It’s not just the deal team: the increasing interdependence of back and front office functions at private equity firms
September 2013 | EXPERT BRIEFING | PRIVATE EQUITY
I am, I should admit up front, a New York Yankees fan. Certain virtues and vices follow from this with grim inevitability: a love of the game and a well-developed sense of history, true, but also – let’s be honest – a slightly unattractive triumphantilism. Most of all, being a Yankees fan means following the machinations of the back office with as much zeal as those of the front office. What Joe Girardi does on the field is incredibly important, but what Brian Cashman does in the smoke-filled back rooms of the stadium are every bit as consequential, if not more so. In private equity, too, the world of the back and front offices are colliding, and in private equity too, a number of the most interesting deal trends are related to underlying drivers in the so-called ‘back office’.
The following are three areas in which the private equity ‘back-office’ – a perhaps slightly unfair generalisation comprising all of a financial sponsor firm’s non-deal functions – has an impact on, if not governs outright, ‘front office’ behaviours – and why, as an adviser to financial sponsors, it is critically important to keep the ‘back office’ in mind.
First – overall fund life cycle governing buyer behaviour
It has become increasingly clear to us that funds behave differently as buyers depending on where they are in their life cycle, with risk tolerance generally decreasing over the course of a fund’s life. The key exception to this trend, of course, is where a fund has materially underperformed – at which point risk tolerance can be expected to increase rather than decrease as the sponsor seeks to swing for the fences. This means that both fund life and fund performance must be analysed in concert to successfully gauge a sponsor’s buyer behaviour. When advising sellers, we are always careful to track these metrics, and we utilise a number of proprietary databases to do so. We specifically review aspects of fund life as well as fund performance when preparing buyers’ lists and, to an even greater extent, when down-selecting buyers in the latter stages of an auction.
Second – valuation
Since the financial crisis, it has been the norm for hedge funds to hire third party valuation experts to value their Level 3, and, to an increasing extent, their Level 2 assets. Private equity firms, by contrast, usually perform and self-report their own valuations. However, because of increased regulatory scrutiny, diminished risk tolerance by auditors, and an awakening of interest in independent third party valuations within the limited partner community, this trend is also changing. More private equity firms are reviewing and considering third-party valuations, and calling on third party valuation experts to provide this service.
Valuation isn’t just an accounting or ‘back office’ issue, however; portfolio valuation marks impact sponsors’ ‘front office’ behaviour as both a buyer and seller of assets. In addition, these valuation marks also may be of critical relevance in both the primary and secondary markets for a fund’s limited partnership interests. Because of this, we find ourselves working increasingly closely with not only the chief financial officers of funds, but also their IR professionals, and even their general counsels and chief compliance officers.
Third – the ‘zombie fund’ phenomena
Market interest has been piqued by a number of innovative transactions recently, which some characterise as ‘Whole Fund Recapitalisations’ (WFRs). While WFR transactions still vary somewhat among themselves, an emerging paradigm has an alternative capital provider, perhaps but not necessarily from the secondary market, fund the acquisition of an entire fund. Old limited partners can opt to either cash out or roll their interest and the old general partners are re-incentivised by resetting the carried interest and other performance incentives in a way that benefits all stakeholders. A properly-structured WFR can do much more than is currently and commonly understood. For example, it can provide offensive as well as defensive capital for the restructured fund. Even more interestingly, a WFR can provide enable portfolio-level debt recapitalisation at individual portfolio companies, thereby forging a powerful weapon for a beleaguered fund. A zombie or near-zombie fund can find new life in a WFR.
These three examples are emblematic of the truth that as the private equity world becomes more competitive, the most creative advisers to alternative capital providers will need to understand the complex interactions between what happens on the deal side and at the fund ‘entity’ level. The best advisers will be those who have professionals working with both the ‘front’ and ‘back’ offices of their private equity clients and who fundamentally understand the interaction between the two.
Justin Abelow is a managing director in the Financial Sponsors Coverage Group at Houlihan Lokey. He can be contacted on +1 (212) 497 4206.
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