On 10 April 2012, CFA Society Toronto, the Canadian Venture Capital and Private Equity Association (CVCA), Financial Executives International (FEI) and The Canadian Institute of Chartered Business Valuators held its 5th annual private equity symposium. Those who attended learned among other things, about the mating rituals of pandas from our keynote speaker, David Rubenstein, co-founder and managing director of The Carlyle Group, and were serenaded by New York activist manager, Eric Rosenfeld, President and CEO of Crescendo Partners LP. (Yes, you will probably not want to miss next year’s event when we may have circus performers, and other novel presentations!)

Advice for General Partners (“GPs”)

If you are a GP looking at raising capital for your next fund, you may want to take note of the advice from four of Canada’s largest institutional investors. You will need:

1. A strong and consistent track record of outperformance over the applicable public benchmark of between 800 to 2,000 bps (that is not a typo – Canadian pension plans who invest in third party funds are looking for net returns of 20% or more from fund managers or they will invest directly themselves!)
2. A sense of investment discipline and ability to time entry and exits well. How your fund(s) performed during the financial crisis is important.
3. Competitive advantage, either through geographic or sector expertise.
4. Internal operational and strategic bench strength (not reliance on leverage and debt) as a basis for outperformance.
5. Superior transparency and reporting to Limited Partners (“LPs”) so they can evaluate independently whether unrealized valuation gains are being fairly recognized.

LPs also offered insight into behaviours of GPs that they disliked:

1. Undisclosed turnover of management and key investment staff.
2. Strategy shifts either midway through a fund or between funds. (So if you are a large cap buyout fund and you are suddenly adding small cap companies to your portfolio – watch out!)
3. Large numbers of unrealized companies in portfolios and few exits, especially funds that are getting “long in the tooth”, and seeking to raise a next fund.

More advice for GPs

As for advice on exits, the second panel of GPs gave the following advice and comments:

1. Plan exits before entry. Determine who your natural buyer might be, whether it is strategic or financial or whether you can bring the company public.
2. Build value first. John Haick of Brookfield Asset Management, suggested a laser focus on operations; surface hidden assets and concentrate on the high margin products and services; engage and be active with management; preserve capital; and be conservative when using leverage.
3. IPOs are not the best exit option today as markets are choppy and you will end up still owning some percentage of the company (and thereafter are subject to daily mark-to-market changes on that position).
4. For quality companies it is a seller’s market currently as EBITDA multiples have almost returned to their 2007 highs of around 9X EBITDA.
5. If selling a portfolio company, determine if you will be hosting a wide auction or conducting a targeted sales process.

What to do when an activist comes knocking?

A message from the third panel was that if you are a GP and if: (a) your company has poor management (either you have an evil CEO or he/she is simply incompetent); or (b) your company has operational and/or strategic issues; or (c) your board is no longer independent; or(d) your company has the wrong capital structure – watch out – your company may be on the radar screen of an activist investor. Eric Rosenfeld particularly likes to target Canadian companies because our securities laws make it easier for activists to requisition shareholders meetings and submit shareholders’ proposals, including proposing new director nominees. Stephen Griggs, President and CEO of OPSEU Pension Trust said that it was due to Canada’s broader shareholder proposal rules that “Say on Pay” practices have been adopted by many corporations in Canada.

“Attractive PE opportunities exist in Europe, China, Brazil, Indonesia, Sub-Saharan Africa and North America”

Stan Pasternak, former SVP and Treasurer of Canadian Tire gave advice on how to defend against activist investors such as Eric Rosenfeld. He strongly recommended that every public company develop a “playbook” that can be taken off the shelf at a moment’s notice and that sets out the company’s plan when confronted by an activist’s forays. The playbook should contain a detailed contact list of who is on the emergency team, including all outside advisors. It is necessary to have a response protocol as to who is authorized to speak on behalf of the company. This protocol must immediately identify key constituents including, important customers and suppliers, unions, bankers, rating agencies, and employees. An engagement protocol is also necessary. But most importantly, management must maintain strong operational management and focus on cashflow and liquidity. In the meantime, the company must maintain high quality communications with the investment community.

Stephen concluded the third panel by saying that what we used to call “greenmail” is today considered good governance. How times have changed!

Challenges and opportunities for private equity (PE) firms

David Rubenstein gave a chilling warning to his fellow private equity fund managers – the next several months will be an investor relations’ nightmare for Global & U.S. PE firms due to the upcoming presidential elections with Mitt Romney being named the Republican candidate. PE firms already have image problems and he listed challenges as follows:

1. Returns – it will be difficult to produce 20% plus returns that top quartile PE firms have historically generated for investors because firms now need a minimum of 40% equity in deals (not the extreme leverage of yore). As well, today’s sellers are sophisticated and demanding 9X EBITDA multiples for quality portfolio companies.
2. Talent – does the PE firm have professionals with hands-on operating expertise?
3. Data gathering – PE firms have not historically gathered and shared data about job creation in portfolio companies and as an industry will need to provide evidence that they have created (not destroyed) jobs through downsizing and offshoring. Otherwise, they may find themselves targets for regulation and adverse media attention.
4. PE firms will need to find new sources of funding as traditional institutional investors, including public pension plans, are scaling back the number of their fund investments. PE firms need to reach out to sovereign wealth funds and to private wealth firms for capital. There were only 900 PE firms in 2007 and today there are almost 1,800 firms competing for the same pool of institutional private equity capital.
5. PE firms need to brand themselves more effectively and to be able to define what they are good at and to stick with it.

“Returns of 800 to 2000 bps above the applicable public benchmark are required by prospective investors”

Despite challenges, David was optimistic about the following:

1. PE firms that can add value by bringing in experts to improve a company’s operations will continue to be able to generate outperformance over public market benchmarks.
2. While 20% plus returns may be unrealistic, mid-to-high teen net returns are not. These return expectations are still significantly higher than those of public equity markets.

Geographies and sectors where PE firms can still generate attractive returns were also highlighted:

1. Europe – out of the debt crisis there will be some good companies trading at very attractive valuations. He noted the Eurozone’s GDP is larger than either the US or China.
2. He is a bull on PE investments in China. China is likely to overtake the US as the world’s largest economy by 2030.
3. He is bullish on Brazil as it has the world’s 5th largest population and the 6th largest economy. Unlike China, 70% of Brazil’s GDP is domestic consumption.
4. Indonesia – it is abundant in natural resources, has the 4th largest population and has recently sorted out its political problems.
5. Sub-Saharan Africa – though still a frontier investment market, PE opportunities are growing in this region. There are 800 million people in 40 countries in the region and the average age is 18 versus 40 in most of the developed world.
6. Arctic – 15% of the world’s oil reserves can be found in the Arctic. With the polar ice cap only approximately 75% of the size that it was 20 years ago, shipping routes have been opened up in the north that will allow for increased transport and development through the north.
7. US and Canada – there is something to be said about continuing to invest private equity capital in a region that respects the rule of law and corporate governance.

In terms of sectors, David is quite keen on: carbon energy; agribusiness; healthcare; and mining. If David’s predictions prove to be correct, this will bode very well for the Canadian economy; however, this may not be the case for the poor panda.

Content at this year’s Private Equity Symposium was strong, insight was in abundance and time was very well spent. We look forward to next year’s program and hope to see you there.