Image Credit: Christophe Vorlet
By Jason Zweig | June 30, 2016 5:30 am ET
For years now, big banks and brokerage firms have been urging their wealthiest individual clients to get into private-equity funds. Buying such a prestigious fund can make you feel like a big cheese with privileged access to the high returns corporate deal making can generate. Trying to sell one, however, can make you feel like a tiny mouse in a giant glue trap.
Consider J.C. Flowers II L.P., once one of the most glamorous of the buyout funds. By July 1, investors must decide whether to stick with the fund, which has lost roughly 60% over its life, or sell their stakes to a group of buyers for less than three-fourths of its shriveled value.
Investors face two risks. If they sell now, they lock in an even more severe loss than they have already suffered. If they hang on, they gamble that the manager can turn the fund around, while having no idea how much longer they will have to wait to get their money out.
It’s instructive to see how investors ended up in this bind.
Launched in 2006 by the firm led by J. Christopher Flowers, formerly a top banker at Goldman Sachs, J.C. Flowers II sought to raise $3.5 billion.
As the financial bubble peaked, Flowers practically had to beat investors away with sticks. Lured by the success of the firm’s first fund and the hope of giant gains from buyouts of banks and other financial companies that Mr. Flowers knew so well, money came pouring in.
J.C. Flowers II closed the floodgates at $7 billion. Among its investors were such giants as the Andrew W. Mellon Foundation, the Colorado Public Employees’ Retirement System, the Teachers’ Retirement System of the State of Illinois and the University of California. A number of wealthy individuals bought in, too.
Before the fund could get all that money invested, the bubble burst. Flowers also made some unfortunate investments, including MF Global, the brokerage firm that collapsed and sought bankruptcy protection in 2011, and Tokyo-based Shinsei Bank, which has fallen more than 60% since the fund bought it in 2008.
Scheduled to earn a 1% annual management fee and 20% of profits, Flowers cut its yearly fee to 0.9% after the losses. It hasn’t kept that 20% cut of investors’ profits, because there aren’t any.
The latest transaction may change that. The new investors in the fund, Coller Capital of London and Goldman Sachs Asset Management of New York, are acquiring their stakes at a 27.5% discount from the fund’s already depressed value as of March 31.
Under the terms of the deal, Flowers will take one-twentieth of any gains the fund earns in excess of 10% and one-tenth of any profits above 20%.
Here is an important detail: The starting point against which those gains will be measured isn’t the fund’s actual net asset value on March 31, but rather the deeply discounted price the new buyers are paying..
That makes it easier for Flowers to earn back a percentage of the fund’s profits. Some of those gains, after all, would merely be a bounceback from the artificial discount imposed by the buyers.
To restate: Flowers’s fund is down about 70% from its starting value, when factoring in the discount. And it is getting new fees.
Furthermore, Shinsei Bank, which makes up nearly half the fund’s assets, is a publicly traded security. The fund’s investors could sell it themselves if Flowers distributed the shares, which have risen 9% since March 31.
Coller and Goldman Sachs declined to comment.
A person familiar with the fund says Flowers’s new cut of profits is well below the 20% industry standard and gives the firm an appropriate incentive to maximize the value of the remaining assets. Flowers has consistently told the fund’s investors that it would hold Shinsei Bank for as long as necessary, the person says.
Four institutional investors who own the fund told me such terms aren’t problematic. But institutions dislike highlighting an underperforming investment, lest their constituents criticize them over it. They also suffer a financial form of Stockholm syndrome: the fear of being excluded from future private funds if they are publicly critical.
No amount of rationalizing can make such a deal completely palatable.
To be sure, a buyout fund is inherently illiquid, and it can’t always clean up its investments by the time the clock runs out on the typical 10-year term of the fund.
“If you’re in year 10,” says David Ewer, executive director of the Montana Board of Investments, which manages $10 billion in pension assets, “there’s at least a 50/50 chance you’ve still got a long tail in front of you.” Another large investor recalls waiting 22 years to get the last payout from a 10-year fund.
No wonder big institutions often hold dozens, even hundreds, of private-equity funds to spread such risks.
If you have millions to spare, buying a buyout fund is easy. Selling it can be a lot harder.
Source: The Wall Street Journal, http://on.wsj.com/2foG8oW
For further reading:
Definitions of LIQUIDITY, PRIVATE-EQUITY FUND, SMART MONEY, SOPHISTICATED INVESTOR in The Devil’s Financial Dictionary
Robert S. Harris et al., “Private Equity Performance: What Do We Know?”
Erik Stafford, “Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting”