Wednesday, May 20, 2020

Silence of the Hams is the earnest request of much of the population as we are forced to endure clueless elected officials, network talking heads and faux Cassandras as they elbow Dr. Fauci and other thoughtful speakers away from the microphone. Massive unread aid bills are approved with little thought given to implementation nor to whether or not their terms would discourage reopening. In 1632-33, the plague inflicted death upon every family in Oberammergau, Germany. Townspeople vowed to perform a Passion Play revering god every ten years at the town cemetery if there were no more plague deaths. The Passionsspielen has been held for the past 400 years and was to be held this year. Ironically, due to the current plague, it has been postponed until 2022. Once the current plague ends, it is unlikely we will see plays written offering homage to the chattering officials who presided over this sadness. Now that the head of Softbank, Masayoshi Son has compared himself to Jesus, perhaps he imagines he will be the Son between the Father and the Holy Ghost.

The Covid shutdown and staggered reopening has several implications for private equity. At the macro level, two conclusions are apparent: 1) politicians, for whom a good sound bite is never trumped by facts, have deemed private equity a force for evil and 2) the company and investment performance reduction caused by the Covid issues and the inevitable slow return to growth will likely sever the structured alignment built into Private Equity Fund agreements. If we explore for a moment the consequences of each they are distressing. The CARES Act which provides loans and grants to business was drafted to exclude private equity companies from receiving any of the money. Private equity companies employ millions of American workers yet the law says the jobs of those workers are less worth protecting than similar jobs in companies owned by others. Thousands of workers have been laid off due to this decision. The cartoon notion is this somehow punishes a Shylockian private equity manager, but it actually puts at risk the worker and the pension fund investors in private equity. If a politician were asked “Will you protect jobs and worker’s pensions?” they would race to say “yes” while, in fact, they have just done the opposite. Full disclosure: Olympus did not need nor seek any of their money, but we were astonished at the favoritism.

Years of iterations of negotiations between investors and private equity managers have led to a structure that aligns interests between the two parties. The basic structure calls for the following priorities for splitting proceeds before the private equity manager earns any profit interest: 1) return of capital, 2) return a profit of 8% and 3) return all fees paid to the managers. Once all conditions are met, then the private equity manager shares in the profit. IRR, or internal rate of return, is the measurement used to calculate returns in this business and it is keenly time sensitive. The longer it takes to realize gains and the longer it takes a company to achieve targeted performance, the lower will be the IRR. Clearly, the Covid period is causing severe performance issues for many companies. The sheer math of the lower performances, the extended time period required to recover and the effect on exit timing and valuation dictate an expected decline in IRRs. The result of this is likely to be several vintage years of funds that will see their IRR sink below the waterfall discussed earlier and leave the private equity manager with little incentive to sell assets, a strategy misaligned with their investors.

I’m Rob Morris and I approved this blog.

Silence of the Hams