Private Equity Keep LPs Happy

8/3/2019 Private Equity Keep LPs Happy

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Keeping LPs happy: Its a whole newballgame for private equity

Timely topics in private equity Issue 5


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The people in the independent rms of Grant Thornton InternationalLtd provide personalized attention and the highest qualityservice to public and private clients in more than 100 countries.Grant Thornton LLP is the U.S. member rm of Grant ThorntonInternational Ltd, one of the six global audit, tax and advisoryorganizations. Grant Thornton International Ltd and its memberrms are not a worldwide partnership, as each member rm isa separate and distinct legal entity. Our vision is to be a rmcomprising empowered people providing bold leadership anddistinctive client service worldwide. As such, Grant Thorntonunderstands the unique needs and strategies of private equityrms and their professionals. Throughout the life cycle of a fund,we deliver timely value through our audit, tax and other advisoryservices. Visit Grant Thornton LLP at www.GrantThornton.com.

The Association for Corporate Growth (ACG) is the globalcommunity for mergers and acquisitions and corporate growthprofessionals, helping connect capital with opportunity. ACGprovides its members with the research, tools and networkingopportunities to grow their businesses and themselvesprofessionally. Founded in 1954, ACG has grown to more than13,000 members from corporations, and private equity, nanceand professional service rms representing Fortune 1000, FTSE100, and mid-market companies in 56 chapters in North America,

Europe and Asia. For more information, visit www.acg.org.

Jack DiFrancoNational Managing Principal, Private EquityGrant Thornton LLP

Jack DiFranco is the national managing principal for

Grant Thorntons Private Equity Services. He also served as nationalmanaging principal for Grant Thorntons Transaction Services Groupas well as Grant Thornton Corporate Finance LLC.

Jack has assisted clients with business acquisitions, divestitures,recapitalizations, management buyouts, and nancing transactionsfor senior debt, subordinated debt and equity. He specializesin providing M&A advisory services to clients in a variety ofmanufacturing and service industries. In addition, he has helpedcompanies and their shareholders identify and evaluate theirstrategic and nancial options for increasing shareholder value.

Prior to joining Grant Thornton, Jack was a managing directorin the Investment Banking Group of Stout Risius Ross, Inc.Preceding his experience with SRR, Jack was a member of theinvestment banking groups at First of Michigan Corporationand Ernst & Young Corporate Finance LLP. In these positions,he provided M&A, nancing and transaction advisory servicesto corporate acquirers, private equity rms 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, andfood processing.

Jack earned an MBA in nance and corporate strategy fromthe University of Michigan and a bachelors degree in nance fromOakland University.

About the sponsorsAbout the author


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Keeping LPs happy: Its a whole new ballgame for private equity 1

Introduction

Contents

1 Introduction

2 Fund performance and theeconomic environment

5 The regulatory environment

7 Alignment of interest

10 Firms that perform

11 Potential solutions

Infrastructure, operationalenhancements, transparency and

better reporting

Industry specialization

Alternative investment strategies

Value creation

16 Concluding thoughts

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 rms

deferred fundraising until market conditions improved. With the slight

recovery we have seen, private equity rms were expected to ood the

market looking for capital this year. However, with limited partners (LPs)

remaining somewhat cautious about investing, many private equity rms

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 rms will also change the landscape. This white paper

explores the current fundraising climate, what LPs expect from privateequity partnerships going forward, and how regulatory issues will affect

private equity rms 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 condentiality, we have withheld thenames 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 rms can meet the increasing

expectations of LPs in the context of the current economic and deal

environment.

With limited partners (LPs) remaining somewhat cautious about investing, many privateequity rms are faced with the prospect of not being able to raise a new fund in 2011 or,for some, ever again.


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

Fund performance and the economicenvironment

After emerging from one of the most difcult economic

environments in history, most private equity professionals had

started to feel a little more condent 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 signicantly. 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 nancial

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 thegood news. However, regulatory changes and difculty raising

new funds are two obstacles facing dealmakers today.

After aggressively putting money to work during the

2004 through 2007 period, private equity rms 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.

Source: PitchBook Data Inc.

Capital raised ($B)

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Private equity fundraising by year

Figure 1

Number of funds closed

0

50

100

150

200

250

300

Number offunds closed

Capital raised$ in billions

0

$50

$100

$150

$200

$250

$300

$350

Companies that had held out on selling

started to creep back into the market in2010, and by the end of last year, dealvolume had picked up signicantly.


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With all the pent-up demand for new capital, private equity

rms are nding that LPs are rmly 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 rms for most of 2009 and 2010. As a result

of private equity rms being able to raise a record amount of

capital and the wide-open leverage markets, many rms paid

aggressively for the companies they purchased. As expected

(with the benet 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).

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

nal 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 rm closed on roughly $4.1 billion, far below its

revised target of $7.5 billion set in the summer of 2008.

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).

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0

5%

10%

15%

20%

25%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Figure 2

Average internal rate of return for U.S.-based fundsPE Mezzanine

Source: Pitchbook Data Inc.

Internal rate of return

Vintage

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 ($5 B)

Timber funds

European/Israeli venture capital

46

39

37

33

30

27

25

22

19

19

18

17

15

13

13

11

9

9

8

5

4

2

Source: Probitas Partners


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However, the number of private equity rms that are able

to raise capital will likely diminish overall, and there will be

a divide between rms 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 have-

nots. Fundraising will be very easy for some because they

have had spectacular track records and a loyal LP base. These

rms wont have to make huge concessions either, says

Erik Hirsch, chief investment ofcer 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 rms are having serious

problems, which will eventually lead to a weeding out in the

market.

Its important to note that even the rms that cant raisenew funds will not go away immediately we wont see

the wind-down of those funds for another ve 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 nally decide to wind down until 2007 or later. I think

about 10 percent to 15 percent of private equity rms may

disappear, but it will happen slowly.

If a private equity rm raised its most recent fund in

2006, it should be raising its next fund in 2011. Even if a rm

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 rms will nally cease operations.

As an aside, with fewer rms in business and the size of

some rms 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 rms, 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 rms to manage their assets.

Its important to note that even therms that cant raise new funds will notgo away immediately we wont seethe wind-down of those funds for anotherve years.


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The regulatory environment

In addition to dealing with a more difcult fundraising

environment, private equity rms 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 nancial stability of the United States

by improving accountability and increasing transparency in

the nancial system. While the largest private equity rms will

most likely face greater scrutiny from the SEC, all rms that

will be required to register with the SEC should do so and

prepare themselves now for SEC inspections.Every registered rm is required to appoint a chief

compliance ofcer (CCO) to maintain the rms books and

records, which will be subject to SEC examination as the

agency sees t. Private equity rms 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 rms will be needed.

As part of registration, Form ADV Parts 1 and 2 must be

led. We are nding that many private equity rms 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 rm; however, costs can

vary widely depending on how in-depth a rm gets with its

registration and how prepared it is when beginning the process.

Appointing a CCO is the rst step toward satisfying the

requirements set forth by the SEC. The CCO can be a full-time person or someone who is outsourced the cost is

expected to be roughly the same regardless of which route a

rm takes. The CCO should not be one of the rms partners.

It shouldnt be someone who gets paid off the proceeds of the

rms investments. That creates a conict, warns Goldberg.

The CCO should be someone who is knowledgeable,

competent, empowered by the rm and up to speed on

registration requirements.

While the largest private equity rmswill most likely face greater scrutiny fromthe SEC, all rms that will be requiredto register with the SEC should do soand prepare themselves now for SECinspections.


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Next, the CCO has to have the rm ready for SEC

inspection, which is a periodic examination of the rms books

and records. The ADV forms are where the initial process

really begins. Filling out the rst 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

rms are required to create a narrative brochure that provides

information such as afliations, conicts, fees charged,

investment strategies, and specics on the advisers past

performance and services. This material needs to be updated

annually and delivered to current and potential clients.

A lot of rms think the process ends with their newly

appointed CCO lling out the ADV form. But thats where

the process really begins. The information in the form needsto be accurate, and rms 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

rms 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 rm immediately. The SEC will probably look

at the larger funds rst 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

rm shouldnt be ready because the SEC could just as easily

inspect those rms too.

In fact, to deal with the inux of new registrants, the SEC

recently asked Congress to form a separate organization

that can examine the private equity rms and hedge funds

registering. While how the SEC plans to deal with all the

new registrants is not yet sorted out, private equity rms 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 rms record with the SECwill cause the rm 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 withall the new registrants is not yet sortedout, private equity rms that complyearly on will be in better standing in thelong run, not just with the SEC,but with LPs as well.


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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 benets 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 rms were able to charge signicant 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 rms because they generated higher-

dollar fees, but middle-market rms 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 rms 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 fundstructures, with 53 percent of them saying they are spending

more time focusing on the GPs level of nancial commitment

to the fund.

Alignment of interest

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

When raising very large funds, private equityrms were able to charge signicant fees tomanage LP assets, and the fees were not basedon return on investment.


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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 rms new fundraising effort is

that KKR is offering potential investors concessions to invest.

According to The Wall Street Journal, [f]or the rst

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 rm purchases,

including transaction and monitoring fees. The rms

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 stickwith 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 prots,

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 inuence fund terms, LPs are increasingly identifying issues

that are most important to them, often using those terms as the

nal lter 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 rms can probably claim, LPs are asking for fee

reductions and better alignment.

Lots of private equity rms 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 rms 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 rm that was willing to adopt

all of the principles. Unfortunately, because there are about100 principles, it seems many private equity rms 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.

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

It is important for private equity rms tolisten to what the LPs are asking for andbe ready to address management fees asappropriate.


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Calculation of carried interestAlignment is improved when carried interest iscalculated on the basis of net prots (not grossprots) and on an after-tax basis (i.e., foreign orother taxes imposed on the fund are not treated as

distributions to the partners).No carry should be taken on current income orrecapitalizations until the full amount of investedcapital is realized on the investment.

ClawbacksClawbacks should be created so that when they arerequired, they are fully repaid in a timely manner.

The clawback period must extend beyond the termof the fund, including liquidation and any provisionfor LP giveback of distributions.

Management fees and expensesManagement fees should be based on reasonableoperating expenses and reasonable salaries, asexcessive fees create misalignment of interests.

During the formation of a new fund, the GP should

provide prospective LPs with a fee model to be usedas a guide to analyze and set management fees.Management fees should take into account the

lower levels of expenses generally incident to theformation of a follow-on fund, at the end of theinvestment period, or if a funds term is extended.

ExpensesThe management fee should encompass all normaloperations of a GP to include, at a minimum,overhead, staff compensation, travel, deal sourcingand other general administrative items as well asinteractions with LPs.

The economic arrangement of the GP and itsplacement agents should be fully disclosed aspart of the due diligence materials provided toprospective LPs. Placement agent fees are often

required by law to be an expense borne entirely bythe GP.

Term of fundFund extensions should be permitted in one-yearincrements only and be approved by a majority ofthe limited partner advisory committee (LPAC) orLPs.

Absent LP consent, the GP must fully liquidate thefund within a one-year period following expiration ofthe fund term.

GP fee income offsetsTransaction, monitoring, directory, advisory [and]exit fees and other considerations charged by theGP should accrue to the benet of the fund.

GP commitmentThe GP should have a substantial equity interest inthe fund, and it should be contributed in cash asopposed to being contributed through the waiver ofmanagement fees.

GPs should be restricted from transferring theirreal or economic interest in the GP in order toensure continuing alignment with the LPs.

The GP should not be allowed to co-invest in selectunderlying deals; rather, its whole equity interestshall be via a pooled fund vehicle.

TeamThe investment team is a critical consideration inmaking a commitment to a fund. Accordingly, anysignicant change in that team should allow LPs toreconsider and reafrm positively their decision to

commit.

Investment strategyThe funds strategy must be well-dened andconsistent.

The investment purpose clause should clearly andnarrowly outline the investment strategy.

Any authority to invest in debt instruments, publiclytraded securities, and pooled investment vehiclesshould be explicitly included in the [agreed-upon]strategy for the fund.

Fiduciary dutyGPs should present all conicts to the LPAC forreview and seek prior approval for any conictsand/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 fundGiven the long-term nature of the private equitypartnership, the funds terms and governance mustbe well-dened upfront but also be exible enough toadapt to changing circumstances. With appropriateprotections for the interests of the GP, LPs shouldhave the option to suspend or terminate the fund.

Management and other feesAll fees generated by the GP should be periodicallyand individually disclosed and classied in eachaudited nancial report and with each capital call anddistribution notice.

All fees charged to the fund or any portfoliocompany by an afliate of the GP should alsobe disclosed and classied in each audited nancialreport.

Capital calls and distribution noticesCapital calls and distributions should provideinformation consistent with the ILPA StandardizedReporting Format.

The GP should also provide estimates of quarterlyprojections on capital calls and distributions.

FINANCIAL INFORMATION

Annual reports Funds should provideinformation consistent with the ILPA Standardized

Reporting for Portfolio Companies and Fundinformation at the end of each year (within 90 daysof year-end) to investors.

Quarterly reports Funds should provideinformation consistent with the ILPA StandardizedReporting for Portfolio Companies and Fundinformation at the end of each quarter (within 45days of the end of the quarter) to investors.

Portfolio company reports A fund shouldprovide a quarterly report on each portfolio companywith 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 keyevents in respect of the portfolio company

Selected nancial information (quarterly andannually) regarding the portfolio company,including:- valuation (along with a discussion of the

methodology of valuation),- revenue (debt terms and maturity),- EBITDA,- prot and loss,- cash position, and- cash burn rate.

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:

Source: Institutional Limited Partners Association


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First and foremost, the private equity rms that have performed

well and have a stellar track record will be able to garner attention

from their LPs. Top-quartile rms 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.

Firms that perform

Figure 4

Internal rate of return by year 2006 2010

Fund name Investor name Vintage Closedate

Fund size($M)

IRR

Walnut Investment Partners I The Walnut Group 2000 02-Jan-04 105.00 120.66%

T3 Partners II TPG Capital 2001 02-Jan-05 378.00 95.40%

GCP California Fund Leonard Green & Partners 2001 02-Jan-05 50.00 91.00%

Information Technology Ventures Information Technology Ventures 1995 02-Jan-99 75.00 89.71%

WLR Recovery Fund II W.L. Ross & Co 2002 02-Jan-06 400.00 79.30%

Providence Equity Partners Providence Equity Partners 1996 02-Jan-00 363.00 78.50%

Permira Europe I Permira 1996 02-Jan-00 890.00 74.50%

Clessidra Capital Partners Fund Clessidra Capital Partners 2005 02-Jan-09 1,100.00 63.70%

Platinum Equity Capital Partners Platinum Equity 2004 02-Jan-08 700.00 60.59%

DLJ Merchant Banking Partners I DLJ Merchant Banking Partners 1992 02-Jan-96 1,000.00 58.10%

Carlyle/Riverstone Global Energy and Power Fund II Riverstone Holdings 2004 02-Jan-08 1,100.00 55.80%

Carlyle/Riverstone Global Energy and Power Fund II The Carlyle Group 2004 02-Jan-08 1,100.00 55.14%

OCM/GFI Power Opportunities Fund II GFI Energy Ventures 2005 02-Aug-09 1,020.00 55.03%

Advent Global Private Equity IV Advent International 2002 11-Jan-06 1,768.69 52.30%

Advent Global Private Equity V Advent International 2005 26-Apr-09 3,235.79 50.80%

First Reserve Fund IX First Reserve 2001 02-Jan-05 1,375.00 48.10%

Lincolnshire Equity Fund III Lincolnshire Management 2005 02-Jan-09 433.00 47.16%

OCM Opportunities Fund IVb Oaktree Capital Management 2002 02-Jan-06 1,340.00 46.50%

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 rms with the same strategy in my portfolio?

At the core of the issue is LPs taking a hard look at which rms

with good track records are additive. Its not about simply beingdifferent, 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.

Source: Pitchbook Data Inc.


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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 specic 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 nally,

enhancing performance through a more proactive approach to

value creation will be required to produce attractive returns in a

very competitive marketplace.

Potential solutions

Infrastructure, operational enhancements, transparency and

better reporting

Better infrastructure and operational enhancements as well

as more transparency and faster nancial reporting will bekey differentiators for private equity rms. Believe it or not,

registering with the SEC can be benecial. While registration

may take some time, it will help rms 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 condence, 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 conicts out of the equation, which is

a positive for the private equity rms. Theres sometimes a

negative connotation when rms do their own books. Firmsare 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 rms, which they,

especially smaller rms, 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 ofLPs 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 takesome time, it will help rms keep better tracof their information and in turn help themdisseminate it to LPs faster.


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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

rms 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 ofce. LPs are absolutely going to make a distinction

and will penalize rms that cant produce this information

when it is requested, says Hirsch.

For example, before Monument Group allows any of itsprivate equity clients to present funds to LPs, it insists that

GPs be prepared to demonstrate their rms 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 specically about their back ofce initiatives and

how they help the rm 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.

There are companies that can help private equity rms

organize their nancial information. In 2005, John Grabski

founded ClearMomentum, a software rm that provides

nancial reporting and analysis tools to private equity rms

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 rms learn

about problems at the portfolio level sooner and can addressthem quicker. It also allows private equity rms to report

information about fund performance to their LPs faster and in

a uniform style.

The bottom line is that a private equity rms 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 rms 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 rms need to hire CFOs, invest more in their rm

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.The bottom line is that a private equityrms job is twofold to be a goodinvestor and a good fund manager.


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Industry specialization

Going forward, attracting LP investors will require more

differentiation. Industry specialization will endear private

equity rms to LPs, but as Hirsch says, the rms offering has

to be additive, not just different for the sake of being different.

That being the case, over the past ve years theres been a

push toward private equity rms becoming more specialized.

In fact, according to a Probitas Partners survey, 49 percent of

respondents nd 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 nancial 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 theearnings 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 rms have begun adding areas

of specialization to their offerings in hopes that operational

efciencies will help boost returns for their funds. For example,

the Riverside Company, historically more of a generalist

rm, 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 rm that he had co-

founded in 1995 with two other veterans of Citicorp Venture

Capital.3 Shortly thereafter, he announced the launch of a

new rm called Rosser Capital Partners, which will have a

narrower investment thesis. He toldFortune that he left his old

rm 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; nancial services; and

transportation.

Being a generalist fund can make people think you will

nancially engineer the company, which isnt what anyone

wants to hear today, says one LP. We want to hear that

private equity rms can make a real difference at the company

level.

3 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

The only thing that consistently generatesvalue is increasing the earnings of aportfolio company.


16/20


Alternative investment strategies

Alternative investment strategies will also help differentiate

private equity rms.

In addition to having some sector-specic expertise, privateequity rms that have exible 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 exibility 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 rms that raise funds with a exible mandate

will be in a good position to take advantage of minority-

stake 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

rm, is agile enough to invest at all different points of the

capital structure.

For instance, a company in a distressed situation may

need rescue nancing 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 rst 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 benet,

says Monument Groups Campana.

Private equity rms that raise fundswith a exible mandate will be in agood position to take advantage ofminority-stake investments as well.


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Value creation

And of course, value creation at the portfolio level is key.

Like Kelly DePonte says, private equity rms need to improve

earnings at the companies they buy. Making fundamental

improvements is really the only sustainable way to do that.

Financial engineering and beneting from multiple arbitrage

cannot be relied upon in the future to generate favorable

returns.

The topic of portfolio company value creation justies 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, operatingmargin efciency 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 nancial 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, thoroughdue diligence must be undertaken tounderstand the impact of the value driversand challenge the potential achievement ofoperational synergies.


18/20


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 difcult. 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 rms

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 arentclear 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.

Concluding thoughts

The private equity rms that step up tothe challenge and strive to enhance theiroperations and distinguish themselves inthe eyes of LPs will be successful.


19/20

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