ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OCTOBER 2010 OF NUMBER 279a

Chicag­o Fed Letter

Understanding the new world order of by William Mark, lead examiner, Supervision and Regulation, and head, Private Equity Merchant Banking Knowledge Center, and Steven VanBever, lead supervision analyst, Supervision and Regulation

The Federal Reserve System’s Private Equity Merchant Banking Knowledge Center, formed at the Chicago Fed in 2000 after the passage of the Gramm–Leach–Bliley Act, sponsors an annual conference on new industry developments. This article summarizes the tenth annual conference, The New World Order of Private Equity, held on July 21–22, 2010.

To kick off the conference,1 Carl loss of competitiveness over the long Tannenbaum, Federal Reserve Bank ­ term for the U.S. and other developed of Chicago, reflected briefly on the ­ economies relative to China and other decade since the passage of the Gramm– emerging countries. Hutchins cited a Leach–Bliley Act. These years saw exten- number of negative indicators in the U.S., sive financial innovation, along with the such as rising health care and energy removal of regulatory barriers that ­ costs, the trade deficit, governmental traditionally separated the activities ­ budget deficits, loss of leadership in tech- of commercial and investment banks. nological innovation, lagging educational The financial crisis prompted a reeval- systems, and political polarization. By a number of measures, uation of many views that had been the state of private equity widely held, culminating in President State of the industry has improved since the worst Obama signing the Dodd–Frank Wall A panel led by Mark O’Hare, Preqin of the financial crisis, but Street Reform and Consumer Protection Ltd., explored the evolving role of pri- Act on July 21, 2010 (by coincidence, vate equity (PE) in the economy and many features of the asset the first day of the conference). in investor portfolios. It featured Paul class have been altered. Carbone, Baird Private Equity; John In another wide-ranging presentation, Crocker, Atlantic-Pacific Capital; William Glenn Hutchins, Silver Lake, offered a Franklin, Conversus Asset Management; sobering assessment of the long-term Greg Uebele, The Boeing Company; challenges facing the U.S. economy. He and Wilson Warren, Lexington Partners. emphasized how massive deleveraging Based on extensive data presented by by financial institutions, businesses, and O’Hare, PE has clearly improved since consumers could severely reduce fu- the severe downturn it experienced in ture economic growth. He also warned late 2008 and early 2009. Net cash flows that recent fiscal and monetary stimu- to limited partner (LP) investors (see lus programs could lead to future note 1) fell sharply during that time problems, such as unsupportable levels period. Valuations have recently recov- of public debt or high inflation. U.S. ered after large declines. The impact consumers, who represent approxi- was most severe in the largest (“mega”) mately 17.5% of global gross domestic (LBO) funds,2 but product (GDP), may no longer be re- these have also rebounded substantially. lied upon to drive economic growth. Surprisingly, even the worst vintage of Hutchins also stressed the potential LBO funds—2006—has largely recovered its value, reflecting favorably on the PE mergers and acquisitions volume, deal better terms in the current environment. business model. flow, fundraising, and other factors Investment opportunities over the next that reinforced the conclusions of 18 months that the LPs were most inter- Fundraising is still very challenging, but O’Hare’s panel. ested in included mezzanine7 and other LPs, by a large margin, still plan to main- fixed-income securities, “rescue financ- tain or increase their allocation to PE, Meredith Coffey, LSTA, surveyed recent ing” for deleveraging companies, and especially in smaller funds and specialty developments and future prospects in “dislocated and distressed seller” trans- areas. Deal flow has clearly recovered, the leveraged loan market.5 In the 12 actions—all relatively nontraditional particularly in North America and Asia, months prior to the conference, there targets for PE by historical standards. covering a wide range of industries. In was a considerable recovery in this mar- 3 the secondary market, strong motiva- ket, followed by a small retrenchment Investing in the financial sector tion to sell on the part of LPs needing due to European sovereign debt prob- Mark Gormley, Lee Equity Partners, ­ liquidity has been offset by the large lems. A large volume of leveraged loans, assessed the opportunities and risks of price discounts sellers have recently which Coffey referred to as the “refinanc- investing in the financial sector. Histor- faced. Finally, O’Hare cited a number ing cliff,” is due to mature over the next ically, a significant amount of private capital has been invested in financial institutions in difficult times, such as The new financial reform legislation will significantly affect when banking problems arose in the banks’ involvement in private equity; however, many of the late 1980s and early 1990s and during specifics remain unclear. the most recent banking crisis. Gormley judged that, from a policy perspective, the regulatory response to the most re- of studies indicating the favorable effects few years. Strong issuance of high-yield cent crisis has seemed to be appropri- of PE on the broader economy. These bonds during 2009 and the first four ate—regulators have proactively and ­ include creating jobs, improving the per- months of 2010 has supported the ­ effectively managed the impact of bank formance of portfolio companies, pro- refinancing process, but high-yield ­ failures. However, he also said that in viding superior returns to pension funds issuance dropped sharply in May and some cases regulators may have been too and not-for-profits, spurring innovation, June. Purchases of leveraged loans by patient with distressed banks, allowing and seeding economic recoveries. issuers of collateralized loan obligations them to persist with minimal or negative (CLOs)6 will need to play an important equity. Letting banks remain impaired The panelists, representing both gen- role in reducing the size of the refinanc- reduces new loan origination; this in eral partner (GP) and LP perspectives ing cliff. However, Coffey indicated turn lowers new job creation and slows (see note 1), provided additional con- that recent legislation, specifically the the pace of economic recovery. Gormley text for these industry data. They noted Dodd–Frank Act’s risk retention require- said that, with fund managers having how the quality of valuations has im- ments for certain securitizations and allocated more than $20 billion of funds proved in recent quarters, coinciding the Foreign Account Tax Compliance to recapitalize banks, private capital can with the application of fair value account- Act, threatens the revival of the CLO be an important part of the solution. ing rules.4 In addition, new legal and market (and thus the future liquidity Private capital investors assist firms by regulatory developments (discussed in of the leveraged loan market). 1) working with seasoned management detail later) may significantly increase teams, acting where strategic, more short- secondary market sales, since banks will LP perspectives term-oriented investors often cannot, and be required to divest some of their PE John Kim, Court Square Capital Partners, 2) focusing on long-term value creation. investments. At the same time, banks led a panel of LP investors, made up ­ Therefore, private capital offers a needed, are increasingly being targeted for invest- of Stephen Can, ; David willing, and valuable resource in the ­ ment because of the current challenged Fann, PCG Asset Management; John recovery of the banking sector. state of the banking industry and its need Rompon, McNally Capital; and Greg for new capital. Turk, Teachers’ Retirement System of The global model Steven Pinsky, Sutton Advisory Group, the State of . The panel was ­ Randy Mitchell, U.S. Department of led a panel of investment professionals subtitled “passive no more,” implying Commerce, moderated a discussion on that discussed PE trends in the recent increased assertiveness on the part of global venture capital (VC), with panel- economic cycle. The panel comprised LPs. However, panelists indicated that ists Robert Ackerman, Allegis Capital; Warren Feder, Carl Marks Capital ­ most LPs have had limited success in Susan Boedy, Knightsbridge Advisers; Advisory Group; Thomas Janes, Kerry “shifting the paradigm” of GP/LP rela- Victor Hwang, T2 Venture Capital; ­ Capital Advisors; Joseph Linnen, The tions—the top GP firms are still able to Matthew McCall, New World Ventures; Jordan Company; and James Marra, Blue raise money on their own terms. Never- and John Taylor, National Venture ­ Point Capital Partners. The panelists theless, LPs with larger amounts of capi- Capital Association. While VC funds rep- identified recent trends in PE activity, tal to offer are able to obtain marginally resent only 0.2% of U.S. GDP, revenues from former VC-backed firms correspond Mathonet, European Investment Fund. prohibit them. The Volcker rule will ­ to 22% of GDP. U.S. VC assets under These panelists emphasized the many become effective no later than two years management are down about 35% from dimensions of successful risk manage- after enactment, at which point a two-year their recent peak, but Taylor attributed ment in PE. Risk-management processes transition period begins, with the possi- this to a “healthy shakeout” from some must cover the entire life cycle of PE bility of additional extensions thereafter. of the excesses of the tech bubble ten investment (origination, analysis, due William Mark, Federal Reserve Bank ­ years ago. Investment in U.S.-domiciled diligence, approval, closing, documen- of Chicago, led an interactive discussion venture funds continues at a respectable tation, monitoring, and sale). They must with the audience about the impact and pace. Most of this money has been in- also address each level of activity—i.e., implementation of the Dodd–Frank Act. vested in U.S. targets, but there have portfolio investments, funds, and funds Although banks make up a relatively also been spurts of investment activity of funds. While quantitative methods small portion of the PE asset class (esti- in Chinese and Indian targets. With few (such as stress testing) are important, the mated by some at around 9%), partici- new initial public offerings (IPOs) since human element (in the form of leader- pants expressed concern about the 2007, strategic acquisitions have become ship, culture, attitudes, and so forth) is potential reduction in capital available increasingly important exit vehicles for equally crucial. The panel attributed the to the U.S. economy as a whole. Among venture investments, with many good recurrence over time of large, unexpect- the unresolved questions concerning the companies “waiting in the wings” to ­ ed losses at financial firms to a number law are whether VC is excluded from be acquired. of factors. These included limitations the investment restrictions because of of models, the human tendency to for- Panelists stressed how VC is a unique its purported contributions to economic get lessons over time, and pressures to business dependent on an entrepreneur- growth, whether banks’ direct balance- grow businesses by lowering risk-manage- ial, “mentoring” culture and an “ecolog- sheet investments (as opposed to spon- ment standards. ical” network of small firms in proximity sored or third-party funds) are also to each other and to sources of capital. Whether compensation practices at ­ exempt, and exactly how the “grace ­ This start-up ecosystem depends upon financial firms may have contributed period” for divestitures (including the a delicate balance between risk and re- to excessive risk-taking has been a major various extensions) is to be calculated. ward. Currently in the U.S., risk appears recent concern for policymakers. Steven Mark also interviewed Richard Smith, to be increasing and reward decreasing. Kaplan, University of Chicago, provided One Equity Partners, about how fund The opposite appears to be true for some a detailed look at compensation in ­ managers are able to maintain strategic other countries that compete with the PE. He concluded that compensation focus in a rapidly changing environment U.S. The entrepreneurial activity in arrangements have been very lucrative shaped by new regulations and tax rules, China and India reflects these dynamics. for successful PE investors. He charac- among other factors. Smith emphasized terized these practices as useful tools The environment for VC varies greatly to generally align the interests of GPs across nations and can be adversely af- with those of LPs and predicted that Charles L. Evans, President; Daniel G. Sullivan, fected by regulation and other public Executive Vice President and Director of Research; recent principles formulated by the LP policies. However, policy can also have David Marshall, Senior Vice President, financial markets community would create pressures for group; Daniel Aaronson, Vice President, microeconomic a positive catalytic effect in addressing further alignment. Kaplan also predicted policy research; Jonas D. M. Fisher, Vice President, market failures in emerging regions; e.g., macroeconomic policy research; Richard Heckinger, that proposed changes to U.S. tax laws Assistant Vice President, markets team; Anna Paulson, global venture markets are starting to increasing the taxes on PE firms would Vice President, finance team; William A. Testa, Vice flourish largely because of the role of President, regional programs, and Economics Editor; modestly reduce the attractiveness of foreign government investment. This Helen O’D. Koshy and Han Y. Choi, Editors; PE (especially VC), lead to attempts to Rita Molloy and Julia Baker, Production Editors; sovereign investment activity can be seen Sheila A. Mangler, Editorial Assistant. circumvent the changes, and create stretching far beyond just the China and more conflict between GPs and LPs. Chicago Fed Letter is published by the Economic India markets. Overall, the panel was Research Department of the Federal Reserve Bank of Chicago. The views expressed are the authors’ optimistic about investing in VC at this Private equity and financial reform and do not necessarily reflect the views of the time, and there was even some suggestion Federal Reserve Bank of Chicago or the Federal Subject to certain exceptions and a tran- that a great new wave of innovation might Reserve System. sition period, the so-called Volcker rule be imminent. © 2010 Federal Reserve Bank of Chicago ­ portion of the Dodd–Frank Act prohibits Chicago Fed Letter articles may be reproduced in whole or in part, provided the articles are not ­ Risk-management and compensation any “banking entity” from engaging in reproduced or distributed for commercial gain issues proprietary trading or from sponsoring and provided the source is appropriately credited. or investing in a hedge fund or PE fund. Prior written permission must be obtained for A panel on risk management was mod- any other reproduction, distribution, republica- erated by Timothy Kelly, Adams Street It also requires systemically important tion, or creation of derivative works of Chicago Fed nonbank financial companies to carry Letter articles. To request permission, please contact Partners. The panelists were Eric Eubank, Helen Koshy, senior editor, at 312-322-5830 or ; Edward Hortick, VCFA additional capital and comply with cer- email [email protected]. Chicago Fed tain other quantitative limits on such ­ Letter and other Bank publications are available Group; Christopher Laursen, NERA at www.chicagofed.org. Economic Consulting; and Pierre-Yves activities, although it does not expressly ISSN 0895-0164 that his firm, guided by a distinctive but current financial conditions. The econ- disappear abruptly, even for otherwise resilient business model, provides value omy is likely in recovery. Credit market solvent institutions, and that risk-man- to its parent, JPMorgan Chase, in terms conditions have improved, but new ­ agement discipline cannot be ignored of both return and “intellectual capital.” securitization issuance remains well ­ with impunity. Watchwords for the new In addition, since his firm uses only the below pre-crisis levels. Bank lending ­ world order of PE might be “recapital- bank’s capital (and none from a third is slowly recovering, but real estate credit ize, revitalize, and reprivatize.” party), he argued that One Equity ­ remains a focus of attention for many Partners does not generate systemic risk. firms. The crisis has reinforced the con- tinuing relevance of the business cycle Conclusion and the importance of understanding To close the conference, Tannenbaum the so-called shadow banking system.8 provided a regulatory perspective on It has also shown that liquidity can ­

1 For more information about the confer- borrowing (through bonds or loans) to taxes, depreciation, and amortization) ratio, ence, see www.chicagofed.org/webpages/ meet the cost of acquisition. Usually, the or it is one that trades at wide spreads over events/2010/private_equity_conference. assets of the company being acquired are Libor, or London interbank offered rate cfm. Private equity funds are pools of cap- used as collateral for the loans. (e.g., more than 150 basis points). ital invested by a private equity partnership, 3 A secondary market is a market where an 6 CLOs are structured credit securities backed typically involving the purchase of majority investor purchases an asset from another by whole commercial loans, revolving credit stakes in companies (not listed on a public investor rather than from the original issuer. facilities, or letters of credit, where interests stock exchange) and/or entire business in the securities are divided into tranches units to restructure their capital, manage- 4 U.S. accounting rules that expand and clarify with differing repayment and interest- ment, and organization. The standard ve- the use of fair value (or “mark-to-market”) earning streams. hicle for investment in private equity funds accounting went into effect at year-end 2008 is the limited partnership. The manager of for most firms. Implementation of these 7 Mezzanine funds target debt instruments the fund, the partnership’s general partner, rules was controversial during the worst ­ that provide the layer of financing that has makes, monitors, and ultimately monetizes of the financial crisis, when some market intermediate priority (seniority) in the capi- investments for a return on behalf of the values were severely depressed and may tal structure of a company, demonstrating investors (the limited partners). Limited not have represented true economic values. both debt and equity characteristics. partners include pension funds, 5 A leveraged loan is a bank loan that is rated 8 The shadow banking system is a network companies, asset management firms, and below investment grade (BB+ and lower by of lenders, brokers, and opaque financing fund-of-fund investors. Standard & Poor’s or Fitch, and Baa1 and vehicles outside the traditional banking 2 Leveraged buyouts involve the acquisition lower by Moody’s) to firms with a sizable system that has grown substantially in re- of a company using a significant level of debt-to-EBITDA (earnings before interest, cent years and has been much less regulated.