Private equity?

Private equity? Due diligence questions to ask BEFORE investing with range of answers to expect.

1) A quant says she studied public equivalents to evaluate your private equity fund and found no evidence of portfolio diversification benefits. Your reaction:

i) If investors chose large-cap value index funds and borrowed 3X more cash and put that in also, they outperformed most private equity funds in most vintages. Please don't tell them leveraged buy-outs usually underperform leveraged public equity

ii) Quants should creep back into their hedge fund hovels. We are a pure alpha generator. Beta repackager? How dare she? Our brilliance drives our returns

iii) Our funds' performance are totally independent of the public markets and IRRs can never be transformed into time-weighted metrics anyway

iv) We comply with "peer" return reporting and our LPs are delighted with the numbers we claim to achieve and always commit to new fund raisings

v) We avoid anyone with mathematical ability beyond basic arithmetic. It would destroy our fundraising business model. Swensen says we add value therefore we do.

2) Why is your firm trying to IPO when you claim a company being private is so good?

i) So we can take ourselves private again later after our public stock implodes. Only way to get proprietary dealflow these days

ii) We urgently need public stock currency so we can short sell our founders' equity

iii) It is our master plan. Take everyone else private while we go public and the passive index tracking crowd will only be able to buy us

iv) Permanent capital - ten year lockups and high fees for the repackaged beta we provide don't pay for the standard of living to which we have become accustomed

v) Future carry monetization, getting out while we still can...anything else that sounds plausible to the unwashed masses

3) What is the outlook for big private equity?

i) Big private equity is a dinosaur and the industry destructing credit cataclysm heading our way is getting bigger in the sky

ii) Private equity? What's that? We are a hedge fund firm now

iii) There will soon be no banks left who will finance the debt on our dubious deals so we are reliant on dumber hedge funds">hedge funds that don't understand credit risk either

iv) We are going to crush those hedge fund clowns although we ourselves use more leverage and take higher risk

v) The day traders running hedge funds">hedge funds are bound to get it wrong if they try to step on our turf. We can lose clients' money even quicker.

4) How many private equity people does it take to change a light bulb?

i) 10 big private equity firms, 100 investment bankers and a 100 lawyers

ii) Not applicable. My deals never fail and my light bulbs never fail

iii) I think one of the underbutlers takes care of my light bulbs

iv) Don't know. But the LPs pay for our light bulbs somewhere in the numbers

v) The CEOs of our portfolio companies change our light bulbs whenever we say so

5) What are you working on right now?

i) I can't talk about future LBO dealflow but, off the record, the tickers GE, XOM, MSFT, AAPL and GOOG could be available soon

ii) sprucing up my resume to try to get a hedge fund job

iii) raising a new fund and getting our own and portfolio IPOs out while we still can

iv) Not much. We prefer to do deals in the last quarter just before carry calculations. Our deals are long term but fees are short term

v) Selling an overvalued pre-IPO stake to a strategic investor so the retail punters will think we have a proprietary pipeline of "Asian" deals.

6) What is your outlook for the alternative investment industry?

i) LBOs are widely understood now. Corporations can take on debt and recapitalize themselves. Quick flips are gone and we have little to offer long term

ii) Hedge funds speculate in obscure securities, exotic derivatives and arcane strategies incomprehensible to anyone without a Fields medal. Forget about hedgies

iii) We've had a good run with institutional investors and our IPOs permit some extra fun with retail as we exit the big private equity end game

iv) "Absolute consent", "Yank the bank", "Snooze you lose". As long as we retain total control of every aspect of the financing behind deals we will be fine

v) Who cares? My estates, planes and yachts will be secure after the IPO.

7) Where have all the trade buyers gone?

i) Private equity people are supreme geniuses but trade buyers are "corporate" bureaucrats

ii) Trade buyers have a thorough understanding of the prospects and risks for their industry and deep domain experience but private equity firms don't

iii) Private equity firms have taken any potential strategic buyers private already

iv) Private equity funds invite investment banks into the syndicate and pay higher advisory and fairness "opinion" fees than trade buyers

v) Trade buyers acquire a firm when it makes a logical fit at a sensible price whereas private equity firms are a tad less choosy

8) Portfolio company CEOs, CFOs and chairman of the boards?

i) Are our partners in restructuring and realizing gains in a future public listing

ii) Are required, by law, to work to maximise shareholder value

iii) Are required, by us, to work to minimise shareholder value to get the stock
down to our target acquisition price

iv) Must agree to pay us vast dividends regardless of EBITDA and financial strength

v) Receive a few crumbs of compensation that drop off our table

9) The most important hire for a private equity firm is:

i) A former corporate titan with a golden rolodex who I met recently in Davos

ii) A has-been politician who told you they have lots of global "friends"

iii) Very good-looking male and female fund raising placement agents

iv) Some associates to do some work while I am out partying and pontificating

v) Anyone who looks at the balance sheets of our recent deals and doesn't vomit

10) Why did the private equity GP cross the road?

i) To avoid the roadkill of lending banks and default protection sellers
ii) Because there was an unemployed former head-of-state on the other side
iii) Trucks and SUVs cannot hit them, just like economic downturns cannot hit them
iv) Road? I always use the helicopter. I might buy roads but I don't use them
v) Because he saw a bunch of disgruntled LPs ahead, who had just found out that private equity is not an alternative investment

Bonus question:

Fund A fully invests from day one and an independent administrator begins calculating accurate performance numbers. Investors have liquidity and access to all their compounded capital at a month or two's notice. Even if the equity and fixed-income markets implode and the world economy collapses, Fund A still generates good absolute risk-adjusted returns. Fund A manages strategies which are kept proprietary.

Fund B draws down dribs and drabs of your capital over many years. You must keep the cash at hand because you don't know when the call will come. It charges fees from day one but returns are calculated from when it invests. Investors won't know for a decade how the fund performed and even then it is not so clear. Sometimes it might get around to paying out a distribution. Fund B is dependent on good equity AND credit markets. Fund B's strategy is well known and easily copied.

Should a prudent fiduciary seeking REAL diversification invest in Fund A or Fund B?

by Veryan Allen. Copyright

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