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November 03, 2008

PE Funds' Growing Stakes in Listed Companies, or How to Extract 2 + 20 Through the Stock Market

Unable to deploy vast amounts of leverage under conditions of credit meltdown, private equity funds have increasingly turned to taking stakes in publicly listed companies. Alongside some spectacular recent forays (and spectacular investment failures) into the financial services sector - e.g. TPG's investment in Washington Mutual, or the J.C. Flowers-led consortium investment in Germany's Hypo Real Estate - Eurazeo (France's largest private equity fund) and Colony Capital continue to increase their coordinated stake in the French-based Accor Group.

From 17.5% in May this year, the two funds have increased their stake to over 21.5% (with 20% of the voting rights) and are on course to reach their target 30%.

As in the retail sector (see e.g. the October 28 article on Carrefour below and
New Era in Litigation? Bankrupt US Retailer Charges PE Funds with Asset Stripping), one of the key goals of the funds' investment strategy is "unlocking value" through separation of the real estate and hotel operations. Earlier this year, Accor announced the sale of its Sofitel the Grand Amsterdam for €92 million. Accor will run the property on a 25 year "sale and management back" contract indexed to hotel revenue (though Accor keeps a 40% stake in the real estate vehicle which now owns the property). This type of contract (which transfers increased risk from the property fund to the hotel management, and ultimately to hotel workers) is increasingly replacing the "sale and lease back" arrangements under which the hotel chain sells the property and leases it back.

UK-based private equity fund 3i established 3I Quoted Private Equity (QPE) as a listed vehicle in June 2007 for the sole purpose of investing in publicly quoted companies, raising GBP 400 million (USD 746 million), of which it has since invested GBP 169 million. Establishing investment vehicles (listed or unlisted) to invest in listed companies certainly flatly contradicts the buyout funds' claim to represent a superior business model through the closer alignment of ownership and management interests, alleged relief from the pressures of short-termism etc. Pension funds and other institutional investors have also traditionally questioned the logic of paying 2% in up front fees and 20% of the profits for investing through a fund in listed companies, preferring to aim for the above-market returns promised through the leveraged buyout process. According to a recent Financial Times article, however, "31 YPE aims to double its investors' money over four years, equivalent to an annual net return of 16 per cent." The FT went on to note "But its shares have lost more than a third in a year to well below its net asset value…"

Private equity funds, like "activist" hedge funds investing in public companies, are structurally obliged to aggressively seek the maximum short-term extraction of cash through sell-offs and hyper dividends from their investment targets, for the simple reason that they have to beat the "hurdle rate" - the defined profit threshold below which they cannot extract their 20% of the profits.