Breakingviews

Private equity bubble hangover yields HR headache

By Quentin Webb

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Private equity’s bubble hangover has brought staffing headaches – and Terra Firma is suffering acutely. Guy Hands, the boss of the British buyout firm, is dipping into his own pocket to fund 20 million pounds of bonuses for employees over the next two years. The largesse is a necessary step to keep staff through an otherwise lean period. But Hands has made life particularly tricky for himself.

The industry used to be a millionaires’ factory. “Carried interest” typically gives private-equity partners a 20 percent share of profits from a successful fund, usually above an 8 percent annual return hurdle. For large funds, fees based on assets managed can also bring in sizeable annual sums, which cover a firm’s running costs and big salaries too.

Promises of great wealth ring less true now. For ambitious staff, hedge funds and even banks can start to look like more alluring destinations. The boom years were full of expensive, over-leveraged buyouts. Some collapsed, while others have proved hard to sell on to corporations or stock-market investors. In September last year, the median European buyout fund raised in 2007 had generated a median internal rate of return of just 0.6 percent, Preqin says. True, these funds run until 2017. But some will struggle ever to generate carry. And investors are being pickier about backing new funds.

Terra Firma has a bad case of this, and that’s largely its own fault. Partly the problem is insufficient diversification. Its 2007 fund is 40 percent underwater, after the firm lost a total 1.75 billion pounds on EMI, the record label. The fund could yet break even, but may never pass the carry hurdle. A follow-on fund is at best some way off. And as is typical, management fees have halved after five years, as the fund switches focus from buying to selling.

Then there’s weak cost control. Hands is to pay 10 million pounds annually for the next two years, lifting Terra Firma’s salary and bonus bill to about 50 million pounds. For a 100-person firm, with about 60 “investment professionals”, that implies an average payout of 500,000 pounds, including non-financial staff. That seems an extraordinary reward at a firm whose current fund may at best return investors their original stake.

Oaktree IPO gets marked to Howard Marks

 By Jeffrey Goldfarb

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Oaktree Capital’s initial public offering was marked to Howard Marks. In the run-up to Wednesday night’s share sale, the outspoken co-founder of the debt-focused private equity firm made clear that accumulating assets would never be his top priority. Public investors, who have been conditioned to prize management fees from investment firms like Oaktree that have gone public, took the message to heart.

Underwriters, led by Goldman Sachs and Morgan Stanley, could only unload about four out of five Oaktree shares on offer. They sold at the bottom end of the firm’s price range. And then the market whacked them another 5 percent when trading started. That may reflect the Los Angeles-based firm’s guiding philosophy that clients, not shareholders, come first.

This was clearly spelled out in the deal’s prospectus as Oaktree’s first risk factor, among some 40 pages of them. Marks and co-founder Bruce Karsh stated unequivocally that Oaktree might not always think bigger is better. In 2001-02, they returned $5 billion to investors in their distressed debt funds. The warning wasn’t merely historical or boilerplate. Oaktree’s assets under management declined 9 percent last year, to $75 billion.

The problem with the firm’s promise to prioritize performance over scale is that it hasn’t delivered on that front lately. Though Oaktree is generally considered one of the best in the business, distributable earnings fell 23 percent last year. And returns in four of its last five distressed debt funds started before 2011 have underperformed its own long-term aggregate of 22.9 percent.

That still may have been less of a concern than Oaktree’s lack of size ambition. After Blackstone floated at the top of the cycle in mid-2007, its publicly traded units tanked during the financial crisis. That led to a revised private equity valuation pitch favoring the industry’s captive and steady fees over lumpier investment profits, or the so-called “carried interest.”

Wall Street hangs in limbo despite market rebound

By Antony Currie

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Wall Street shouldn’t get too excited about the latest recovery. Helped in part by a more stable Europe, investment banks have started 2012 far better than they ended 2011. They probably raked in more revenue in all areas but M&A and buying and selling equities in the first three months of the year. But false dawns have marked each of the past two years. And even if this comeback sticks, most firms will need considerably more trading and deal-making to earn decent returns.

That isn’t to say the recent improvement can be sniffed at. Fees in the first quarter from selling new bond deals shot up a whopping 87 percent from the end of the year, according to Thomson Reuters data, as investors piled back into riskier securities like high-yield debt. Improving markets also pumped up asset prices, meaning banks should – hedges permitting – record some gains on their balance sheets.

This effect in turn spurred greater fixed-income trading revenue – average daily trading volume in U.S. high-grade debt jumped 40 percent, according to Trace data. Even compensation for arranging equity deals improved, rising 27 percent, despite a lackluster market for initial public offerings.

Everything isn’t rosy, however. Fees from completed mergers fell by a quarter, U.S. equity trading volume was 8 percent lower and banks will again have to take annoying hits to revenue because of improvements in their own liabilities. Even allowing for these, net income should be much improved. Jefferies, for example, posted a 60 percent increase in earnings on a one-third jump in revenue for the three months to February.

But it will still leave most banks almost certainly wallowing in mediocrity. Jefferies eked out only a 9.5 percent return on equity, probably below its cost of capital. And Goldman Sachs may generate a mere 11 percent return even though FICC revenue could almost treble to $3.7 billion, analysts at Credit Suisse estimate.

Dodger blue outshines gold after $2 bln deal

By Christopher Swann and Martin Hutchinson The authors are Reuters Breakingviews columnists. The opinions expressed are their own. The $2 billion deal for the Los Angeles Dodgers is a home run for sports owners everywhere. The near five-fold rise in the value of the West Coast baseball team since it last changed hands in 2004 underlines a surge in the value of top sports franchises. Only gold comes close to keeping pace as an investment. Rising television revenue is bringing in more cash. But it’s the swelling ranks of the ultra-rich in search of trophy investments that’s stoking prices.

These new owners usually stem from the ranks of high finance. Last year, Apollo co-founder Joshua Harris bought basketball’s 76ers in Philadelphia while Tom Gores and his buyout firm Platinum Equity snapped up the Detroit Pistons. And only last month, hedge fund manager Steven Cohen bought a 4 percent slug of the Mets.

But Frank McCourt has scored the best deal so far from selling to a consortium including Guggenheim Partners and basketball legend Earvin “Magic” Johnson. The Dodgers’ owner, who paid $430 million for the team eight years ago and managed to keep control despite its bankruptcy last year, is walking away with a far better return than he would have earned elsewhere. Putting his money in the S&P 500 Index would have won only a 42 percent return. Gold fared better, up about 300 percent.

The Dodgers’ sale suggests that estimated valuations of other leading sports franchises now look conservative – by 25 percent or more, according to the consultant Sportsimpacts. National Football League team the Dallas Cowboys has probably soared roughly 12-fold since Jerry Jones bought it for $150 million in 1989, according to Forbes estimates.

There are some solid economic reasons for valuations to look healthy, not least swelling TV audiences. That emboldens sports networks to pay ever more for screening rights, especially for live games that are relatively immune to commercials-skipping DVRs. NFL owners, for example, expect a boost of up to 60 percent in TV revenue when current deals with CBS, ESPN and Fox expire in 2013. But most sports teams have mediocre cash flows, with the payoff coming mostly though capital appreciation.

With around 1,226 billionaires worldwide, there is an ever bigger buying base for prestige assets. But if they lose interest, or their fortunes falter, the price of sports teams will start to look like a bubble.

Apax finds French twist on bankruptcy tourism

By Neil Unmack

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Restructuring specialists have a lot to thank the UK for. The country’s creditor-friendly legal framework has drawn companies from across Europe to restructure in London. European Union law states that companies should use the insolvency regime relevant to their centre of main interest, or “comi” for short. But the concept is elastic; a Greek mobile telecoms company, Wind Hellas, was able to restructure in London by relocating one of its companies from Luxembourg to the UK.

Disgruntled creditors say the UK has become a bankruptcy brothel. Restructuring experts prefer to extol the advantages of UK law, which allows for smooth restructurings by disenfranchising stakeholders who are out of the money, such as shareholders or junior creditors.

Apax has found a new twist on this theme. When Marken, a logistics company it bought in 2009 for 975 million pounds, breached covenants at the end of December, it moved a unit of the group to France. Unlike the UK, French bankruptcy law and its restructuring framework, called sauvegarde, is considered borrower-friendly. Courts give greater credence to shareholders and employees, and it is harder to disenfranchise creditors whose loans are out of the money. Take Eurotunnel, where shareholders were left with value even though creditors took losses.

In practice, a so-called “comi shift” to France could be harder and less predictable than it sounds. Bondholders may threaten legal action. French courts could look askance at highly leveraged arrivistes, while documents drafted under UK law could create complications.

However, the move may give Apax, and other buyout houses in similar situations, a subtle edge in negotiations with creditors. In Marken’s case, the two sides will probably hammer out a deal without the company having to go through the trauma of sauvegarde. However, a high-profile example of a French comi shift and restructuring would create a precedent for other financial sponsors. With many private equity-owned companies creaking under high debt loads, sponsors may be tempted to explore all ways of stopping creditors from seizing control.

Top hedgies show Wall Street how it’s done

By Richard Beales

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

For bankers, the cash is greener on the other side of Wall Street. The top 40 hedge fund managers took home $13.2 billion between them for 2011, Forbes estimates. Yet even industry godfathers like Ray Dalio of Bridgewater Associates manage to attract far less opprobrium than bank bosses, whose paychecks are considerably smaller.

Dalio made $3 billion for last year, Forbes reckons. By contrast JPMorgan Chief Executive Jamie Dimon, for example, looks set to do no better than the $23 million he pocketed for 2010. The comparison isn’t clean. Hedgie figures typically include gains on their holdings in the funds they manage, whereas for bankers and other corporate executives, it’s usually just annual pay being quoted.

Even so, top hedge fund managers pull in far more than the top earners in banking. Yet an unscientific test suggests they also escape the public’s anti-wealth wrath. A check of the Factiva news archive shows big-name hedgies generate only a fraction of the publicity associated with words like “pay” and “bonus.” With the gap between haves and have-nots high on the U.S. election agenda, it’s worth understanding the discrepancy.

One explanation is that hedge fund titans are for the most part also entrepreneurs who built their firms from scratch. Also, they provide a product that, in good years, pleases investor clients. Dalio’s flagship fund just overtook retired George Soros’ Quantum Fund as number one in total dollar terms for investor returns over the years, at $35.8 billion, according to estimates from LCH Investments.

Most hedge funds stay private, too, echoing the closely held bank partnerships of years past and largely defying the trend of fellow alternative asset managers like Blackstone going public. And when it comes to pay, despite the high fees, hedge fund bosses get a lot richer only when their investors do.

Browne’s North Sea idea is more than nostalgic

By Kevin Allison

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Buying into Fairfield Energy, the North Sea-focused UK oil producer, would be a fitting move for John Browne. In the 1980s, when some of Fairfield’s most attractive assets were first being developed, the ex-BP boss was managing the Forties oil field off the coast of Aberdeen. But Browne’s interest in Fairfield, reported by the Sunday Times on Feb. 26, is likely to be more than just nostalgic. Fairfield specialises in mature oil fields that no longer interest the big majors. With oil prices likely to remain high for some time, and opportunities to buy unwanted acreage increasing, the deal has sound commercial appeal.

North Sea oil production is in long-term decline – peak output was in 1999. But there are still plenty of barrels waiting to be extracted. New seismic technologies, advances in horizontal drilling and other so-called ’enhanced oil recovery’ techniques mean even picked-over fields can be cajoled into giving up more of the black stuff. For oil majors, this is often not worth the hassle. With huge new volumes required to boost production significantly, the likes of Shell and BP have bigger fish to fry. But it creates opportunities for smaller players. Both Shell and BP have sold acreage to Fairfield since it was set up in 2005. And BP is still flogging North Sea gas assets it put up for sale last year after the Gulf of Mexico oil spill.

Fairfield and its backers clearly believe that the business model has legs. A planned flotation in 2010 would have valued the whole company at $1.3 billion but investors including Warburg Pincus, the U.S. private equity group, wanting to retain a 60 percent stake. In January last year, Fairfield’s shareholders injected an additional $150 million to help it develop its assets. Since then the group has struck development deals on several properties.

Oil prices have also risen since the IPO was abandoned, so Browne and Riverstone must expect to pay more for a piece of Fairfield than they would have two years ago. The key danger is that they become too confident about the price of the black stuff, and overpay for assets that could prove less accessible than is hoped.

Twitter revolt could march next on proxy season

By Jeffrey Goldfarb

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The revolution is being Tweeted. Social media have enabled political uprisings in the Middle East, the global Occupy movement and even a swift blowback against banking fees in the United States. A logical next step would be for Facebook, Twitter and their ilk to intensify the voice of the investing masses.

The upcoming proxy season in Corporate America could be the perfect opportunity. The annual rite whereby shareholders get a chance to vote on a variety of corporate proposals, including matters of corporate governance, provides a testing ground to see if social media’s influence can extend to the world of finance.

Corporate directors seem ill-prepared for the possibility of digital activism, though Carlyle co-founder David Rubenstein did sound the alarm a year ago when he suggested employees and shareholders “could use Facebook to rally support against an acquisition.”

Yet bankers were as caught off-guard by the swift mobility of the Occupy Wall Street protests as the autocratic regimes in Egypt and Syria were by the Arab Spring’s dawning. Bank of America was forced into an embarrassing climb-down after customers rallied online against its $5 monthly fee for debit-card use.

Services like Twitter offer an opportunity for increasingly marginalized retail shareholders to regain influence. A half century ago, individual investors owned nine out of 10 shares of U.S. companies. But the rise of public pension funds and insurers has shrunk the retail base for most large companies to below 20 percent. Many of the biggest investors typically sit on their hands when it comes to challenging management.

Romney tax row may bite European private equity

By Quentin Webb

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Mitt Romney’s low-tax private equity payouts caused a storm stateside. European buyout bosses are unlikely to run for high office. But, like the former Bain Capital boss fighting to clinch the Republican presidential nomination, they also cash in on “carried interest” schemes which usually avoid income tax. The system is due a re-think on both sides of the Atlantic.

Carried interest arrangements typically entitle private equity partners to about a fifth of the profits from a successful fund. These can be life-changing sums. Say a 1 billion pound fund at a 12-partner London PE firm doubles its money and “carried interest” kicks in after an annual hurdle rate of 8 percent. The lucky dozen could expect to receive an average 16.7 million pounds on top of regular pay and bonuses. Taxed as capital at the United Kingdom’s 28 percent, the partners take home 12 million pounds. If it were taxed as income at Britain’s top rate of 50 percent, the post-tax carry would be worth just 8.3 million.

The industry considers these payouts as rewards for patient entrepreneurship and therefore as capital gains. But while funds may need a decade’s nurturing, that rings hollow. Firstly, the capital staked is tiddling: the dozen in the example above may have invested a total of just 250,000 pounds. Secondly, outside investors usually also demand PE staff make separate “co-investments” on similar terms to everyone else. So they clearly doubt that partners’ “carried interest” puts real capital at risk.

Britain has half-reformed its system already, moving in two steps from sub-10 percent tax to 28 percent after a 2007 backlash. In Stockholm, an important hub for buyouts, the tax authorities now reckon carry is income and are pursuing cases against several big PE houses.

To be sure, European rates are already higher than the U.S. ones. Exchequers wouldn’t get huge boosts, since the industry’s still suffering bubble-era indigestion. And coordinated action would help, otherwise firms could simply switch between jurisdictions. Nevertheless, austerity has made financiers’ pay a political battleground and tax loopholes, real and imagined, are vulnerable. The tide may be turning.

April Fool’s comes early to comical M&A market

By Robert Cyran

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

It’s hard not to smirk at the latest transaction to shoot out of the M&A pipeline. America’s largest title insurer, the $4 billion Fidelity National Financial, is buying O’Charley’s, an owner of U.S. steak joints. Not only is it a deal ripe for bad jokes about a combination plate of mortgage deeds and French fries. It also defies all convention.

Fidelity specializes in the humdrum world of processing real estate documents to ensure sellers actually own the properties they’ve put on the block. O’Charley’s is a struggling casual dining chain serving up delectables like “New York Pizza Pasta.” Not even the most hubristic investment banker would pitch huge synergies.

But there’s a still funnier twist. Fidelity National’s chairman, William Foley, knows both mortgages and meat. The company is essentially his brainchild. He rolled up a bunch of smaller title insurers over a quarter century. During some of that span, Foley also ran CKE, parent company of the Hardee’s burger joints.

That may explain the direction Fidelity National has been moving. It already owns stakes in restaurants with revenue of $400 million a year – and recently sold its flood insurance business. Of course, insurers often seek ways to invest proceeds from premiums. It’s just they typically use an intermediary, like a private equity firm, instead of direct ownership of uncorrelated companies.

Investors aren’t so sure about Foley’s ambitions. Fidelity National shares fell over 1 percent on the O’Charley’s news. The 42 percent premium it is paying may impede any hopes of a reasonable return. What’s more, shareholders could be worried Foley will replicate the trouble he ran into at CKE when it expanded too rapidly.