Delusions of adequacy have permeated many private equity operations for years, yet investors to whom a fiduciary duty was owed are left with a series of poor options independent of poor investment results. In 1935, Austrian physicist Erwin Schrodinger described a paradox known to physicists as Schrodinger’s Cat. In the paradox, a cat is placed in a sealed box containing, a flask of poison, a radioactive source and a Geiger counter. If the Geiger counter detects a single atom decaying, the flask is shattered releasing the poison which kills the cat. Per quantum mechanics theory, after the passage of time, it is implied the cat is simultaneously alive and dead (trust me on this). Many private equity funds have followed the life cycle of the cat and become zombie funds. Ironically, a Fund that is no longer in a position to raise new capital from its existing investors is able to use the residual of the Fund that could not attract more capital from existing investors as a fulcrum to establish a new starting point for carried interest in a buyout of the entire Fund by a third party. For the general partner, this relieves it of having to settle any accrued unpaid preferred return or management fee liabilities as the existing investors will have sold their interest to the new capital source as part of the Fund’s rebirth. Until the new capital source has committed, the Fund is akin to Shrodinger’s Cat. Investors are confronted with poor choices as no one is seeking to sell the Fund’s individual assets for maximum value. Investors must choose between voting for the general partners’ plan or waging a long fight to get individual assets sold. This idea is not new as many corporate in-house private equity operations were given similar Lazarus like rebirths as “spinout” new firms in the 1980’s as part of a graceful corporate exit.
Recent Casablanca like faux shock has appeared in the financial media that private equity firms have been using fund level leverage, in the form of lines of credit for funding capital calls, to manipulate internal rates of return (IRR). This practice has been prevalent for at least two decades. In the late nineties when we were first approached by banks about this product they marketed it as a way to avoid the hassle of calling capital. Set-up fee for the line of credit in those days was $500,000. We had raised a fund from creditworthy investors and a capital call involved faxing a sheet of paper to all the investors with their dollar share on it. We asked the bank if they felt $500,000 was the present value of typing one page and declined the product. Leveraging the fund also creates the risk that the fund’s income instead of being passed through tax free to investors becomes reclassified as unrelated business taxable income (UBTI), a consequence to many pension funds hardly worth the risk. A well-known axiom in behaviorist circles is “Tell me how you measure and I will tell you how people will behave”. IRR has for years been the simplest measure bandied about to quickly summarize private equity performance. Weaknesses of the calculation such as its susceptibility to time and the banality of its reinvestment assumptions get ignored because it is simple to use. Given that both managers and investors place an inordinate importance on the measure, it is reasonable to expect efforts to enlarge IRR would be made. As high as a 25% increase in IRR has been achieved by use of a line of credit. The challenge for an investor in private equity is to determine which managers are achieving their results by improving the enterprise value of their portfolio. Seeking data that is fund financing agnostic is one way to compare apples to apples in addition to examining loss ratios and multiples of capital.
I’m Rob Morris and I approved this blog.