“Strong relationships are crucial to successful investing in buyouts. We are very proud of the depth and breadth of the connections we've established after more than a decade in this industry.”

Media Coverage

Mergers & Acqusitions
A Different Kind of Tombstone
(Cover Story - September 2007)
By Ken MacFadyen

"Private equity has the highest barrier to exit." It's a quote htat has been widely attributed to Peter Dolan, a director in Harvard's endowment, and appropriated by pros of the industry for the past couple years. Its premise, of course, is that even private equity's poor performers can always live to see another day.

Until recently, evidence has been scant to disprove Dolan. With limited partnership fund lives aged to perfection for ten years, it's hard to miss an upcycle (or two) in which to find realizations. And over a decade, unless a firm bet big on a sector that completely blew up, it can be easy to pad the track record with at least a few big scores. Moreover, with $972 billion flowing into the asset class curing the past two and a half years, according to Private Equity Intelligence, it would be a good bet that much of that capital is cascading down to those not lucky enough to call themselves top-quartile funds.

Indeed, one market watcher, who wished to remain anonymous, likens the asset class to an aging hair band. "It's a lot like a rock group in some ways," the source says. "Look at Van Halen. David Lee Roth is still out there and Eddie Van Halen went solo. With all the capital in this market, almost anyone can raise a new fund, or in a worse case scenario, line up some investors and put together a pledge fund." (The source didn't even mention Sammy Hagar, who is still out touring as well.)

Evidence of this tough-to-kill portraiture is easy to find. Take the case of J. H. Whitney. The venerable firm has been around since 1946 and its founding partner Benno Schmidt, who worked alongside John Hay Whitney, is even credited for coining the term venture capital (a derivation of "private adventure capital" according to a 1989 New York Times story). But if Whitney was a rock group, to borrow the band theme, it would probably be likened to Guns 'n Roses. The cast has largely changed, and they've suffered through their share of turbulene, yet the firm is still around and active. In February of last year, Whitney was even able to surpass its $750 million target for its sixth fund, despite a track record that includes a negative 23% IRR for its 1999 vintage Fund IV, according to CalSTRS.

But Whitney is not the only group to demonstrate such stubborn perseverance. "Take a group like Fenway Partners," says one LP who didn't want to be named. "They've had disastrous results but they'll still end up raising $750 million. If that's the penalty for being wrong, than this is a pretty great asset class to be in."

A source familiar with the firm said that Fenway has yet to close its latest fund. A Fenway spokesperson, meanwhile, declined to comment. But evidence of the firm's mixed performance has been made public by CalPERS. According to the latest return data from the pension, Fenway's first fund, raised in 1996, is showing an IRR of 0.2%, while its second fund, raised in 1998, has fared much better with a 12.9% IRR. (It should be noted that according to Thomson, the top quartile for 1998 vintage funds begins at 10.9 percent.)

While Whitney and Fenway would seemingly provide ample evience to support the Peter Dolan chestnut, a change is afoot in the middle market that would suggest the barrier to exit is being lowered. Last December, Questor Management announced it would disband following a slew of defections and a failed fundraising effort. The firm but itself into wind-down mode and AlixPartners vet Larry Ramaekers was brought in to sell off the remaining portfolio companies.

It seemed like an isolated incident. Then in June came news that Cypress Group and Trimaran Capital Partners had abandoned plans to raise their respective third funds, with each also showing similar symptoms to Questor, namely partner defections. Trimaran, reportedly, will raise what Dow Jones' "LBO Wire" termed an "interim fund," which reportedly will enable the firm to continue hunting for new investments as it determines its next move, while the partners from Cypress, again according to Dow Jones, have been using their own capital to pursue investments.

Trimaran declined to comment for this article, while calls to Cypress and former partners of the rim, were not returned by press time.

If a fund isn't all that great, the LPs will take a step back, and say, 'Let's see how the next one goes,'" says Brian Gallagher, co-founder of the fund-of-funds manager Twin Bridge Capital Partners. "Once you start getting that kind of negative momentum, it can snowball. Some of the guys with connections will move on, and the story only gains more momentum from there until it's a self-fulfilling prophecy."

"It can be any number of reasons," says Larry Jordan Rowe, a partner at Ropes & Gray, describing what can send a firm into crisis mode. "It could be the departure of a star manager, a high-profile investment failure, or other large investors abandoning a fund. Even if it's unfair, these factors can make finding capital that much more difficult."

Ultimately, though, most pros agree that it begins and ends with performance. If a firm's fund is in good shape, LPs will fight to get into it, while GPs who might consider defecting could be leaving too much on the table to ever follow through. And considering the discrepancy between upper quartile and bottom quartile in the middle market, the bar has been raised on what constitutes "acceptable" performance.

"If you're a mid-market fund generating median returns your limited partners will not be happy," says StepStone Group's Monte Brem, CEO at the institutional consultancy and asset manager. He further identifies that the median in the middle market means "not losing money, necessarily, but not producing any significant return, either."

Based on the symptoms of dissolution, it would appear that Cypress and Trimaran aren't short on company, and some of the names scrambling to find money might surprise industry watchers. J.W. Childes Associates is one group that by all appearances could be approaching its final throes. In July, principals James Rhee, Jeffry Teschke and Mark Tricolli all left the firm, following a path blazed by former J.W. childs president Dana Schmaltz and partner Ted Yun. According ot one institutional invetor that wished to remain nameless, "They've had some shaky results lately. I think they could easily raise capital at some level, but they won't get close to what they're used to."

According to the latest fund performance data from Utimco, J.W. childs' most recent fund, raised in 2002, is showing an IRR of 8.35% with a cash-on-cash return of 0.35. And a report from the Boston Business Journal indicated that the firm has indeed pospoed plans for a fund IV.

For the Boston firm, the question now becomes whether or not John Childs and the remaining top brass want to forge ahead and can swallow their pride enough to take significantly less than the $3.5 billion target originally brought to market. The same institutional investor equates the decision Childs is currently faced to what Ted Forstmann confronted before he decided to wind down Forstmann Little back in 2006. "John Childs has more money than he can spend for at least a couple lifetimes, so it will come down to pride," the institutional investor says.

Multiple calls to Childs, meanwhile, where not returned by press time.

Willis Stein & Partners is another group showing similar warning signs. It has encountered some turnover, as Mark Michaels and Daniel Gill no longer reside among the firm's managing directors, but the most conspicuous red flag is its up-and-down performance. Its first fund proved to be a huge success, with a 20.3% IRR, according to data from Utimco. The 1999-vintage follow-up, though, has underperformed, with a negative IRR of 7.22% as of February 28, 2007. What is perhaps more telling is that Willis Stein, based on its Website, hasn't lined up a new platform deal since October 2005, when it brought Strategic Materials from Lincolnshire Management.

"it's because they don't have any money," quips the LP source, although another industry source close to the firm insists that Willis Stein still has capital available and has been making follow-up investments in the companies that are already part of its portfolio.

The firm is trying to remedy that, however, as it has stepped up its efforts ot appease LPs with a push to secure some realizations, the idea being that retuning money to the limiteds, the firms backers will be more apt to recommit. As of press time, it was shopping supermarket chain Roundy's, and stated to sell of Ziff Davis Holdings though a piece-mail sale process (the Ziff Davis' Enterprise division was sold to Insight Venture Partners in a $150 million deal in late June.) This past April, Willis Stein also exited National Veterinary Associates through a sale to Summit Partners, but in December, its 1998 investment in Neoplan USA took a hit when the bus-maker went bankrupt.

Willis Stein declined to comment for this story, but the same industry source speculates that a Willis Stein Fund IV could be coming soon. If it manages to match the $1.8 billion raised by its predecessor, however, remains to be seen.

While things migh look bleak at the moment, few in the industry would bet against these firms. Says the LP source: "It's hard to kill these guys off. They can linger around for years, and I think they're all hoping that they can hol on long enough to show their limiteds that they can change."

Fire Drill Mode

To be sure, before dissolution becomes the answer, most pros will scratch the claw for money in order to live another day. "They'll resort to any alternative," says Mounir Guen, founder of global placement agency MVision. They don't have much of a choice."

Guen describes that often firms will reduce the conomics of a fund in order to generate interest among potential backers. In the case of Trimaran, for example, the partners will reportedly not collect the management fee on the capital commited to the interim fund, and the fund's backers also have the right to forego any deal that the partners bring their way.

Others, meanwhile, have sought other paths. A number of pros from Triumph Capital, which disbanded after its chairman was caught bribing pensions for fund commitments, helped launch a blank-check company, Stone Arcade Acquisition Corp. Through that vehicle, the investors eventually bought the assets of an International Paper subsidiary. The former pos at McCown De Leeuw, meanwhile, which disbanded in 2004, also attempted to go the public route, but never did follow through with an IPO for blank-check company MDC Acquisition Partners.

While these alternatives are a far cry from a blind pool with a two-and-twendy fee structure, the idea is that if the pros can reprove their strategy, even if it's one deal at t time, they can get back in the good graces of the limited partner community. However, to to this route requires pros to put aside their ego for an alternative tha offers no gurantees.

"Anyone and their mother can have a pledge fund," says on pro currently in the midst of launching his own debut vehicle. "It's really not even a fund, but people who don't have a track record or need to rebuild a track record will try to get deals done however they can. They'll try to realize some returns and use that to line up institutional investors,"

According to LPs in the marketplace, though, once a firm hits the wall, it can be difficult to ever convince investors to re-up for a new vehicle. "Once you becume a fundless sponsor, it's vvery hard to get back on the mainstream track," says Twin Bridge's Gallagher.

Moreover, a mid-market banker says that when a firm starts showing signs of trouble, the negativity could start impacting dealflow. He cites the case of one general partner that, after the expiration of their fund, "had a warehouseing deal with Goldman Sachs."

The source notes that "under closer inspection" Goldman's backing not only included proprietary deals. "Goldman's not going to supply upfront equity to look at an auction with 100 other guys. So as it turned out they didn't really have any commited financing, which makes it awfully hard to show them deals."

That shouldn't preclude anyone from keeping up the fight, though. A year ago, most industry watchers though Boston-based Heritage Partners was a likely candidate for dissolution. The firm had sent out a memo to its limiteds, according to The Deal, that detailed and warned investors of pending and future writedowns, and disclosed the retirments of two of the firm's three founders. Today, however, the firm's remining co-founder Peter Hermann tells M&A that things are back on track after what he clals "an enormous transition." Heritage trimmed staff, executed a string of realizations and rebranded itself as a lower middle market firm (as it had been prior to its $840 million third fund).

Heritage, which is working iwht institutional backers on a one-off basis, has even started lining up new deals, according to Hermann, and he anticipates returning the fundraising market "shortly" for a new vehicle.

"We worked extremely hard to do the right thing for our limited partners," Hermann says. "Others in our shoes would've said, 'The hell with it," and just walked away... It took an enormous effort to get the old portfolio in shape, and it hasn't been a lot of fun, but the hope is that we were able to earn the appreciation and respect of our LPs."

He adds that certain investors have remained "tremendous supporters," while others will probably walk away. But he fully expects to raise a fourth fund, and has even started adding staff again.

Meanwhile, a source close to Trimaran is confident the New York firm will show similar resiliency. He cites that since Trimaran's first attempt to raise its third fund, it has scored a number of realizations, which should make fundraising easier the next time it goes back to its limiteds. "The investors probably though they were a little early [going to the market]" the source says. "They've returned a substantial amout of money in the past 18 months, so they will get it done."

One down, three up

A number of factors have contributed to struggles facing some in the middle market. Many pros M&A spoke with are quick to point to the amount of capital being consumed by large market funds, saying that the $15 billion-plus vehicles raised by the likes of Blackstone Group, Kohlberg Kravis Roberts, Apollo Management and others are sucking the market dry. Others, meanwhile, cite the competition in the middle market, alluding to Hamilton Lane's now famous barbell theory.

And for every firm that closes its doors, it's relatively easy to find three or more new groups that have launched debut funds - and sometimes these new groups can have a lineage that extends to the shuttered shops in question. When Questor shut down, for example, there was a diaspora of the firm's former pros, who opened up new firms and launched new funds. Mark Carroll is heading up Superior Capital partners, which is reportedly seeking around $100 million in commitments for its inaugural fund, and Kevin Prokop, along with four other former Questor pros, launched Wimbleton Partners to target deal sin the aerospace sector. Not to be forgotten, Michael Madden, who left Questor in 2005, is currently raising a debut fund for BlackEagle Partners.

"In a market in which there's so much choice, investors can afford to take a critical look at performance and say they're not interested," says the LP.

This sentiment is echoed by Gallagher, who describes the juxtaposition of good and bad in today's market as "a real mixed bag."

"At one end of the extreme are groups that don't even need to print out the PPM. Enough buzz is surrounding them that they can literal just reach out to their existing LPs and close a fund," he says. "At the other end are the groups whether it's first time funds or firms with a track record that's not so great, who'll really have a hard time raising capital."

Whether more groups succumb to the fate of Questor or Cypress remains to be seen, but some in the market anticipate this could be just the start. "I think we'll see more [firms dissolve] going forward," MVisions Guen notes. "Investors are quite focused on finding exactly what they're looking for. Even though there's so much money available, if you don't fit the bill, you could be in trouble."