PureVC

Avista Gets Early Liquidity from Wide Open West

For those of you that follow the LBO world, The Deal reported that Avista Capital Partners tapped its new portfolio company, WideOpenWest LLC, for a $400 mm dividend. If you remember from my previous post about Diamond Castle, Avista is a new firm started by Tom Dean, formerly of Credit Suisse. If you recall, Larry Schloss and his cronies peeled off of DLJ Merchant Banking and Credit Suisse's Alternative Asset Group to start their own shop. The successor to Schloss was Tom Dean, who subsequently jumped ship as well to start Avista.

Well, Avista has reportedly received a handsome dividend from its portfolio company in just under a year and has apparently doubled its investment. I'm kicking myself for not giving Avista's offering more consideration. I will say though that I am happy for the Avista team and I bet they have a nice feeling of vindication with their first liquidity event.

For those of you that don't understand the power of an LBO, this is precisely it. Get into a high cash flow company  at a reasonable leverage, grow it and make it more efficient, and when the company is strong and the time is right pay down some leverage or even better, take some profits.

In the private equity world, lifting out and jumping ship to start your own thing is not uncommon. I have always been the one that likes to support those who want to control their destiny. So I definitely get a good feeling when I see the success of a new firm like Avista.

Blackstone Update

I must apologize to my readers for I haven't blogged in nearly a month. In all honesty it's been an extremely busy month for me and I also was laid up for a week with a horrible bout of the flu. I'm back now in full force and can't believe only a week ago I was so sick that I was wishing I was not alive.

So the big news is that Blackstone has amended its IPO filing while concomitantly taking in a large $3 billion investment from China. China's investment for an almost 10% non-voting piece of the company helps put a valuation on the company. It will probably end up being a "floor" on the valuation as I suspect that the China investment will significantly up the appeal of the firm to investors. Not only is it strategically opening up the largest market in the world, it is basically doing so with the blessing of the Chinese government. There are few financial firms that have this kind of clout or can gain this kind of clout with China. Goldman is the obvious leader in currying favor with China on the economic front.

I must admit that I was somewhat skeptical about the Blackstone IPO. I have not always favored private investment firms going public because in many ways it is merely the cashing out of key personnel in those firms. There is a large part of me that feels that when the shit hits the fan, those firms who kept themselves private and did not sell out to the short term market demands of investors, will have more permanence. However, with this move by Blackstone, I do see opportunity for the investor and particularly opportunity for Blackstone to become a major raider in China.

I'm looking forward to the IPO. Maybe it will be the beginning of the end of the beginning of an even newer boom.

On another note, things are definitely heating up in the IPO space. There seem to be more tech filings of late and for my IPO junkies out there I promise that when I have more time I will start to dissect some S-1s for you.

Where Would You Invest In Private Equity?

Poll results are back for Our First Poll here at the PureVC blog.  73% of responders indicated that they would not invest in the Blackstone IPO. I was among the nays of the group.

I'm not sure what it means, but it clearly shows that readers of this blog can taste the frothiness of PE firm valuations. It will be interesting to see how this closely followed IPO turns out. The rumor mill has been churning these last few weeks of an Apollo Management and a KKR filing. I can't wait to get my hands on the filings and see what has been behind those closed doors.

So now it is time for our second poll. In an effort to stimulate some thought and in light of all of the emails I have received about the different types of private equity, this week's poll wants to know if you had to choose one category of private equity in which to invest, which would it be: Venture Capital, Buyout Funds, Hedge Funds, or Real Estate?

Once again, the poll password is purevc

Compensation Structures at PE Firms

I am weighing an opportunity to join a unique PE opportunity as a Principal/VP.
Can you share with me how compensation at that level is structured?

This is a difficult question to answer because internal firm structures vary considerably. A common structure is a partnership structure used at VC firms. An alternative is more of a corporate structure. At any firm, whether it be a PE firm or a Law firm, there is always going to be an Inner Circle of Founders and Partners.

Given the evolution of Private Equity, it is clear that the partnership structure is more old school and the "institutionalization" of firms has brought about a corporate ladder. I have always felt that one of the weaknesses of the partnership system is that it is nearly impossible to break into the Inner Circle. Either you have to climb the ladder for too long or you need to hit a huge winner. Either way, this obstacle is the primary reason that firms have trouble retaining their stars. Either they let them join the Inner Circle or they will end up being your competition. Not that I want to mention Blackstone again, but their $40 billion valuation would beat Lehman Brothers $39.5 current value (both Blackstone founders were previously at Lehman).

Even though this reader's question is about compensation at the Principal/VP level, I am mentioning the Inner Circle because the objective of anybody at at PE firm should be to learn the skills necessary to run the show. It simply isn't in the personalities of most young ambitious financiers to one day become the second or third guy in charge. Those that are second or third are likely to be patiently waiting the changing of the guard. Otherwise, those guys are the type that probably never imagined being there in the first place and are more than satisfied with their wealth and their extracurricular activities.

One other difficulty in talking about compensation is that nowadays firms have so many levels within their ranks that it is difficult to gauge who actually does what. I would say the more common spectrum is this (with some having multiple levels):

Analyst
Associate
VP
Principal
Director
Managing Director
Partner

The main difference between firms is how much carry is shared with the lower tiers and how many levels of lower tiers there are. At many firms, you will not share in the carry until you are a Director. At some firms, you will at the VP or Principal level. At some you will at the Associate level. It is rare to see a piece of the pie given at the Analyst level.

What is confusing is that duties for a given title vary among firms. This also depends on firm size and number of employees. I don't think that the Analyst/Associate duties have changed much, but in between that level and the Inner Circle, things tend to blur a bit.  To make matters worse, some have titles that aren't widely used, such as Capital Raising Specialist. 

I would say that at the Principal/VP level compensation ranges from 200k to 400k with half or equal as a bonus and a carry that can be up to 10 times that amount. I don't have any statistics or hard data to support that and given the PE boom these last few years those numbers could be way off. As you can see, what is important is the carry.

You need to take what I am saying with a grain of salt. Compensation will vary according to fund assets under management, years of work experience, contribution to successful deals, graduate degrees, and other things that are out of your control.

Blackstone Files for IPO

Blackstone filed its S-1 for an IPO today. I know there has been a lot of news about the IPO, so I'll dissect a little bit of it and provide some discussion. This one is a filing that will go down in the record books. If you thought Fortress was a gold mine, then you'll easily see that Blackstone is indeed the mothership of Private Equity. Although exact numbers are not provided, the rumor is that 10% of the company is being sold for $4 billion, placing a nice $40 billion valuation on the company.

Principal Shareholders & Leadership: Stephen Schwarzman, Peter Peterson, Tony James, J. Tomlinson Hill, Michael Puglisi. Interestingly, these are the only people listed as more than 5% shareholders. Their exact stakes are not identified. Schwarzman was an MD at Lehman Brothers and Peterson was the CEO. James previously founded DLJ Merchant Banking and came from CSFB/DLJ. Hill is from CSFB and was co-CEO and co-COO of Lehman Brothers. Puglisi is from Andersen.

Company Story: Started in 1985 by Schwarzmann and Peterson from scratch. Now boasts $78.7 billion under management. Assets under management have grown nearly 40% per year. Four main business lines with their IRRs since inception:

1. Corporate Private Equity - IRR 30%
2. Real Estate - IRR 38%
3. Marketable Alternative Asset Management - Funds of Hedge Funds IRR 13%, Proprietary Hedge Funds 11.6%, Mezzanine IRR 16%, Debt, Closed End Mutual Funds (India IRR 43%), (Asia 42.5%)
4. Financial Advisory - M & A, Restructuring/Reorganization, Fund Placement

These are impressive IRRs for all funds since inception. If you look at the IRRs since 2002, you see that they are much higher. If you look at all of their business lines you will see that they are well diversified almost like an investment bank. They even have a fund placement arm that has placed a significant amount for other fund managers. It is rare to see a buyout shop raising funds for other people.

It is also interesting to note that the highest returns actually come from two of its closed end mutual funds which are investments that are accessible to the general public.

Financials: Expanding revenues of 500 mm in 2005 and 1.1 billion in 2006. Expanding investment income of 8.1 billion in 2006, 5.2 billion in 2005. Net income of $2.2 billion in 2006 and  $1.3 billion in 2005.

Structure: Units in a Limited Partnership are being sold to the public. The LP will be controlled by a General Partnership controlled by Blackstone managers. A portion of the proceeds will be used to buy stakes from managers. Another portion to be used to invest in funds that have no finite lives such as Blackstone's hedge funds and debt funds, but nothing will go toward buyout funds. It seems that the funds will be primarily used to help managers cash out as well as invest in the business of Blackstone, rather than the funds. This is a different strategy and actually in my opinion is a more appropriate use of the funds. Investors will actually get to participate in ownership of the manager rather than just be an investor in Blackstone's funds.

Another interesting thing is that Blackstone clearly says in their prospectus that it is not being hypocritical by going public when it is in the business of taking companies private. They will not bow down to the pressures of being public and provide any financial guidance for quarterly or annual operating results. They will not let short-term pressures affect their investment decisions.

I could probably go on and on about the filing, but I'll leave it to the financial press to dissect it ruthlessly. It will be interesting to see what the final filing reveals.

PowerShift - Knowledge is Power

Alvin Toffler wrote a book called Powershift quite some time ago. In it, he had the vision and foresight to guess that the information highway would be built and more importantly that information intelligence would be the most valuable asset in the world. Countries that embraced information technology had the chance to leapfrog straight from the agrarian economy over the industrial economy to the information economy.

Clearly, the information and high technology boom exemplified this. You simply cannot deny the power of the great information companies such as Microsoft, Intel, and now Google.

While Toffler laid most of his weight behind the power of information, I think his more subtle point was that knowledge was the most valuable currency.

What does this have to do with Private Equity?

Well, if you consider the putative public valuation of Blackstone Group, you will clearly see that these days knowledge is more valuable than any hard assset. A $40 billion valuation would give Blackstone a larger valuation than many huge investment banks and multinational corporations.  It wouldn't trump Google, but then again, it would be interesting to argue whether the Knowledge at Google is worth more than the Knowledge at Blackstone.

In considering that monster valuation, you must certainly ask this: What exactly does Blackstone have that other people don't?

Well the answer clearly is Knowledge. Knowledge of how to run companies efficiently. Knowledge of how to creatively finance. Knowledge of how to privatize and monetize companies. Knowledge of how to manage hedge funds. Knowledge of all types of private equity. Knowledge of how to create wealth.

It's the best business model out there - valuing and selling a renewable resource that gets replenished with a good night's sleep.

Sure, it takes more than knowledge to run Blackstone. You need connections to powerful people with money. You need connections to key financial players. But more than anything you need to know how the global financial system works.

This just goes to show that financial knowledge is in itself a tremendously valuable technical skill. It's just a matter of putting that knowledge to work. Let's thank Blackstone for showing us not only how to make money using financial knowledge, but how to make money selling that system of wealth creation.

The CXO Network

I've been running this blog for a few years and every week and month my readership has been increasing. I'm getting more emails from entrepreneurs, investment managers, students, and curious people than ever before. Some people respond to specific posts, some people have specific questions they want answered, some people are pitching their businesses, and others are looking for funds or advice. I welcome all of this communication and will try to get back to you as soon as possible, following my own set of Business Etiquette rules.

At CXO Ventures and CXO Private Equity, we have always had a relatively closed network of investors, entrepreneurs, investment managers, and advisors. We tend to do business with people we know or people who know someone that we know well. It's not because we don't trust people or because we don't do due diligence. We have found (and others have too), that investing in successful people or people you have worked with before (and thus know very well) has a higher likelihood of success. In addition to feeling more comfortable working with people within our network, we feel we are better serving our investors and adhering to our fiduciary duty to manage their financial interests. In some areas of Private Equity such as Real Estate and Leveraged Buyouts, we feel it is essential to know the developer or the management. In other areas such as Venture Capital or Hedge Funds it is important but less realistic to have every deal done within our network.

This blog has generated a lot of interest in our firm. We have found that the readers of this blog tend to be a select group of people. If you have found this blog, you have found it by word of mouth, by reading someone else who links to us, or by searching for a specific topic on Google and wading through those results to find us.  We have been close to doing business with several people who have come to us through this blog. In fact, there are definitely readers with whom I ping regularly on several topics.

In an effort to formally expand our network and to perhaps better serve you readers, I am extending a formal invitation to readers who want to be added to our network list - entrepreneurs, investment managers, investors, students, and anybody else. Here are some details of each list:

Entrepreneurs - Network of entrepreneurs in our network that we would typically contact if there is an opportunity within one of our companies or if we have an idea we are willing to fund and are looking for someone to run with it. If we know an investor that may be interested in finding someone with a particular background, we will pass the entrepreneur's information on to them.

Investment Managers - Network of managers that are looking for deals in a specified category of Private Equity. We refer deals that come to us that fit the profiles of our managers.

Investors - Investors with an appetite for a specific type of deal or category. We see a lot of deals that we pass on. We can direct you to these deals or to people we know to help find what you are looking for.

Students/Interns - Although we do not offer an internship yet, we maintain a list of interested persons that we may have unique opportunities for in the future.

If you have an interest to be added to any of these networks, please contact me with your information (email, phone, address) and a little blurb about yourself and what you are looking for. We are sparing in our use of our network lists and typically we send out notes to people who confirm that they wish to continue receiving our contact. I hope this is ultimately of benefit to both of us. I am hopeful it will increase the efficiency of our deal and job matchmaking.

Please note the following: This is not a solicitation for investment. We do not solicit investors. We do not share information outside of our firm. We are protective of proprietary deal information. We will seek permission for information sharing for each specific transmission.

Blackstone May Go Public

My Blackberry is blowing up today - rumors have been flying that Blackstone is going to file for an IPO. While these are only still rumors, I don't think people are surprised given the successful Fortress IPO. What may surprise people is the valuation placed on Blackstone. It scares me to think that if a relatively new firm like Fortress could be valued at roughly $11 billion, then a behemoth and storied firm like Blackstone could be valued at much much more. This is going to be a very interesting year for Private Equity...

Private Equity Returns

Last week I received a note from a reader who wanted to hear my thoughts on this table of private equity returns from Thomson Financial/NVCA (Download pe_industry_performance.xls). In specific he was wondering why the 1 year returns of buyout funds are significantly higher than in subsequent years.

I think the table of returns is interesting. I do not know the specific inclusion and exclusion criteria of the data. However, I am surprised that the 5 yr and 10 yr returns of buyout funds is not higher. This is somewhat suspicious to me. I am also suspicious of the table because if you look at the VC returns of 1 and 3 years, across all stages, they seem a little high to me. Most of us know that vintage 2000 to 2003 have not had strong returns.

At any rate, what I will first say is that you must take these tables with a grain of salt because this is PRIVATE equity. It is difficult to get data from every partnership and every transaction. Additionally, given the J curve effect of funds, not all funds can be compared, nor can you compare funds at different stages of their life cycle. The only way to really get accurate data on a fund is when the fund life is over and the fund is completely liquidated.

I'm not trying to avoid the question or evade the truth behind returns. But a buyout fund will invest in a company and ultimately have a liquidity event. Just because it has a liquidity event doesn't mean that it has realized all of its gain. So when you hear that KKR or Carlyle or Blackstone has flipped their investment, the truth is most likely that on paper they have had a huge mark up in value, but they probably have not liquidated that investment. Hence the return on that fund may be only the realized return and not inclusive of the unrealized return. Given the variance and leeway in valuation practices by accounting firms (many funds value their investments at cost, irrespective of true value), you can imagine that the only way to figure out the return is by counting it up when all is said and done.

OK, now to the real question. The 1 year returns are probably higher than other periods because the last few years have provided more liquidity to buyout funds than previous years. The new issues market has been slow and the markets have shown an appetite to buyout-backed new issues. So there has been more liquidity for buyouts. Given that most of these issues have done well in the aftermarket, it is imagineable that the 1 year returns are higher because of more activity in the new issues market.

Similarly, buyout funds have ballooned in size and have done club deals and thus the secondary buyout is more common. Instead of holding that company for 4 or 5 years, funds have been able to unload earlier to other bigger funds in secondary buyouts.

Money has also been cheaper the last few years. Thus, funds have been able to do more deals with cheaper debt service.

Perhaps an additional factor is that there have been more quick flips. I'm not sure if this is true. Although the quick flip clearly has garnered more publicity than in the past.

It would be difficult to prove any of this. We all know that fundraising is at an all time high and that deal size is getting bigger and bigger. I'm sure someone with more time than me could come up with numbers showing that total buyout activity has increased over these period as well.

Big (Potentially) Changes in Private Equity Compensation

Rumors have been floating the past few days that legislators are mulling a change in the way management fees and carried interest will be treated for tax purposes. The Deal, Wall Street Journal, and PE Hub all have blurbs on this rumor. Dan Primack has once again posted a nice document dump that has an alert to private equity clients from a law firm.

For those of you that don't know about management fees by private equity funds, read some of the old posts from my VC Primer series on Management Fees and The Carry. What the issue comes down to is that annual management fees are taxed as income on investment managers at high rates (30% to 40%). The carry, or incentive allocation from a fund's winners, are taxed as capital gains at low rates (15%). This is because the carry is considered "deferred compensation" and results from the capital gain on invested funds.

Legislators have been considering changing the carry from a capital gain to earned income. You could imagine the potential havoc this would wreak on the private equity community. Essentially, private equity managers would be getting a 20% haircut on their carried interest profits!

One reason the issue has come under the microscope is that as funds have become larger and larger, management fees have ballooned. Investment managers have found an innovative way to convert this immediate income into deferred compensation. Typically investment managers contribute a certain percentage of a fund's size, typically 2% at the low end. Instead of contributing this money upfront, managers have been opting to get paid their management fee in the form of equity - basically instead of putting up 2% they have used what would be their management fee as their capital contribution. What this effectively does is convert what would be taxed as income (management fee) into equity that they would otherwise contribute and that down the road will earn them deferred compensation (carry). While this might seem like a tax loophole, it is a compensation form that is commonly used in any startup. Founders and managers always to some degree earn equity for their efforts. In the pooled investment arena, "sweat equity" is not a new concept.

What is disturbing about this is the clear lack of understanding legislators have on this matter. While some may consider the fees and carry charged by PE managers ridiculous, they have always been this way and are a huge incentive for mangers to earn outsized gains. Taking away private equity's "sweat equity" that comes in the form of the carry is like taking away a founder's stock. We all know what would happen if founder's stock was taxed as earned income and not as capital gain. If things are moving in this direction, why have a capital gain tax at all and just treat all income as earned income?

The economic machine of this country has always run on risk investment capital with generous tax incentives. Whether it be venture capital, hedge funds, or leveraged buyouts - private equity funds are all drivers of economic efficiency. As long as people use the best products, money flows to the highest return, and investments are made to transform companies for better return, then private equity has done its job on the economic forefront. I am not even considering the impact of job creation and new industry creation. Peaks and valleys of the markets are necessary to wash away inefficiency. Private equity just like other economic factors plays a role in this.

By clamping down on private equity, legislators could potentially turn off the engine of innovation and some large drivers of economic efficiency. I'm not really sure this will ever happen, but if you've been around the lately you've seen legislators single handedly shut down the US new issues markets and make foreign IPO markets large world contenders in a matter of a few years.

I'm sure the best and brightest in private equity will continue to find ways to combat this. Perhaps by the sheer dollars behind their lobby. Perhaps they will find a way to convert their compensation in the form of equity in underlying companies. Perhaps derivatives or contracts will be used between funds and their managers. I'm not sure exactly how it will pan out, but if these changes come, legislators will have thrown down the gauntlet on PE managers. Let's hope they are ready to play ball.