into more sales leads or greater demand.

The bottom line is that a private equity firms job is twofold to be a good investor and a good fund manager.

There are companies that can help private equity firms organize their financial information. In 2005, John Grabski founded ClearMomentum, a software firm that provides financial reporting and analysis tools to private equity firms so that they can better manage their portfolio companies. Grabski, CEO of the company, says its incredible how much demand for his product, ClearFinancials, has grown during the last couple of years. With macrodrivers like the Dodd-Frank Act and the push for more transparency, there is a lot of interest in our solution, says Grabski. The more transparency there is in the industry, the less risk there is in investing in the industry. This will drive more money into the industry. ClearFinancials will typically shorten the average reporting cycle by 25 days, which means private equity firms learn about problems at the portfolio level sooner and can address them quicker. It also allows private equity firms to report information about fund performance to their LPs faster and in a uniform style. The bottom line is that a private equity firms job is twofold to be a good investor and a good fund manager. Being a good fund manager is something most LPs feel GPs have lacked in the past. Being a good fund manager requires private equity firms to have best practices in place concerning infrastructure, reporting and cost. The big guys are good at this because they have been under pressure to disclose more. More firms need to hire CFOs, invest more in their firm and give LPs timely information thats usable, says Hirsch. Going forward, having infrastructure in place will be a requirement to play the game. An LP wont even look at you if you dont have it in place.

12 Keeping LPs happy: Its a whole new ballgame for private equity

Industry specialization

Going forward, attracting LP investors will require more differentiation. Industry specialization will endear private equity firms to LPs, but as Hirsch says, the firms offering has to be additive, not just different for the sake of being different. That being the case, over the past five years theres been a push toward private equity firms becoming more specialized. In fact, according to a Probitas Partners survey, 49 percent of respondents find middle-market funds focused on operational improvements and heavily staffed by professionals with operating backgrounds to be the most attractive funds to invest in. Firms used to be able to use financial engineering and increase the leverage at a portfolio company, but with less leverage available this strategy is less likely to be successful. The only thing that consistently generates value is increasing the earnings of a portfolio company. The best strategy to increase earnings is to make positive changes within the portfolio company. You have to have experienced people onboard making that happen, says DePonte. Successful private equity firms have begun adding areas of specialization to their offerings in hopes that operational efficiencies will help boost returns for their funds. For example, the Riverside Company, historically more of a generalist firm, has developed specializations in select industries like healthcare, training and education, franchising, and software.

Fortune magazine reports that in early 2011, Hal Rosser announced his departure from Bruckmann, Rosser, Sherrill & Co., a New York-based private equity firm that he had cofounded in 1995 with two other veterans of Citicorp Venture Capital.3 Shortly thereafter, he announced the launch of a new firm called Rosser Capital Partners, which will have a narrower investment thesis. He told Fortune that he left his old firm because he wanted to focus on buying companies in the restaurant, retail and multiunit consumer industries. Wynnchurch Capital Partners, which is in the midst of raising Wynnchurch Capital Partners III, is a generalist fund, but it has special expertise in the areas of manufacturing; transportation and logistics; energy and power; and business and industrial services; while Jefferies Capital Partners, which is raising Jefferies Capital Partners V, touts industry expertise in distribution and logistics; restaurants; manufacturing; energy; health care; media and telecom; financial services; and transportation. Being a generalist fund can make people think you will financially engineer the company, which isnt what anyone wants to hear today, says one LP. We want to hear that private equity firms can make a real difference at the company level.

The only thing that consistently generates value is increasing the earnings of a portfolio company.

Primack, Dan, Term Sheet: Hal Rosser Talks About His New Firm, and Why Its Always a Good Time to Buy Restaurants, Fortune, Jan. 11, 2011

Keeping LPs happy: Its a whole new ballgame for private equity 13

Alternative investment strategies

Alternative investment strategies will also help differentiate private equity firms. In addition to having some sector-specific expertise, private equity firms that have flexible mandates may also fare better with LPs. Being able to invest in more than one point in the capital structure is appealing. Deerpath Capital Management, founded in 2006 by James Kirby, Gary Wendt (former chairman and CEO of GE Capital), and John Fitzgibbons (founder and chairman of Integra Group), targets equity and debt investment deals between $2 million and $20 million. Having flexibility wont seal the deal, but it could help, especially in times like we just went through. Being able to choose to put debt versus equity into a deal can be a real advantage at certain times, says one LP.

Private equity firms that raise funds with a flexible mandate will be in a good position to take advantage of minoritystake investments as well. These types of investments gained popularity during the last couple of years as fewer sellers wanted to exit their companies fully during turbulent market conditions but nevertheless needed some liquidity. For example, Clearlake Capital, a Chicago-based private equity firm, is agile enough to invest at all different points of the capital structure. For instance, a company in a distressed situation may need rescue financing to avoid a bankruptcy, but a company in bankruptcy may decide to sell off all or a portion of its business, and Clearlake can assist with either. LPs see the logic in this investment thesis. In January 2010, Clearlake was able to close its first institutional fund with $415 million an almost impossible feat today. In this market, GPs have to have the ability to work different points of the capital structure. It is a real benefit, says Monument Groups Campana.

Private equity firms that raise funds with a flexible mandate will be in a good position to take advantage of minority-stake investments as well.

14 Keeping LPs happy: Its a whole new ballgame for private equity

Value creation

And of course, value creation at the portfolio level is key. Like Kelly DePonte says, private equity firms need to improve earnings at the companies they buy. Making fundamental improvements is really the only sustainable way to do that. Financial engineering and benefiting from multiple arbitrage cannot be relied upon in the future to generate favorable returns. The topic of portfolio company value creation justifies a great deal of discussion. In fact, our next ACG white paper will be focused on this topic. That said, there are some important factors that should be highlighted here. Value creation starts with understanding the key value drivers in a business. These are the levers that create the opportunity to enhance value. Sales growth, operating margin efficiency and (in the case of add-on acquisitions) synergistic SG&A cost rationalization are all examples of value drivers. Before a deal is consummated, thorough due diligence must be undertaken to understand the impact of the value drivers and challenge the potential achievement of operational synergies. Proper due diligence is not just about the quality of the earnings or other financial measures.

Every deal has the potential to be a good deal or a bad deal it depends on what you pay for it. Aggressively valuing a business or paying for synergies means that the bar for creating value is getting raised higher and higher. People say they dont pay for synergies, but it happens all the time. During the deal, everyone is focused on the deal. Not enough buyers focus on the 100-day plan or how the pursuit of operational improvements is going to be actively managed post-transaction. An effective performance improvement program (or integration plan, in the case of an add-on acquisition) is often the key to success.

Before a deal is consummated, thorough due diligence must be undertaken to understand the impact of the value drivers and challenge the potential achievement of operational synergies.

Keeping LPs happy: Its a whole new ballgame for private equity 15

Concluding thoughts

As an asset class, private equity will continue to play a very important role in the economy and the transaction market. Investors still like and need this asset class. Private equity provides growth capital and succession liquidity to privately held businesses. Private equity has also proven to be a great home for corporate divestitures. However, the industry is changing. The regulatory environment is getting more difficult. At the same time, LPs are becoming more demanding. Add to that a very competitive marketplace and an economy that is moving slower toward recovery than everyone had hoped these circumstances all create challenges as well as opportunities. The private equity firms that step up to the challenge and strive to enhance their operations and distinguish themselves in the eyes of LPs will be successful. This will require a more effective approach to meeting LP expectations. If private equity professionals arent clear about what their LPs want, they just need to ask. As we found in our interviews for this white paper, they wont be too shy about letting you know what they want.

The private equity firms that step up to the challenge and strive to enhance their operations and distinguish themselves in the eyes of LPs will be successful.

16 Keeping LPs happy: Its a whole new ballgame for private equity

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