Occasionally you might wonder where your next few million may be coming from. How is the yacht going to get paid for? What about the alimony? How will you ever afford a house in the Boltons, the Hamptons, or any other kind of 'tons? Relax. Put on a Dido CD, swing your feet up on the desk, and read on: This column is about to explain how you can make free money for the rest of your life with no effort whatsoever.
It's called the private equity business. Right now, it looks like the best thing going.
Two recent court actions have shone some light on this often neglected corner of the financial universe. In one, a New York-based hedge fund called Millennium Partners LP is suing a venture capital fund called meVC Inc. In another, Forstmann Little & Co, the buyout fund run by Wall Street veteran Theodore Forstmann, is being sued by the Connecticut state pension plan.
Both illustrate why private equity is such a lucrative industry, in ways that its champions would rather not talk about.
They help to explain why for many of the smartest people in the financial markets, it has been the hottest ticket around for the last few years.
A battle between a hedge fund and a private equity fund looks like the kind of spat in which it would be foolish to take sides. Like piranhas complaining that sharks are giving flesh-eating fish a bad name, there is probably right and wrong on both sides. All the same, the statement put out by Millennium is an education in the sharper side of corporate finance.
The story goes like this. MeVC runs a fund called the meVC Draper Fisher Jurvetson Fund 1, in which Millennium has been one of the major investors. So far so good. The trouble started when Millennium looked at what was happening to its money and didn't like what it saw. In its lawsuit, Millennium alleges "excessive, unreasonable and unearned fees have been received by meVC Advisers." Excessive, unreasonable and unearned? It is hard to say which of those adjectives sound sweeter to anyone interested in making lots of money for doing nothing. How do we get our fingers into that honey pot exactly? Like this, according to the writ. The stated objective of the fund was to make venture capital investments in information technology companies. But, through the 2001 fiscal year, over 60 percent of the money remained in cash. In spite of that, meVC carried on collecting fees on all the money sitting in the fund.
Not just that. Millennium goes on to allege that even though Securities & Exchange Commission approvals to make follow-on investments in other Draper Fisher funds weren't forthcoming, meVC made no downward adjustment in its 2.5 percent advisory fee or its 20 percent incentive fee.
Nor, it further alleges, did it make sufficient mark-downs in the net asset value of the fund, even as the value of those investments it did make tumbled in value (by January this year, those investments had lost 54 percent of their value). The result of not marking down the net asset values was "inflated advisory fees." "The advisers took in excess of US$12 million in fees," said Robert Knapp, the managing director of Millennium in a statement accompanying the action, "essentially making shareholders pay them to `manage' money sitting in money-market assets." Now, no one would question that opening a bank account can be a tricky business. There are forms to be filled in, boxes to be ticked, and statements to be checked. Nor would anyone question that meVC did an excellent job of opening the account.
They probably got one that paid an excellent rate of interest, offered a free credit card and maybe even some air miles. Still, US$12 million seems like a lot even for that arduous task.
Over in Connecticut they are little happier with their adventure into the private equity business. In late February, the Connecticut state pension plan said it was suing Forstmann Little & Co to recover more than $100 million in what it claimed were unauthorized investments in two money-losing telecommunications companies.
The nub of its complaint is that the fund they invested in shouldn't have taken stakes in those companies, and that write-offs involved in the investments gave an advantage to partners in later funds. "They double-crossed us, pretending to be our partners and selling us out," said the state's Attorney General Richard Blumenthal. Forstmann is fighting the action.
In both of these cases there is no doubt right and wrong on both sides. MeVC and Forstmann may well be completely blameless, and their opponents just sore losers who start calling their lawyers every time they lose money on an investment. The judges will decide in due course.
The outcome of those cases does not matter much to anyone except the litigants. What does matter is the glimpse it gives us into the way the private equity business works.
Tens of billions have been invested in buy-out funds in both the US and Europe. But those funds remain private, disclose very little information, and remain largely free of scrutiny.
Their doors are usually closed. What happens behind them, few people ever find out.
While again stressing that meVC and Forstmann are most likely as innocent as new-born lambs, there is obviously scope for abuse. Fees can be levied for money sitting in cash accounts.
Net asset values can be manipulated to keep fees buoyant.
Investments can be shunted between funds managed by the same house (or between houses -- it's odd how regularly businesses are sold from one buy-out fund to another), either to salvage poor investments or to make sure performance targets are met. Private equity firms probably don't need more regulation -- few industries ever do -- but they certainly need more disclosure.
Still, it is good to know that even in these straightened, post-bubble times it is still possible for clever young financiers to make lots of money for not doing very much. That, after all, is what the capital markets are mostly about.
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