Final verdict on Nuveen deal a few years away

(updated with correction)

Some Madison Dearborn Partners LLC investors might take a hit on the firm's investment in money manager Nuveen Investments — which it is selling to TIAA-CREF for $6.25 billion — but many are not going to abandon the firm just yet.

While the details concerning the Nuveen deal have not yet been released to investors, insiders say Madison Dearborn Capital Partners Fund V, which made the bulk of the investment, can expect to get its money back, plus a small profit. A group of co-investors might lose some money on the deal, depending on Nuveen's performance over the next three years.

The Chicago-based private equity firm is getting around $1.7 billion in cash and up to about $600 million in cash and potential proceeds from seed investments in Nuveen investment products. The Madison Dearborn investor group will receive a minimum of roughly 25% of the $600 million in cash paid when the deal closes at the end of the year and the rest within three years — if the seed investments perform well.

The Madison Dearborn investor group originally invested $2.7 billion in Nuveen. Madison Dearborn Capital Partners V invested about $975 million. The rest came from a group of limited partner co-investors that included TIAA-CREF and from a number of banks.

Pension investors in Fund V include the $285.5 billion California Public Employees' Retirement System, $173.2 billion New York State Common Retirement Fund, $94.6 billion Washington State Investment Board, $103 billion New York State Teachers' Retirement System, $14.5 billion Illinois State Board of Investment and $17.5 billion Los Angeles Fire & Police Pension Plan.

When the deal closes, the Madison Dearborn investor group could end up with a total of $2.3 billion in cash and investments.

In addition, the Madison Dearborn investor group has an “earn out,” the right to receive a portion of Nuveen's profits over the next three years, based on Nuveen reaching certain performance hurdles.

This earn out — plus returns from the seeded investment strategies that include a collateralized loan obligation managed by Nuveen credit manager subsidiary Symphony Asset Management LLC — could push Madison Dearborn to more than a break-even deal.

Madison Dearborn first made the investment at the height of the euphoric private equity buying spree. Private equity executives' original idea was to include banks and wire houses as part of the investor group, which could help Nuveen — mainly known for municipal bonds — to expand its investment and distribution capabilities, said sources familiar with the transaction.

The financial crisis dashed those plans for a while. Many of the bank investors either went under or were purchased by other entities. Madison Dearborn ended up buying up Merrill Lynch's equity interest in the deal.

Madison Dearborn mitigated losses by gradually refinancing the $4.5 billion in debt it used to buy Nuveen in the leveraged buyout, extending maturities and getting capital to make acquisitions. The private equity firm bought three other money managers to beef up Nuveen's offerings: Winslow Capital Management, a large-cap stock manager, in 2008; FAF Advisors in 2011; and Gresham Investment Management LLC, a commodities manager, in 2012.

These acquisitions boosted assets under management that had taken a nosedive in the financial crisis. U.S. Bancorp, Minneapolis, sold FAF Advisors — which at the time managed $27 billion of mutual fund and institutional assets — to Nuveen in exchange for some cash plus a 9.5% stake in Nuveen. U.S.

U.S. Bancorp expects to post a gain on its investment in Nuveen in the fourth quarter, Andy Cecere, U.S. Bancorp's vice chairman and chief financial officer, said during the bank's first-quarter earnings conference call on April 16.

“As is typical in asset management transactions, there are components of revenue retention and customer retention that will determine the final price, but as we sit today, I would expect that would create a gain of a few cents in the fourth quarter,” Mr. Cecere said.

Many asset owners consider Madison Dearborn's fifth fund, a 2006 vintage fund, a misstep. They view Madison Dearborn as growing too big with the $6.5 billion fund, one source said.

Returns for Madison Dearborn Capital Partners V have risen from negative territory three years ago to a 5.65% net internal rate of return and a multiple of invested capital of 1.3 times as of Sept. 30, according to the most recent data from the Washington State Investment Board, an investor in Madison Dearborn's last four funds, including Madison Dearborn Capital Partners V.

That 5.65% IRR since inception in 2006 underperformed that of the Cambridge Associates LLC U.S. Private Equity index, which had an IRR of 10.48% for the same period.

Multiple sources noted that net IRR has since risen to 6.8% and the net multiple is up to 1.43 times as of Dec. 31.

Some investors are satisfied with Madison Dearborn. “Madison Dearborn has met or exceeded our expectations, with the exception of Fund V,” said William R. Atwood, executive director of the $14.5 billion Illinois State Board of Investment.

The Chicago-based board has invested in Madison Dearborn's funds III, IV, V and VI. The board has not yet received official notification from Madison Dearborn on the particulars of the Nuveen deal, Mr. Atwood said. “It does not appear it (Nuveen) will have a dramatic affect on (Fund V) one way or another,” he said.

As for whether asset owners will sign up for Madison Dearborn's next fund, Fund VII, it's unlikely investors will give a thumbs-up or thumbs-down to a new fund based on a single investment by an earlier fund, said David Fann, president and CEO of San Diego-based private equity consulting firm TorreyCove Capital Partners LLC.

“Madison Dearborn is a venerable private equity firm with a long history of success,” he said.

Whether investors stick with Madison Dearborn will be based on a number of factors. “Investors evaluate the overall portfolio and its construction — not just the success or failure of one investment,” Mr. Fann said.

“In general, we compare a private equity firm's new fund offering relative to others in the marketplace. The idea is to find the best investment fit for our clients,” Mr. Fann said. “We review and assess strategy, performance, organization, terms and their ability to generate outsized investment returns going forward.”

Performance is not the only issue for Chicago-based Madison Dearborn when it goes out to raise capital for its seventh fund. Large buyouts have grown out of favor with investors. Madison Dearborn executives will have to show what they can offer that investors won't be able to get from another firm with a better track record, sources said.

The Illinois board has been focusing on midmarket buyout and lower-middle-market buyout strat-egies and underweighting large- and megacap private equity, Mr. Atwood said. “We think that is where we can get the best risk-return trade-off,” he said. “We consider Madison Dearborn large market.” n