The current momentum behind IPO exits by private equity (PE) funds of their portfolio companies had us thinking whether an Australian PE fund manager might consider floating itself? A number of global alternative asset fund managers have already gone down this path: Blackstone in 2007, Fortress and KKR in 2010, Apollo and Oaktree in 2011 and Carlyle in 2012. Could the same strategy realistically be pursued by an Australian PE firm?
Rationale for floating the fund manager
- There are common themes in the reasons nominated by the above-named US-based fund managers for listing their funds management entity on public markets:
- to access new sources of capital to invest in existing and new businesses (and flexibility in pursuing future acquisitions using public equity as currency);
- to enhance the brand and attract additional investment in the funds they manage;
- as an additional compensation tool to incentivise employees through the issue of equity-related securities representing an interest in the value and performance of the firm as a whole; and
- to allow the principals of the fund managers to realise some of the value of the equity built up in the business.
Much of the public commentary on these IPOs focused on the last of these motivations for going public: an ability for the existing owners (and especially founders holding a substantial share of the equity) to realise headline-making amounts of money from their share of the IPO proceeds. For example, of the US$4.1 billion raised from the IPO of Blackstone, the two co-founders received almost US$2.5 billion from the sale of their equity interests in various operating entities to the new IPO holding entity (and continued to hold 28% of the IPO holding entity after listing).
"Generational transfer of ownership” (as described in the Oaktree prospectus) can be effectively managed as part of the reorganisation of the holding structure in preparation for an IPO. The reorganisation transfers the various entities that are entitled to receive the management and performance fees generated from the funds and assets managed by the PE firm under a common holding vehicle. This reorganisation can be a catalyst for rebalancing equity ownership among the key principals such that (to some extent): (a) founders can realise cash proceeds for their equity in the business; and (b) ensure that the executives who are key to the enduring success of the business (including the founders who are often inextricably linked to the firm) are sufficiently incentivised for the future. KKR, for example, held back more than 10% of their issued units to “compensate rising stars as they grow at the firm”.
The reorganisation of the holding and ownership structure as part of the IPO provides an opportunity to deal with these often difficult conversations about succession plans designed to ensure that the PE firm can prosper beyond the original founders.
The commercial need to diversify revenue streams
Public investors in a listed fund manager will be investing in, and valuing the listed entity on the basis of, the fund manager’s future income streams. For a PE firm, these are predominantly sourced from a combination of the management fee (typically calculated as 1% to 2% of the committed capital) and the performance fee (typically calculated as 20% of realised profits on exit subject to achieving a minimum hurdle rate of return).
The management fees (which grow proportionately with the funds under management) provide a steady source of revenue. However, the real driver of a PE firm’s returns are the performance fees which are only realised on exit. PE firms seek to exit their portfolio investments when market conditions are favourable, such as now when price-earnings multiples are increasing and the IPO sentiment is strong. As a result, the revenue generated by PE firms tends to be correlative with general M&A activity and liquidity which can result in lumpy revenues. This may be unattractive to public market investors whose short investment horizon may not sit well with the longer term promise of payouts by PE funds, especially given the difficultly of valuing unlisted investments usually held by such funds prior to an exit event.
The global alternative asset fund managers named in the opening of this article each sought to address this issue by diversifying their revenue streams ahead of their IPO. They did this by variously acquiring real estate funds, credit funds, infrastructure funds, hedge funds, funds of funds and various advisory and equities businesses. For example, Carlyle’s assets under management jumped from US$107 billion to US$147 billion in the 12 months to December 2011 ahead of its 2012 IPO.
It will be more difficult for Australian PE firms to meet these challenges (of a diversified and steady revenue stream) in the same way as their US counterparts. The US asset managers are of a demonstrably different scale with a global operation, across various specialisations and managing multiple funds. On the other hand, Australian PE firms naturally have a local or regional investment focus and there is less scope to diversify into other specialist funds.
The Australian equity and debt markets do not have the breadth or depth of activity to support funds of material scale seeking to, for example, focus exclusively on distressed debt or special situations. Public investors may also be wary of investing in a business where the sentiment towards a PE firm (and its ability to raise its next fund) is strongly tied to the performance of its most recent fund. This is exacerbated by the Australian norm of having a single line succession of funds (rather than multiple and varied funds being managed at the one time).
Some of these concerns can be managed through the IPO itself. The IPO proceeds can be used as a source of ‘permanent capital’ to be invested and reinvested by the fund manager. (This is not dissimilar to the multitude of listed investment companies quoted on the ASX.) This together with the ability to raise additional capital through the public markets can supplement, and moderate the absolute dependency on, the traditional PE fundraising cycle.
Conflicts: shareholders versus fund investors
The legal structure used in the US for listing the alternative asset fund managers has been something to behold. The listed entity has either been structured as a limited partnership (in the case of Blackstone, KKR and Carlyle) or as a limited liability company (in the case of Fortress, Apollo and Oaktree). In either case, the structure has been designed to reserve near absolute control over all operational decisions to the principals of the fund manager with very limited powers retained by the board of directors of the listed entity. This has been justified on the basis of wanting to preserve the existing management structure of these fund managers with strong central control by the managing principals.
We focus on the limited liability company structure given the inherent difficulty and novelty of listing a limited partnership on the ASX. This reservation of control to the principals of the fund manager has been achieved by having the limited liability company enter into an operating agreement pursuant to which a management entity controlled by the principals manages all the activities of the listed entity. These activities include discretion over the issue of securities, payment of distributions, asset sales and compensation decisions. The listed entity in turn has two classes of share on issue with the effect of granting a veto power to the management entity in respect of the limited matters on which public shareholders have a vote (including amendments to the operating agreement). As a result, the power of the principals is entrenched provided they collectively continue to hold a specified minimum voting interest.
The public filings for the IPO disclose the inherent conflicts of interest with this structure, including: (a) the management entity (controlled by the principals) determining compensation levels which impact on the free cash flow available for distribution to shareholders; and (b) subsidiary entities (controlled by the principals) owing fiduciary and contractual obligations to investors in the funds they manage, which may be in conflict with the interests of shareholders.
The operating agreement provides that if a conflict arises, the management entity will resolve the conflict and is not required to take the matter to a vote of the shareholders. The operating agreement also contains provisions that reduce and eliminate the management entity’s duties (including fiduciary duties) to the shareholders and restrict the remedies available to the shareholders (to circumstances where the management entity (or its officers) act in bad faith or engage in fraud or wilful misconduct). The management entity is expressly entitled to consider its own interests to the exclusion of the shareholders.
In the Australian context, various legal considerations will cut across any similar structure being implemented here. These include directors duties (and the more limited extent to which the content of the directors’ fiduciary duties can be attenuated), related party provisions and the ASX Listing Rules (including the requirement that the terms that apply to each class of equity securities must be appropriate and equitable). There will nonetheless be scope to implement a contractual framework that can replicate a reasonable degree of control for the principals though perhaps not with the same degree of incumbency or structural misalignment with the interests of listed shareholders as is tolerated in the US.
Any PE firm seeking to list in Australia will in any case need to be able to market all aspects of their business model, including the governance structure. Institutional investors will have little appetite for a governance structure that attempts to disenfranchise their ability to take activist steps if management are underperforming. This should be nothing new to Australian PE firms that are used to being judged with each new fund by the amount of dollars entrusted to their management.