More and more, LBOs are becoming hot potatoes

For some time we have discussed that the world has changed and we have observed private equity firms selling amongst each other which is tantamount to flipping companies. Similar to what happened with the housing market. Therefore the returns that they have offered will not be sustainable. Aivars Lode

FORTUNE --  Increasingly, private equity is looking like a roach motel. Deals check in, but they never check out.

Take Simmons, one of the industry's most notorious hot potatoes. Over the past two decades the mattress company has been handed via leveraged buyouts from one private equity fund to another. In the early 1990s, it was owned by a unit of Merrill Lynch. Since then it has passed through the hands of Fenway Partners and famed private equity shop Thomas H. Lee. Earlier this month, Simmons was on the move again, this time from Ares Management and the Ontario Teachers' Pension fund to Advent as part of a $3 billion deal for AOT Bedding, which owns Simmons and rival Serta, itself no stranger to private equity firms.

MORE: Why I'm not buying the "equities are dead" argument

The Simmons deal has plenty of company. Recently, it seems, the most active buyer of private equity's leveraged buyout deals have been other LBO funds. In the second quarter, 51% of all leveraged buyouts were bought with new debt by other private equity firms, according to Standard & Poor's Capital IQ.

So-called secondary buyouts have been around for a while, and have been rising as a portion of deals since the financial crisis. But the second quarter was the first time since Capital IQ began tracking the data a decade ago - and likely the first time in the history of private equity industry - that LBOs themselves have made up the majority of the buyers of other leveraged deals.

A leverage buyout usually entails a public company, or a division of a public company, being bought with debt by a private equity fund. After some time, private equity firms have traditionally sold those companies to other companies or back to the market in a public offering for a higher price than what they paid. But with corporate executives skittish about spending their cash and initial public offerings, especially in the wake of Facebook (FB), relatively rare, private equity firms are picking up deals that would normally go elsewhere.

That may make sense. Nonetheless, at a time when private equity is already under fire, the fact that increasingly the only buyers pe firms can find for their deals are other pe firms could be added fodder for those who claim that the private equity industry creates little value - other than for itself.

"Does it say something about private equity," says Stefano Bonini, a finance professor at Bocconi University in Milan, Italy, who has followed secondary deals. "Probably yes in the sense that private equity funds have probably overgrown in the past and there is too much cash for too few really good deals."

In a recent study, Bonini looked at just over 2,900 private equity deals. While he found that private equity firms were able to improve performance and boost the value of companies they bought from the market or other companies, Bonini said that doesn't appear to be the case when the seller is another private equity firm. Once a private equity firm has bought and sold an investment, most private equity buyers struggle to add value the second time around. "Our findings show that follow-up deals create little, if any, differential value," says Bonini.

Others studies have showed that secondary deals make sense. Private equity veterans argue that firms have different expertise. So even after an initial buyout, a new private equity firm might make changes that the first private equity firm may not have thought of or tried.

At the very least, though, the growth of secondary buyouts could put pressure on fees. Christian Figge, a finance professor at Technische Universität München who has co-authored studies that found secondary deals add value, says private equity firms are paid, at least in part, for their ability to find attractive investments. If investors see that more and more of those investments come from private equity's own backyard, it will become harder and harder for managers to justify their fees.

Downturn forces private equity firms to hold companies longer than expected

The PE model is predicated on Exits and as we have noted during the past decade in numerous cases the PE firms have been trading companies amongst themselves akin to the flippers of the housing market pre crash therefore in numerous cases the PE firms have overpaid for assets and it will be difficult to realize the value they originally perceived. Aivars Lode

  

GLOBAL – Private equity fund managers involved in company buyouts have been forced to hold their portfolios for longer than initially planned in order to extract the desired value in the financial downturn, a report by Preqin has found.

According to Preqin, the fact that many transactions made in 2007 and earlier are still not sold suggests that many fund managers active during this period have been negatively impacted by the financial market turmoil, holding therefore their investments instead of exiting them.

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Preqin nonetheless noted in its research that the current low level of buyouts also needs to be put into perspective, as the unrealised portfolio value held by the industry comes as a result of the prevalence of large deals made during the buyout 'boom period'.

The report showed that in 2006-07, the industry saw an exceptionally high level of deals with around $1.3trn (€1trn) worth of private equity-backed buyout transactions. Such records have been unequalled since then.

However, the report revealed that buyout fund managers have made exits whenever favourable market opportunities have arisen since 2007.

Therefore, in the second quarter of last year, around $130bn worth of exits were recorded.

Manuel Carvalho, manager private equity deals, said: "Many buyout fund managers were extremely active deal-makers in the years preceding the financial crisis, with record levels of buyout activity registered during the 2006-07 'boom era'.

"For much of the period since, however, we have seen sustained periods of unfavourable exit conditions, and we have consequently witnessed some portfolio companies being retained for longer than originally intended to ensure that attractive returns can be provided to LPs [limited partners]."

Carvalho went on to say that investors in buyout funds can nonetheless be reassured by the fact that fund managers are making the most of any exit opportunities and investors will begin to see further distributions as soon as conditions are favourable enough for fund managers to sell at the right price.

Once those exists will have taken place, Preqin expects industry assets under management to decline in the short term as these companies are sold but as distributions filter back to investors, capital will be fed back into private equity funds through new commitments.

Preqin also noted that the primary concern for LPs is whether the asset class can still offer strong returns.

According to the report, while the onset of the financial downturn and the introduction of mark-to-market valuations in 2008 saw a steep fall in value in the short term, the asset class as a whole has been in a state of recovery since that time.

Author: Cécile Sourbes

Adapt to Low Volumes or Perish, Credit Suisse Tells Traders

The markets remain difficult and yield with acceptable risk elusive. Aivars Lode

Published: Friday, 17 Aug 2012 | 4:28 AM ET

By: Holly Ellyatt
Assistant News Editor

·          

Declining volumes on global stock markets appear to show that real money trading activity is at decade lows, according to a new report from Credit Suisse, and investors believe volumes will stay low for two more years unless global resolutions to the risks of the economic crisis are found.

Credit Suisse’s report on trading activity shows that over the past four years, volumes in equity markets have been steadily falling and are now at half the level seen in the middle of the credit crisis — and traders fear they could get worse.

After surveying trade desks in the U.S., Europe and Asia, the report found that 76 percent of institutions are trading “a lot less”, with 35 and 40 percent of desks responding that they were trading “well below average - down 20 percent” and “below average - down 10 percent” respectively.

And there is no sign that there will be any change in a hurry, with 83 percent of respondents telling Credit Suisse that it would take 2-5 years (or possibly more) for volumes to recover. As long as global economic woes continue unabated and unresolved, or indeed approach in the months ahead, trading activity would stay subdued and risk averse, according to traders.

“Almost half of the responses said macro-risk needs to be resolved before trading activity is up…This is consistent with the popular view that macro risks are a key factor in decreasing investor risk-appetite — including European defaults, recessions, the U.S. fiscal cliff and its own deficit,” the report said, adding, “It’s unlikely all will be resolved in less than a year.”

Norwegian oil fund sees investment losses of 2.2% in second quarter

Pension funds around the world are dealing with the new reality of reduced returns which translates to reduced pension’s and resetting expectations on retirement age. Aivars Lode

NORWAY – Equity losses of 4% have resulted in the Norwegian Pension Fund Global seeing investments return -2.2% over the second quarter, although actual declines in the oil fund's value were offset by a weakening kroner in the same period.

Financial stocks – comprising more than a fifth of the fund's equity portfolio – and holdings in oil and gas-related companies were particularly affected between April and June.

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Norges Bank Investment Management (NBIM) noted that crude oil prices dropped by 20%, thereby leading to -7.8% returns across the sector.

Bank holdings fared marginally better, returning -6.1%, while basic materials lost nearly 10% in value over the three months.

However, when broken down by region, European banking stocks declined by 8.5% in value, with Norges citing Cyprus and Spain's request for financial assistance as a reason for the fall.

Yngve Slyngstad, chief executive at NBIM, said the weaker-than-expected global economy "weighed on stock markets" over the period.

"There was also increased uncertainty about the repercussions of the European sovereign debt crisis," it said.

The quarter saw the NOK3.6trn (€477bn) fund rebalance its fixed income exposure, further implementing a shift in asset allocation away from Europe first announced in February.

US Treasury bonds – at 21.1% of fixed income holdings, the fund's largest single investment – helped boost sovereign debt returns.

T-bills returned 3.3%, while UK gilts returned 5.1% and euro-denominated debt netted the fund 0.8%.

Following last quarter's decision to sell Irish and Portuguese debt, it also reduced exposure to French, Spanish and UK sovereign bonds, while increasing by 0.6% percentage points its fixed income holdings denominated in emerging market currencies.

"A lower exposure than the benchmark to Italian and Spanish government bonds contributed positively to the relative return," the quarterly report added.

However, it also highlighted that the emerging market holdings had contributed to a 0.17 percentage point benchmark underperformance for the overall portfolio.

NBIM also confirmed that it had bought an undisclosed amount of shares in Formula One, which has plans to list in Singapore in the near future.

However, despite investment losses of NOK77bn, the fund's total assets under management increased NOK65bn at the end of June.

"A weakening of the kroner against several major currencies boosted the market value by NOK70bn," NBIM said, adding that it received an additional NOK72bn in revenue from the government, of which 80% had been invested in equity.

Author: Jonathan Williams

Pension Giant CalPERS Appears Ready to Abandon Most VCs

A topic that I have previously discussed extensively. The world has changed and the promise of exits through strategic sales and IPO’s for tech companies are only available in a limited way, therefore the returns that VC’s seek are no longer there. This will have a profound effect on software companies shareholders when thinking about exits.  Aivars Lode

By: Gregory Roth

The nation’s largest public pension fund, CalPERS, appears likely to slash its investments in venture capital in what could be a blow to this still recovering asset class.

Venture capital has wallowed through nearly a decade of difficult returns and sluggish fundraising. The decision by the California Public Employees’ Retirement System to largely abandon new commitments to venture funds will likely prolong the agony.

The California money manager’s new strategy, which it has discussed before, appears tied to flagging returns from its existing investments and concerns that taking a large enough stake in future funds is nearly impossible. CalPERS, with $239 billion in assets, needs to hold significant positions in new securities for them to have an impact on the bottom line.

The pension fund this year has about $2.1 billion in venture capital assets, or 6% of a $34 billion private-equity portfolio that includes buyout, distressed debt and mezzanine funds. The new plan, which will be debated at an investment committee meeting on Aug. 13, would cut that allocation to less than 1%.

If adopted, the plan would make good on signs CalPERS has dropped over the past year that it wants to step away from venture. Whether that means secondary sales is not clear.

The pension fund cites several reasons for the proposed move, “One is that venture has been the most disappointing asset class over the past 10 years as far as returns,” says Joe Dear, CalPERS’s chief investment officer. “Second, it’s very difficult for a large fund like CalPERS to gain access to the best venture partners in the size that makes a difference to our performance.”

The fund’s venture capital portfolio in addition has “little upside remaining,” according to a report to be submitted to the investment board.

Over the past decade, venture capital has been the worst performing asset class in CalPERS’ private equity portfolio. It has delivered a net return of 0.0%, according to June 30, 2012 pension fund data. Part of the poor performance stems from the continuing fallout from the dot-com bust, which saddled many venture funds with negative returns. Performance was hurt again by the recent financial crisis, which had an impact on almost all asset classes.

In the past year or so, venture returns have improved as IPO activity has risen. Still, venture capital has fared poorly relative to other asset classes at CalPERS. Buyout funds, which represent 57% of CalPERS’s private-equity portfolio, have produced average annual returns of 15.4% over the past 10 years, while credit related investments, another big CalPERS investment focus, generated 14.1% annual returns.

Yet venture capital, on CalPERS’ home turf of California, is the stuff of fairytale riches, helping to finance fabled companies such as Apple, Facebook, Google, Twitter and eBay. Most venture-backed firms don’t blossom into multi-billion-dollar goliaths. But they still can produce astronomical returns for investors, and the competition to get in funds managed by Kleiner Perkins Caufield & Byers, Sequoia Capital, and Andreessen Horowitz is fierce.

It is hard to gauge the impact of CalPERS’s plan. Fundraising has been tough in venture with just $11.2 billion raised this year through June. If other large pensions were to follow CalPERS’s lead, it is likely that the pot of money VC funds can access would get smaller.

Reporter Mark Boslet contributed to this story.

Random Ramblings

The new reality as we have discussed many times. The promised returns from VC, PE are just not there to provide the returns previously promised. Aivars Lode

Most California public employees are facing a 5% pay cut. Now the state’s largest pension system, CalPERS, wants its contractors to accept a similar reduction.

Fortune has learned that CalPERS last week sent a letter to 112 service providers, asking them to voluntarily help “reduce the operating expenses of the system.” Recipients included many firms that work with CalPERS’ private markets group, including Capital Dynamics, Cogent Partners, Hamilton Lane Advisors, LP Capital Advisors and Wilshire Associates.

Actual private equity fund managers did not receive the letter, with a system spokesman citing investment staff’s well-publicized efforts to hold down fees as part of the new commitment process. Chances are that there also were most-favored nation considerations, since a cut for CalPERS could result in a cut for all other LPs (something few PE firms would voluntarily accept).

The letters do not specify a target reduction, although the 5% appears to be guidance. CalPERS last issued a similar request back in 2009. At the time, CalPERS sent letters to 600 contractors and received 99 affirmative replies (to differing extents) that the system estimates saved it a little over half a million dollars.

Swiss Banks Face Slow Death as Taxman Chases Assets

The more complex structures that attorneys and accountants have previous advised us upon seem to be unraveling. Aivars Lode

 
By Giles Broom 

Aug 5, 2012 6:01 PM ET 

Swiss banks must lure affluent clients from emerging markets or face a “slow death” as the pursuit of tax dodgers by U.S. and European authorities results in outflows of assets, industry officals and investors said.

Reyl Group Chief Executive Officer Francois Reyl said, “Those banks which don’t adapt will die a slow death.” Photographer: Stephane Gros via Bloomberg

Julius Baer, Sarasin and other Swiss banks are investing onshore branch networks to retain European clients repatriating money. Compliance and regulatory costs, plus competition from local banks, mean the profit margins on those customers are lower. Photographer: Gianluca Colla/Bloomberg

Western Europeans may pull as much as 135 billion francs ($139 billion), or 15 percent of their holdings, from Swiss banks, said Herbert Hensle of Cap Gemini SA. Bank Sarasin & Cie. AG reported last week that private clients withdrew 3 billion francs from Swiss locations in the year through June.

Switzerland built the world’s biggest offshore wealth center during an era of “black money” that ended when the U.S. sued UBS AG (UBSN) three years ago. Many of the highest fee-generating European and American customers are withdrawing funds as the hunt for tax evaders widens. As many as 100 Swiss banks will vanish, according to Vontobel Holding AG Chief Executive Officer Zeno Staub.

“It will not be a big bang, but an erosion as amnesty programs are put together and as clients declare themselves and come clean,” said Francois Reyl, chief executive officer of Geneva-based Reyl Group, which manages 5.5 billion francs of assets. “Those banks which don’t adapt will die a slow death.”

Some banks are already under pressure. EFG International AG, the Swiss bank controlled by billionaire Spiro Latsis, last month reported outflows from continental Europe in the first half, while net new money from private clients at Vontobel fell 86 percent to 100 million francs from a year earlier.

Secret History

Switzerland passed bank secrecy laws in 1934 after bankers of Basler Handelsbank were arrested in Paris two years earlier for aidingtax evasion by wealthy French clients. Swiss banks amassed one-third of the world’s offshore wealth over the next 75 years, before the U.S. government sued UBS on Feb. 19, 2009, to force the disclosure of 52,000 American customers who allegedly hid undeclared assets in Swiss accounts.

Five days after the U.S. filed the UBS lawsuit, Ivan Pictet, then managing partner of Geneva’s biggest wealth manager Pictet & Cie., told Le Temps newspaper that Switzerland’s banking industry may shrink by half if the country abandons secrecy.

Three years on, Raymond Baer, honorary chairman of Julius Baer Group Ltd., said “banking secrecy, as we know it, is history.”

“Swiss institutions are preparing to tackle an outflow of assets and are developing white-money strategies,” said Zurich-based Hensle of Cap Gemini, with Europeans repatriating funds to their home countries. “The number of banks will decrease.”

Fewer Banks

Almost one in three banks will disappear or merge with other firms over the next five years as fees fail to compensate for rising regulatory costs and difficult market conditions, Vontobel’s Staub told Handelszeitung this month.
The number of overseas banks in Switzerland fell to 145 from 154 last year, according to the Association of Foreign Banks in Switzerland. There were 312 banks in Switzerland at the end of 2011, according to the Swiss Bankers Association.

Onshore deposits by individuals in Europe are failing to compensate for Swiss outflows in the last 12 months, Sarasin said July 30, when the Basel-based bank reported a 27 percent decline in first-half profit. Sarasin, which has six offices inGermany, is implementing a strategy to ensure all clients are tax-compliant by the end of 2012.

“Sometime in 2013 or 2014 we will have a drop in assets under management of something like 25 percent of the undeclared money,” Bernard Droux, a managing partner at Lombard Odier & Cie., Geneva’s oldest bank, said June 29, adding that it’s difficult to give precise estimates of undeclared money.

Asset Risk

As much of one-third of the $3 trillion of private wealth managed in Switzerland may be undeclared and at risk from foreign tax collectors, said Benedict Hentsch, chairman of Geneva-based Banque Benedict Hentsch & Cie. SA.

That figure is probably too high, according to Droux, who said that a maximum 15 percent of client money at Lombard Odier and other private banks is undeclared.

UBS said in November that as much as 30 billion francs of assets may be at risk amid changes in tax rules for European clients living outside Switzerland.

Switzerland has ratified a withholding tax accord with the U.K. on Britons with bank accounts in the Alpine country, while Germany and Austria have also signed agreements.

Julius Baer, Sarasin and other Swiss banks are investing in onshore branch networks to retain European clients repatriating money. Compliance and regulatory costs, plus competition from local banks, mean the profit margins on those customers are lower.

Margin Squeeze

Margins on onshore assets in Germany may be less than half the 120 to 150 basis points earned on non-resident funds in Switzerland, according to Booz & Co., a consultancy. A basis point is one one-hundredth of a percentage point.

“Non-declared offshore assets were traditionally the most profitable assets,” said Andreas Lenzhofer, of Booz & Co. in Zurich. “There was very little client interaction, very little cost of compliance and the clients weren’t sensitive to prices. Now offshore clients are becoming the most expensive, challenging the profit model of the banks tremendously.”

UBS, Credit Suisse Group AG (CSGN), Baer and Sarasin have in the past two weeks reported declines in their gross margin, or the revenue they generate on assets under management. The second-quarter margin at UBS’s wealth management unit for clients outside the U.S. fell to 89 basis points from 97 basis points a year earlier.

Smaller banks may struggle to adapt and some foreign-owned wealth managers are looking to leave, said Hensle. Julius Baer is in talks with Bank of America Corp. about buying its Merrill Lynch businesses outside the U.S.

U.S. Probe

An “avalanche of legislative and regulatory changes” from Europe and the U.S. and difficulties in accessing foreign markets could lead to the loss of 15 percent to 30 percent of Swiss wealth management jobs, said Nicolas Pictet, a managing partner at Pictet & Cie.

North American offshore assets in Switzerland have declined 70 percent to about 40 billion francs since 2009, according toBoston Consulting Group.

UBS avoided prosecution in February of that year by paying $780 million, admitting it fostered tax evasion and giving the IRS data on more than 250 accounts. It later turned over data on another 4,450 accounts.

Credit Suisse, Julius Baer and eight other banks being investigated by the Department of Justice may follow UBS in reaching a deferred prosecution agreement after Wegelin & Co. was indicted on Feb. 2 on charges of helping customers hide money from theInternal Revenue Service.

Liechtenstein Deal

One of the banks, Liechtensteinische Landesbank AG, said it’s already negotiating an agreement with the U.S. to prevent it being prosecuted. LLB’s American clients declared less than 4 percent of $795 million of assets, according to a DoJ information request dated May 11 to Liechtenstein’s tax authority.

“It takes time to sort out the U.S. offshore money,” said Peter Damisch of Boston Consulting in Zurich, adding that American clients will probably hold less than 10 billion francs in Swiss cross-border accounts by 2015.

Swiss banks’ hopes that they can counter outflows from traditional offshore markets by building networks across Asia, the Middle East and Latin America may be optimistic, said Beat Bernet, a professor of banking at the University of St. Gallen.

“It’s wishful thinking to assume the industry can compensate outflows by targeting emerging markets,” said Bernet. “Banks ought to face up to the situation that profitability will shrink and adapt their business models accordingly to cope with lower margins.”