On the surface, the PE managers have a lesser reason to get affected by the dismal economic environment. They have raised capital at the right time, and are sitting pretty with a committed fund of at least $100 million or more, on which on a 2 per cent management fee ensures at least $2 million or Rs. 11 crore (thank god for the small benefits of rupee depreciation !) sufficient to run a small and effective organisation.
They have to wait and let the current uncertainty play out, hit the road, tout their success in managing their portfolio and exits, and raise the next bigger fund, perhaps $250 million leading to an increase in management fees without necessarily a similar increase in costs, making the asset management company more valuable. This is based on a longer term macro view of the India growth story.
Look below the surface and you will see a different story about the angst that is bothering the PE managers. Many of the PE funds are of the 2006-07 vintage, started in the days when first time funds were being started by successful PE managers who leveraged their success in institutional promoted funds. They raised capital on the back of the dream run that started in 2005.
Ironically, the euphoria that helped raise the fund is also playing truant with the investments. It is also reflected in higher valuations that the promoters of companies asked for and got in that period. Promoters who stuck to their guns and did equity deals, as opposed to preferential instruments linked to future performance, can be considered clairvoyant as many have not reached anywhere close to their projected performance.
Return for risks
The implication for the PE funds is that many of the deals of this vintage are under water. The continued economic uncertainty also makes it uncertain when these portfolio companies will be able to perform. Even if this were not the case, a 20 per cent depreciation of the rupee has automatically raised the bar for what the PE fund managers need to achieve to show respectable returns.
For the entrepreneurial PE fund manager the commensurate return for all the risks that he has taken is from the carry that the fund makes. His salary is typically at a discount to what he would have made in the corporate world -– in any case in relative terms to the expected carry, the salary is really a small component finally . The point is the real money gets made when the carry happens. In most cases carry kicks in beyond a return of 10 per cent of the fund on an annual basis, and is typically 20 per cent of the returns over and above principal and committed return. With the current valuation of the fund, it is not a likely scenario unless there is an outlier transaction exit.
The probability of an outlier deal saving a PE fund, of the nature of the Spectramind deal which saved Chryscapital’s first fund, happens largely in the technology or technology-driven sectors. My analysis of most of the PE deals done in the 2006-08 period were plays on industrials, infrastructure services -– core sectors far removed from technology and sectors clearly linked to economic environment.
The hazards
The fund manager is now waking up to the harsh reality that the superior economic return to justify the higher risks that he has taken to start the fund will not pay off. Taking on higher risks does not necessarily lead to higher returns every time and certainly not in this case. He now has to condition himself to look to make the money from the next fund, which he should hope to raise in the next three years , which is just an estimate in the absence of any precise view on the timelines.
Assuming that the PE fund manager is about 47 years or so, the second fund would come about when he is 50 and that gives him pretty much time for one more stab at a successful fund and an elusive personal brand. This is of course assuming that he will be able to raise the next fund at all, which a topic for another discussion !
My humble view is that a fund manager who has had a taste of what risk actually is in portfolio management, is actually a safer bet for the future. However, the fund of funds may not see it that way and it might just be the last fund that the manager has ever promoted. The negative sentiments have already put paid to many of the first time funds promoted by star fund managers in recent times who have quietly exited the fund raising process. It is a brutal world out there, fund raising for a PE fund is one of the toughest tasks on hand.
So what does the PE fund manager really do? He still has to come to office every day, five days a week; he still has a staff of 4+ members who have to be kept busy. Portfolio management of 7-10 deals tends to generate a fair bit of work both in portfolio management as well as LP management. He still has time left over as he is not actively investing or raising funds.
Even if he does want to keep himself abreast of what is happening in the market, the market does get to know the real picture very quickly and intermediated deals tend to dry up.
Getting more involved in the portfolio deals sometimes is viewed as interference, and it is my observation, that professional fund managers have not been able to bridge the gap between themselves and industrialists who may have a different educational background. That creates a lack of purpose in his life at the time when he is at this most active.
Leaving the firm and choosing to join another firm or a corporate would normally only be taken by someone who had low stakes in the current set up or whose stakes have no hope of generating returns. Any promoting PE fund manager would be cognizant that leaving the firm at that stage would not be regarded well in the cloistered world of money and would be the final coffin in his plans of ever raising private equity fund money.
There is a fiduciary responsibility further of making sure that the investments are exited and money returned back, whether it is cents to a dollar or a few X. If this were to be the case for many funds, and assuming that fund of funds have an economic pressure to also invest, one could argue that he stood a reasonable chance of raising money again, in spite of the adverse performance of the first fund.
The PE fund manager’s angst gets an amplification when he sees the follow on fund raising of the technology focused early stage VC funds – Helion, Sequoia, NEA, Indo US and Nexus which have all successfully continued to raise money in the difficult environment. Some of these VC funds have had stellar exits to boost their chances of fund raising, but that’s not been the case with all. It is also likely that some of these entrepreneurial PE fund managers have, at some stage in their careers, been offered a partnership by these VC funds which they declined as being a tech focused funds did not really add up to serious wealth on a excel sheet calculation, assuming smaller deal sizes and without the benefit of being able to assume higher exit multiples. Now with the multi time exit multiple demonstrated by the VC funds, the underwater PE fund managers are realizing that the excel calculation had not been truly reflective of the potential.
To add insult to injury, the ex-colleagues of these entrepreneurs who decided not to take the plunge and continued with their salaried position are today on a steep salary curve, earning around three quarters of a million dollars, easily three times that the fund manager is making. When you stack up the opportunity cost over a continued period of a few years, the gap is very difficult to make up.
My advice to these fund managers is – you are reading the tea leaves wrong. You did not make the wrong decision. You just did not read the risks right. Now that you do and are a better investment manager, don’t blow it by doing the comparisons that are not relevant. Focus on your reputation and work on your portfolio. If you have obdurate industrialists, who are out to bilk you from you returns, then be more obdurate. The laws of this country favour the investee so you have to work harder. Hunker down and prepare for the long haul.
The LPs will appreciate the work that has gone in. Those that fail to appreciate that work and are interested in a blame game – offer them an exit through a secondary sale to a secondary player who will be more mature -- there are many. If there is a domain that you are passionate about, invest in building your knowledge and skills – there are many ways. Remain focused, it’s a marathon not a sprint.
(Sumir Verma runs Merisis Advisors, a boutique investment bank.)
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