Buzz

Nothing Will Come of Nothing

David Hawkins, Private Equity International


This article originally appeared August 9, 2002 on PrivateEquityOnline.com.

Transport yourself back three or four years and imagine you're an ambitious, MBA-clad professional who's spent some time with one of the big investment banks or perhaps one of the major management consultancies. You are keen to keep moving up the earnings ladder and know that private equity firms can provide an ideal place to achieve that - whilst letting you make your mark on the business [and its portfolio companies] in a way none of your previous employers could. So you join the crowd of equally competitive individuals wanting to join this exalted community and, by a combination of diligence, networking and, yes, ability you join the private equity group of an aggressive specialist investment bank.

Remember it's 1999: and the technology sector is buzzing. Your firm, which has carved out a strong reputation for its corporate finance services to this sector, is raising a technology fund. With the help of a leading placement agent what was intended to be a billion dollar fund turns into something twice the size. Around you the fireworks of rapidly expanding start-ups, accelerated IPOs and massive realizations are exploding. And you are going to be involved in this new fund dedicated to this amazing sector.

More exciting still is that a percentage of the carried interest for the fund is coming your way. Although your salary is lower than you'd expect if it was your key income source, the cut of the carry has you planning where that beach house is going to be. You begin to identify with the founding GPs at your firm: great income, great life, great guys.

Fast forward to 2001. The tech sector has imploded. Your fund, like so many others, scrambled to invest quickly and bought into companies that now look dead on their feet. You spend nearly all your time working with shell-shocked management in an effort to salvage the salvageable and trashing the rest. It's grinding work and the senior GPs don't seem to make your life any easier. And they seem to be more absent than before too - apparently briefing limited partners on "progress".

And that cut of the carry? You begin to realize that it won't be just much less than you planned but in fact won't be there at all. Zero. Not one cent. It's going to be hard enough thinking what returns the fund will deliver to its LPs much less any carried interest.

So what do you do? You leave. You and some of your closer colleagues who are in the same position decide that there is a better way. You'll start a new fund; where you see a significant chunk of the management fee and not bank on the carry. And where you invest in more substantive companies across a wider spectrum of sectors. This time, you and your fellow founders are going to be the guys in charge. So you call in another major placement agent and go off and raise a new fund. In the meantime, the remaining GPs at your previous firm explain to the LPs that there has been some changes in personnel and a brave new group of hungry young investment professionals have joined the firm.

As you may have guessed, this is not fictitious. Although rendered anonymous, this scenario has happened and will happen again. As the source who recounted it to PrivateEquityOnline said: "this kind of development may have originated in the US but it's inevitable that you'll see more of it in Europe too. The deflation of inflated expectations, the concentration of too much wealth amongst too few partners who have ring-fenced the management firm and relied on fund carry to command loyalty are all factors. The brutality of the markets at present and the fact that these guys are having to nurse what they see as hopeless cases also spurs them to look elsewhere."

There are a host of issues here: succession and compensation structures at private equity firms, key man clauses and clawbacks for LPs, the fate of portfolio companies who see a succession of directors from their private equity owners come and go and the likely disastrous performance of some funds to name but a few. You're left wondering who are the winners here.