Warburg Pincus PE and credit outlook
I had the pleasure of attending a speech last night by Joseph P. Landy, Co-President of Warburg Pincus, one of the original U.S. merchant banks. The firm traces its roots back to 1939. The idea was to “professionalize venture capital” and they started out with a $41 million fund in 1971. But it wasn’t called venture capital back then, Lionel Pincus called it “the deal business”. A few decades later, and they are now raising a US$10+ billion vehicle, on the back of an US$8 billion 2005 vintage fund.
Unlike other massive buyout firms, Warburg runs a single fund. You won’t see them offer a European Fund, a REIT, a Mezz Fund and an Asian Fund, with different co-heads around the globe. Mr. Landy made a convincing case that a single fund allowed their team to invest around the world, in different asset, when the returns were attractive. If there were no great deals in the USA, they’d be off in Asia. From an alignment standpoint, Landy feels that LPs do better under this approach. To prove the alignment point, Warburg approaches fees quite differently than other buyout firms: Warburg takes no fees from individual deals. Whereas many buyout firms keep certain fees for the general partner (rather than call it revenue to the limited partnership, as we do), Warburg puts every penny into the top line.
Landy shared with the audience a recent Wall Street Journal analysis regarding the percentages of GP revenue that flowed to the management teams at firms such as Blackstone, Apollo, etc. The results were telling, and explain why these large firms are become asset managers: 65% of revenue of the GPs studies by the WSJ come from board fees, 2% management fees, consulting fees, etc. Only 35% of their revenue came from the “promote”, also known as the “carried interest” or “upside sharing” of profits between the limited partners and the general partner (management team).
At Warburg, 80% of the firm’s revenue comes from the carried interest, with only 20% coming from the management fee. A remarkable gap, and it isn’t surprising that LPs love them for it.
Unlike other large private equity firms, Warburg talks a lot about “venture capital” and “growth capital”. Phrases we are very familiar with at our shop. Landy said that two thirds of their investments have been either venture capital or growth-oriented companies.
From a return standpoint, it is working: 25% net IRR to LPs over the past 20 years, and something like 40% this decade.
IPOs have been a key source of value generation for the fund, with more than 100 of their lead or co-lead investments having gone public over the years. In addition, twelve different firms have generated at least US$1 billion of profit for Warburg LPs.
Once Landy dispensed with the Warburg story, he gave us his impressions about the capital markets, the credit crunch, and the business of private equity:
“Anything going on with Citibank is a bad bellweather for the economy and consumer.”
“Crazy things going on in the capital markets right now. [Still.]”
Landry cited a quote from Wilbur Ross in April 2007, and it was advice that plenty of investors should have heeded:
“Risk ignored the rate of return. People are susbtituting yield for credit judgment. It is a very dangerous phenonemon.”
One of the things that Landry believes will go away is “non-dilutive equity masquerading as PIK Toggle and Cov-Lite debt”. Funnily enough, the event was co-chaired by Onex MD Andrew Sheiner, a recent beneficiary of a US$550 million PIK Toggle deal for their Allison Transmission buyout (see post “The debt casino is open again“, October 19-07).
For limited partners, “no liquidity will be coming in the near term from leverage recaps and IPOs, but M+A feels better.”
“Valuations are still extremely high on a relative basis to even a couple of years ago.”
One reality of the buyout world was what Landy called the “advent of PR in the deal business”, where “i-bankers and lawyers are using media to validate their fairness opinions.” He told the story of chairing a special committee meeting at Avaya. The next day, many of the items discussed were reported in the media, “word for word.” With three board members on the committee, he turned to the bankers and lawyers to find out who leaked the details of their confidential board meeting. Each advisory group blamed the other.
On his next deal, the takeover of Bausch and Lomb, Landry had to hire a press agent to “work it for the other side”.
Landy was frank about the question of: “should private equity firms be public”?
“We [Warburg] don’t have management transition and succession issues so we don’t need to go public. We don’t see how it makes us better investors. There’s a reason why its called ‘private equity’. We need to do things outside of the public eye. Every investment banker has told us we should go public, but unless we can see how it makes us better, we won’t.”
Landy predicted the general partner compensation is under “heavy attack and scrutiny”, and that “the move to reclassify carried interest as normal income is a certainty under a Democratic Administration.”
Landy also looked back at where the large private equity funds had generated their returns, and the results were expected – but come with a sense of foreboding:
Timeframe was January 2003 to March 2007. The U.S. private equity business generated US$140B of profits:
– 40% of the profits were generated by leverage recaps;
– 40% generated by easy credit; and
– balance came from growth.
During the same window, Warburg generated US$15.8 billion of profit:
– 3% via leverage recaps;
– 11% came from “easy credit”;
– 26% from emerging markets;
– 21% unlevered growth in net income;
– 15% from commodities / energy; and
– 6% in the “other” category.
Naturally, if the leverage has subsided, Landy believes that the buyout “industry in the midst of a downswing for a little while”.
Private equity challenges to come over the next few years:
“Pension fund allocations will be challenged for sometime: lack of distributions.”
“Deal sourcing will have to change.”
“Expectations of entrepreneurs will have to change.”
“Regulatory scrutiny will increase.”
“Compressed returns will force PE firms to look under every rock for incremental returns.”
In the crystal ball category:
“More rational leverage pricing.”
“It will be more difficult to get large deals done.”
“Bifurcation of PE models: asset gatherers will add different products. Investors may resize funds to generate returns. More niche oriented firms.”
“Vintage return compression: large equity outlays will be an anchor around the neck of IRR returns.”
With “no debt covenats to bust, no PE firms will go down but they’ll generate weak returns as RJR did for those firms that participated in that deal.”
“Investing is India and China will abound with risks.”
There you have it. Mr. Landy was quite a force indeed.