Open Discussion of Private Equity

Business Law event scours nuts and bolts of PE funds

by Darren Schenck

Four senior investment professionals led law and business students on a tour of the sometimes opaque world of private equity Tuesday evening at an event sponsored by the USC Business Law Society. The panel discussion detailed key investment considerations and strategies for private equity funds and illuminated how leveraged buy-outs actually work.

David Lee

Prof. Donald Scotten moderated the discussion.

David Lee, a private equity partner at Munger Tolles, described private equity as simply “pools of capital” organized among a team of investors. The money that forms the pool is raised from investors including pension funds, endowments, institutional clients and wealthy individuals.

Lee said a private equity fund is organized under a closed-end fund structure.

“As a result of that, it has a definite, fixed life,” Lee said. “It’s organized in a way that investors come in early in the process… they rely on the fund managers to invest money, realize the investment and ultimately get money back.”

Lee then described the stages in a fund’s life: the fund-raising period, during which the fund manager raises money from investors over a few months to a few years; an investment period of five to six years, during which the fund acquires public and private companies; a management period during which the fund runs the companies; and the run-off or exit period during which the manager sells the companies.

Chris Taylor

Chris Taylor, a senior associate at Tennenbaum Capital, emphasized that a private equity fund’s investment timeline can vary depending on the firm’s strategy.

“We tend to invest focusing largely on the debt of companies,” he said. “Instead of just making an investment and then exiting at the end… we’re able to recycle the capital several times over the course of the fund’s life. When we’re setting up a fund… it’s a little tricky as to when you give the money back to the LPs [limited partners].”

Taylor said his firm took a fund public for the first time last year, so investors can buy shares in it as they would any publicly traded stock.

“That’s the ideal capital situation, from our perspective,” he said.

Ken Firtel ’99, managing director of Transom Capital, spoke about leveraged buyouts (LBOs), which he called the most common strategy for acquiring companies.

Ken Firtel '99

“It’s kind of what you see in the movies, Pretty Woman and the like,” he said. “You’re taking your equity capital from your investors and you’re also raising debt… in essence, you’re using leverage on debt to buy the majority of a company.”

Firtel added that, as part of your fiduciary responsibility to your investors, you put in as little equity as possible into the acquired company, relying most on debt.

But he also noted that the recession has altered the investment formula for private equity funds.

“Four or five years ago… the banks didn’t care how much equity you put at risk,” he said. “And then the recession happened, and that has changed dramatically where what we see typically now is coming around to 50-50.”

Rick Madden, a private equity partner at Skadden Arps, added that private equity funds focus on the cash flow in the companies they seek to acquire.

“If a company has a lot of cash flow, it’s a fund target,” he said. “At the end of the day, what they’re looking for is enough cash flow to service the debt.”

He also addressed some of the legal challenges that come with LBOs.

“The problem with our system, when you’re buying a public company, you will always be sued for aiding and abetting the breach of management’s fiduciary duty, or the board’s fiduciary duty [to the company], and so most PE funds… view it as a cost of doing business,” he said.

Rick Madden

In closing, the panelists were asked to comment on trends in the private equity world.

Lee said that, due to the new regulatory regime under Dodd-Frank, it is more difficult for managers to launch new private equity funds.

“There is an increased cost in starting funds, as well as a flight to quality by investors, resulting in some funds getting bigger and bigger and stronger and stronger,” he said.

Taylor said the recession forced a lot of fund managers to leave the industry, but that it appears to be rebounding.

“It seems like now capital-raising has gotten slightly more favorable,” he said. “I feel like hiring has picked up a little bit.”

Firtel commented on how Mitt Romney’s presidential candidacy has attracted attention to the issue of how a private equity fund’s profits are taxed. Although income from private equity is taxed as capital gains, he said there is a “groundswell” to tax it as ordinary income.

Firtel also addressed how one finds a job working in private equity, emphasizing that there is no one path to follow.

“The key thing is meeting people who are in private equity,” he said. “PE in Los Angeles, both legal and business, is a very small community… which means it’s a lot more relationship-based. I recommend that you get out there and try to meet people.”

View a video recording of the panel discussion.