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Duane Morris Dialogue on the Future of Private Equity

Staff Writer
July 12, 2010
Duane Morris LLP

The Rising Importance of Industry Operating Know-How

A trend that goes back to the industry's start is increasingly gaining attention, as financial markets make it tough to access debt and thus create value from leverage.

Since the beginning, private equity firms have stood out by marrying operating and investment knowledge, said Mike Gaffney, co-founder of EDG Partners. "This is where true value-add comes from," which is different from a holding-company model.

Mark Schwartz, founder of Palladin Capital Group, makes the point that general partnerships (GPs) are not only investors, but also "we run companies ourselves." That operating experience is essential in making investment decisions and evaluating management teams.

And this experience is likely to become apparent in auctions of target companies when "uninformed tourists" tend to outbid more-experienced and informed GPs.

According to George Nemphos, chair of the Corporate Practice Group at the international law firm Duane Morris, limited partnerships (LPs) are looking to invest with GPs that not only have hands-on operating experience and financial investment savvy, but also "rolodex depth" in having the ability to access industry operating-knowledge and services to support deals.

Schwartz noted that GPs may encounter difficulty when they step beyond their industry focus.

It Is a More-Difficult Fundraising Environment

Two of the profound impacts of the global economic downturn were to impact fundraising and shift the bargaining power over terms and conditions in LPs' favor. This was seen dramatically in the establishment of the Institutional Limited Partners Association (ILPA) last fall and its issuance of Private Equity Principles, as well as the evolving, LP-friendly terms and conditions, such as cuts in management fees.

This is what Nemphos is seeing at several GP clients who are fundraising. LPs are generally retrenching, refocusing and asking for more transparency. Moreover, LPs are asking for more-customized participation in funds, such as side pockets, he said.

Schwartz at Palladin Capital says, "Due diligence is extensive—LPs know who my kindergarten teacher was." Gaffney at EDG Partners observes that it comes down to two key scarce resources: leadership and ability to discern good from bad investment opportunities.

A constructive part of the greater due diligence is that it puts focus on how GPs run their own operations as well as the operations of their portfolio companies. After a few UK firms wobbled during the financial crisis, investors naturally turned their focus to "keyman" provisions and other organizational issues.

Despite fears that LPs may want a line-item account of all GP expenses, Schwartz does not anticipate that level of micromanagement happening. Instead, he sees LPs wanting to know "what the GPs" profit and loss looks like generally and how carry is distributed." With capital at stake, GP interests are aligned with LPs, so a certain level of trust can be expected.

Alignment of interest often gets tested when GPs feel pressured to put capital to work quickly—for instance, because they have considerable uncommitted capital to use before their investment period ends. The industry is said to have nearly $500 billion of "dry powder." As Schwartz commented, "This puts the industry in a dangerous place."

Similarly, GPs may feel the pressure to take companies public to enable them to make long-awaited distributions. Yet, some LPs are of the mindset that getting the best value requires more patience. Marc Cabrera at Morgan Joseph views the growing overhang of portfolio companies as attractive targets for increasingly healthy strategic companies, with which he works.

Vendor Relationships Are Put to the Test in These Tougher Times

Just as the balance of power has appeared to shift from GPs to LPs in the down cycle, it has also shifted from venders to GPs, as the latter are under increasing pressure to do more with less. Consequently, GPs are asking more from vendors and compensating them less.

There is an upside to this, as Nemphos at Duane Morris thinks this may force service providers to become better aligned with their GPs' customers and think harder on how to add value. For example, he anticipates vendors to specialize their services to provide more "industry-specific verticals" and be more cross-practice-group centric.

For legal services, law firms must offer "cost-effective and experience-driven services" and "have the ability to pull many teams together," Nemphos said.

As Gaffney at EDG Partners commented, this necessary retrenchment may be more challenging, given that the 2006–2008 period or "golden age" of record private-equity fundraising and dealmaking helped to distort fees to an unprecedented level. Working with entrepreneurs and executives at the smaller end of the market is really difficult he says, as they cannot begin to understand why the price of services could be so high.

Higher Tax on Carried Interest Is Coming and It Will Change the Business

The recently released BNY Mellon and PEI Media survey on the views of global GPs and LPs found a consensus that government intervention in the industry is on the rise, and this would likely lead to higher operating costs. In the United States, the greatest concern of GPs was the potential for a higher capital gains tax, which is projected to disproportionately affect smaller private-equity firms.

Nemphos at Duane Morris anticipates legislation will pass that will impact innovation in the industry and will encourage lawyers to think about how to structure the business to minimize tax impact. To him, it is all about "low-hanging fruit and optics"; that is, tax revenue and a desire of politicians to be seen addressing so-called fat cats in the financial industry.

But, in the end, how do GPs get rich? For Schwartz, while proposed tax changes are likely to have a negative impact on compensation, good GPs will continue to invest alongside their limited partners—preserving some long-term capital gains—and can benefit from prudent management of portfolio companies.

Duane Morris' Corporate Practice Group sponsors the Private Equity Executives Forum, a series of regular programs and substantive content on the changing dynamics of the private equity marketplace. For more information on Duane Morris, its Corporate Practice Group and the PE Executives Forum, visit the Corporate Practice Group page on the Duane Morris website.

About Duane Morris LLP

Duane Morris LLP, a full-service law firm with more than 700 attorneys in 24 offices in the United States and internationally, offers innovative solutions to the legal and business challenges presented by today's evolving global markets. Our Corporate Practice Group provides practical and creative legal counsel, while assisting clients in complying with regulatory, statutory and other legal mandates. Our long history in the private equity and venture capital markets gives our attorneys the knowledge to guide clients from a legal perspective and the experience to analyze the most-effective business strategies at every stage of their growth. Our attorneys assist private equity funds, investment banks, financial institutions and individual investors with structuring and consummating private debt or equity investments. We also help private equity fund clients and management boards initiate, structure and complete leveraged buyout offers to take companies private.