Managers venture into unknown for investments

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Tom Bernhardt

With the investment clock ticking, private equity managers are straying from what they know to strategies they hope will work.

Private equity firms, especially megabuyout specialists, raised records amount of capital in the past couple of years but have nowhere to spend it. Buyout firms have total capital of $472 billion in a holding pattern, after raising $318 billion worldwide last year, according to estimates by Preqin Ltd., a London alternative investment research firm.

And rather than let funds end with little to show, some private equity firms are trying out new strategies — anything involving debt.

“I've seen several managers that have requested approval from limited partners to pursue debt strategies, sometimes buying the debt of their own portfolio companies,” said Tom Bernhardt, director of research at PCG Asset Management, a La Jolla, Calif., private equity investment management consulting and funds-of-funds firm.

So far, roughly 20% of private equity managers — mostly megabuyout but also some middle-market firms — have asked limited partners for permission to change investment strategies, he said. Depending on how the economy fares in 2009, many more could be knocking on investors' doors asking to delve into something completely different. Private equity managers see many more investment opportunities in debt than in leveraged buyouts, which have been extinguished by lack of credit. “It's a target-rich environment,” Mr. Bernhardt said.

Buyout firms did not start changing their investment stripes until the middle of 2008, when the credit crisis began to hit full force, he said. But the trend could reverse in 2010 if the economy improves as anticipated.

Buyout-turned-debt investment firms are doing everything from buying leveraged loans and high-yield debt to making loans.

“It's interesting seeing general partners start to morph strategies because they have money to spend and limited time,” said Stephen L. Nesbitt, chief executive officer of Cliffwater LLC, a Marina del Rey, Calif., alternative investment consultant. “We are seeing (general partners) doing things that they don't normally do.”

Investors are being forced to decide whether to let their managers stray from the investment thesis that got them hired. Some are most comfortable when the firms buy the debt of current portfolio companies, Mr. Bernhardt said. Investors believe investment managers should know their own portfolio companies well, while many buyout managers believe the debt is undervalued and can be purchased at a discount, he said.

There may be another reason their portfolio company debt looks attractive to private equity managers. “A cynic may say they are buying debt so their companies won't go bankrupt,” Mr. Nesbitt said.

Buyout managers have sought explicit approval to change their investment strategies to debt-oriented ones that would, in many cases, allow them to invest in their own portfolio companies' debt, said Sam Green, private equity investment officer at the Oregon Investment Council, Salem, which manages the $47 billion Oregon Public Employees’ Retirement Fund, Tigard.

“It's not just megabuyout but across the asset size spectrum,” Mr. Green said. “They see real pricing anomalies and real opportunities.”

Said Jim Fuchs, spokesman for the $123.9 billion New York State Common Retirement Fund, Albany: “Absolutely, we have seen virtually all of our megabuyout managers at least looking for opportunities to take advantage of debt.”

Many of the largest buyout managers already have fund officials' approval in the original investment agreements to invest 10% to 20% in non-equity investments. Now, however, midmarket buyout managers also are seeking to invest in debt strategies, mainly by launching new funds, Mr. Fuchs said.

While most of the agreements made by the $174.9 billion California Public Employees’ Retirement System, Sacramento, also allow for some investment flexibility, executives there are finding buyout fund managers want to invest fund capital in non-leveraged buyout deals, said Clark McKinley, spokesman.

“The LBO environment is pretty thin right now and we are in regular dialogue with our partners about the landscape of opportunities that are available.  These include non-leveraged deals,” Mr. McKinley said.

But debt purchases could lead to conflicts of interest for investors. Debt and equity holders have different interests and can pull a company in different directions, especially when that company is in trouble, Mr. Bernhardt said. In a bankruptcy, for example, debt holders might recoup at least some of their investment — even pennies on the dollar — while stockholders might walk away with nothing.

Oregon's Mr. Green agreed the biggest drawback of the strategy is the potential conflict of interest and some managers are taking the precaution of developing procedures. Most are not buying the majority of a portfolio company's debt or enough to make the buyout firm the lead debtor, he added.

Balancing act

While investors should not want their managers in straitjackets, some are worried that private equity managers would be straying too far from what they know. Not all buyout executives have the skills to invest in debt.

When deciding to approve a change in investment direction, limited partners look at whether the executives have debt investment experience. Investors also look at the size of the opportunity and the percentage to be invested in strategies not part of the original mandate, consultants said.

Most managers have been careful with how big a slice of their funds is being invested in new strategies, Mr. Bernhardt said. “It's not wholesale shifts in strategy. I've seen between 10% and 20% of uncommitted capital,” he said.

Still, private equity is not like other asset classes. “There can be advantages to shifting and deploying capital in the most attractive areas instead of sticking to the original opportunity,” Mr. Bernhardt said.