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May 28th, 2015

To The Bidder End

To the Bidder End. Private Equity is replete with many legends… We only look at proprietary deals … We are returning to our core for future funds… No one could have anticipated the size of the down cycle that killed that investment… All the partners who decided to make that investment have left the firm… but a personal favorite is “We do not participate in auctions.” If auction is narrowly defined as a large barn, filled with lizard boot clad citizens yelling offers at a string tied auctioneer repeating bids in staccato bursts, then the claim has merit. However, only certain oil leases in Texas are sold through the boys in the barn format. As long as there are two bidders or competition resulting in a bid and an ask there is an auction taking place. It does not take a sophisticated seller to organize an auction.

A simple declaration of “I won’t sell for less than $x” or the mentioning of other offers begins an auction. Today’s “WDPIA”(*) buyers pretend to avoid auctions in the following fashion. They learn of sale processes that are just beginning or that are impending. They contact the seller or his agent to learn what is expected to be the winning price in the process. After doing whatever diligence occurs to them they offer to pay at or well above the expected price to terminate the sale process (auction). If they prevail, they claim they did not participate in an auction as “bids” were never received since the buyer exceeded the anticipated bids. If they do not prevail they say they did not participate in an auction as the bid date for the auction was much later than their bid. In this same fashion Putin did not invade Crimea, he welcomed home Russians.

Other interesting practices filter paradoxically into the day-to-day operations of Private Equity firms. During fund raising PE firms strive to obtain investors who are sophisticated and very creditworthy so there is no issue of capital availability when needed to fund a purchase. As part of that process, the PE Fund promises not to create UBTI (“Unrelated Business Taxable Income”) which is created by borrowing against the Fund’s assets. Yet, with the twin underpinnings of reliable, creditworthy investors and the representation to avoid UBTI the financing tool used most in last two decades at the Fund level is a line of credit where the Fund is the borrower or, in effect, the guarantor. The cost of establishing the line of credit is several hundred thousand dollars. Interest costs are incurred when it is used. Let’s think about the economic decision. Investments take months to negotiate, so time is not a pressure since capital calls generally can be made with two weeks’ notice to the investors. Capital calls are made by secure email after being typed. Borrowing money at the Fund level for one day creates a risk of creating UBTI. Is several hundred thousand dollars the present value of typing? Perhaps the ability to manipulate Fund IRR by deferring the capital call outweighs the risk of UBTI to some firms, but do investors not adjust the performance when evaluating firms to remove the effect of IRR manipulation by leverage?

The methods of establishing the contract for portfolio monitoring fees has received recent deserved attention in the press. Certain private equity firms have purchased portfolio companies while simultaneously negotiating long term monitoring contracts with the companies that continue regardless of how long the PE firm will own the portfolio company. At exit, they get paid for the balance of the contract period even if services are not provided. This practice is akin to agreeing to a contract with your home security alarm company that continues long after you sell the house. No arm’s length contract would ever be so struck (Crimea exception noted). Since the PE firm owns the portfolio company with which they are signing the contract, there is no resistance to terms (Note: When I play golf alone and give myself putts there are few complaints). There is no objection from lenders as the payment is subordinate to the loan. Observers of this practice are left thinking of the Buddhist question “What is the sound of one hand clapping?”

I’m Rob Morris and I approved this blog.

(*) “We don’t Participate in Auctions”

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