Big Money, Big Costs

Great piece by Jason Zweig of the WSJ on the trouble with private equity funds: Trying to get your money out.

For years now, big banks and brokerage firms have been urging their wealthiest individual clients to get into private-equity funds. Buying such a prestigious fund can make you feel like a big cheese with privileged access to the high returns corporate deal making can generate. Trying to sell one, however, can make you feel like a tiny mouse in a giant glue trap.

Consider J.C. Flowers II L.P., once one of the most glamorous of the buyout funds. By July 1, investors must decide whether to stick with the fund, which has lost roughly 60% over its life, or sell their stakes to a group of buyers for less than three-fourths of its shriveled value.

Investors face two risks. If they sell now, they lock in an even more severe loss than they have already suffered. If they hang on, they gamble that the manager can turn the fund around, while having no idea how much longer they will have to wait to get their money out.

It’s instructive to see how investors ended up in this bind.

Launched in 2006 by the firm led by J. Christopher Flowers, formerly a top banker at Goldman Sachs, J.C. Flowers II sought to raise $3.5 billion.

As the financial bubble peaked, Flowers practically had to beat investors away with sticks. Lured by the success of the firm’s first fund and the hope of giant gains from buyouts of banks and other financial companies that Mr. Flowers knew so well, money came pouring in.

J.C. Flowers II closed the floodgates at $7 billion. Among its investors were such giants as the Andrew W. Mellon Foundation, the Colorado Public Employees’ Retirement System, the Teachers’ Retirement System of the State of Illinois and the University of California. A number of wealthy individuals bought in, too.

Before the fund could get all that money invested, the bubble burst. Flowers also made some unfortunate investments, including MF Global, the brokerage firm that collapsed and sought bankruptcy protection in 2011, and Tokyo-based Shinsei Bank, which has fallen more than 60% since the fund bought it in 2008.

Scheduled to earn a 1% annual management fee and 20% of profits, Flowers cut its yearly fee to 0.9% after the losses. It hasn’t kept that 20% cut of investors’ profits, because there aren’t any.

The latest transaction may change that. The new investors in the fund, Coller Capital of London and Goldman Sachs Asset Management of New York, are acquiring their stakes at a 27.5% discount from the fund’s already depressed value as of March 31.

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E.J. Smith - Your Survival Guy

Preparing your investments and family for when disaster strikes.

E.J. Smith is the Founder of YourSurvivalGuy.com, Managing Director at Richard C. Young & Co., Ltd., a Managing Editor of Richardcyoung.com, and Editor-in-Chief of Youngresearch.com. E.J. graduated from Babson College in Wellesley, Massachusetts, with a B.S. in finance and investments. In 1995, E.J. began his investment career at Fidelity Investments in Boston before joining Richard C. Young & Co., Ltd. in 1998. E.J. has trained at Sig Sauer Academy in Epping, NH, where he completed course-work in Practical and Defensive Handgun, Conceal Carry Pistol, Shotguns, Precision Scope Rifle and Kidnapping Prevention. E.J. plays a Yamaha Recording Custom drum set with Zilldjian cymbals. His first drum set was a 5-piece Slingerland with Zilldjians. He grew-up worshiping Neil Peart of the band Rush, and loves the song Tom Sawyer—the name of his family’s boat, a Grady-White Canyon 306. He grew up in Mattapoisett, MA, an idyllic small town on the water near Cape Cod. He spends time in Newport, RI and Bartlett, NH—both as far away from Wall Street as one could mentally get. The Newport office is on a quiet, tree lined street not far from the harbor and the log cabin in Bartlett, NH, the “Live Free or Die” state, sits on the edge of the White Mountain National Forest. He enjoys spending time in Key West and Paris. Please get in touch with E.J. at ejsmith@youngresearch.com. Sign up here to receive all the best content from Richardcyoung.com each week.