A few consultants are raising yellow flags over sovereign funds taking stakes in private equity firms.
Among their questions:
• Will institutional investors be crowded out by the new co-owners, who have agreed to invest in the private equity firms future funds?
• Will the sovereign funds get preferential terms?
• Will the interests of the private equity firms and their investors become misaligned?
• Will the younger generation of investment partners leave the firms?
Executives at Blackstone Group, Apollo Management and Carlyle Group all sold stakes to sovereign funds this year, a trend industry insiders expect to escalate.
There is a big appetite from sovereign funds that can write multimillion-dollar checks, said Adam Goldman, founder and managing partner of Red Rocks Capital LLC, a Golden, Colo.-based private equity index firm.
Private equity firms have been selling off small portions of their firms for the last couple of years. The difference is whos buying, said Christopher J. Ailman, chief investment officer of $176 billion California State Teachers Retirement System, Sacramento.
We want the same opportunities (as sovereign funds), but were too transparent and have a process. We wont write a $3 billion check in just 10 days. Mr. Ailman said.
Fund capacity is another big issue. With more and more money pouring in, is there enough room for money from both traditional sources and the sovereign funds in the top-notch private equity funds, asked Stephen L. Nesbitt, chief executive officer at Cliffwater LLC, Santa Monica, Calif.
In private equity, access is always an issue and access in the size limited partners want, Mr. Nesbitt said. Its an issue for limited partners.
Some consultants maintain that there will always be room in the funds for the larger institutional investors that already have access to the best funds.
If you look at the firms doing these types of deals, they are raising funds large enough to leave room for the most important investors, said Donn Cox, managing director of LP Capital Advisors, a Sacramento, Calif.-based consulting firm. But he acknowledged it will take another six months to see whether private equity fund size shrinks, grows or stays the same.
Its anyones guess whether the next generation of investment partners will be satisfied splitting a smaller pot or whether they will leave to form new firms where they would share 100% of future profits, said Steven N. Kaplan, professor of entrepreneurship and finance, Graduate School of Business, University of Chicago.
The partial sale of the general partnership doesnt change our relationship, but it does change the life inside the general partnership and that is a significant issue, CalSTRS Mr. Ailman said. It also affects that limited partner vs. the other limited partners It is a new world and you have to adapt. Another issue is that limited partners want to be sure that the partners making the investments reap the greatest percentage of the profits. Selling off part of the management company reduces the profits and fees to be shared, Mr. Nesbitt said.
Limited partners would like all the economics (firm profits) to go to the people making the investment decisions, Mr. Nesbitt explained.
The question is what percentage of firm profits will go to the new silent partner and the reason for the sale.
Selling a stake often gives the firm capital to help founders cash out, Mr. Cox said. This leaves a smaller pot of future profits to split among the remaining partners, but it also provides growth capital.
If it (the sale) reflects the general partners wish to cash out, it affects the alignment of interests, said Greg Kulka, director of private equity and economically targeted investment program at the $15 billion New Mexico State Investment Council, Santa Fe. The council has a $1.2 billion private equity portfolio.
While there is more concern over the sale of a 25% stake than with a slice of 10% or less, it definitely raises a flag and you have to figure out whats going on, Mr. Kulka said.
Chris Ullman, spokesman for the Carlyle Group, Washington, said selling a stake to a sovereign fund does not adversely affect investors. Abu Dhabis Mubadala Development Co. acquired a 7.5% in Carlyle for $1.35 billion and committed $500 million to a Carlyle fund. Those investments gave us a presence in the region, Mr. Ullman said. They will be co-investing opportunistically on deals.
Access to good deals is essential to the success of a private equity fund, Red Rocks Mr. Goldman said.
Officials at the $250.4 billion California Public Employees Retirement System, Sacramento, indicated that part of their private equity strategy is dependent on the quality of the deals. (At their Dec. 17 meeting, CalPERS trustees increased the funds private equity allocation to 10% from its 6% target.)
Unlike public equity, our private equity performance stems more from getting great transactions through partners that are less dependent on market trends than other asset classes, said Clark McKinley, CalPERS spokesman. The portfolio is deal-driven in a competitive market, which of course includes sovereign funds as players.
New Mexicos Mr. Kulka said a sale could cut both ways. A private sale to a sovereign fund that is a passive investor in the firm could give the private equity firm access to more deals and expand its geographic reach.
Another question is whether the new part owners will limit the kinds of investments the firms make.
As a fund investor, there is a way to work around the issue, Mr. Cox noted. The sovereign fund might enter into a separate limited partner agreement, called a side letter, saying it would not participate in certain transactions.
The open question is how these issues will be resolved when the sovereign is a co-investor in deals, consultants said.
Mubadala is not likely to have much control over Carlyles direction because the sovereign fund is a non-voting stakeholder, Mr. Ullman said.
If you look at the firms doing these types of deals, they are raising funds large enough to leave room for the most important investors.
Apollo Management LP, New York, announced Nov. 8 that it sold a 9% stake to the Abu Dhabi Investment Authority. In June, the Abu Dhabi Investment Authority had purchased some $600 million in Apollos publicly traded Euronext fund, AP Alternative Assets LP, amounting to roughly 40% of the shares.
In May, Blackstone Group LP, New York, sold a 10% stake for $3 billion to a Chinese government investment fund. And hedge fund Och-Ziff Capital Management Group LLC, New York, is selling a 9.9% stake to Dubai International Capital for $12.5 billion.