The 2-and-20 Crowd

In his recent New York Times article, Andrew Ross Sorkin reports on a conversation he had with Guy Hands, a longtime private equity manager who “offered the most frank assessment of the private equity world-including his mistakes-I had ever heard from anyone still gainfully employed in the business.”

“We all had too much money. It was just too easy.” That’s the unvarnished appraisal of the private equity business by Guy Hands, perhaps best known for his unfortunate $4.73 billion purchase of the record company EMI in March 2007, the peak of the buyout boom — a bet that will almost certainly lose his investors and his firm, Terra Firma, a fortune.

That ill-timed acquisition aside, Mr. Hands’s surprisingly candid assessment of the private equity industry is worth sharing. He was in the midst of the industry’s growth to dizzying heights during the debt-fueled boom, and he is now having to deal with the aftermath of its shopping spree. Like others, he is desperately trying to keep businesses afloat and pay off the equivalent of huge monthly mortgage payments to the banks that financed them.

The problem, he said, was that the funds had grown so big that the 2 percent became just as important as the 20 percent.

"Clearly a large number of P.E. firms were totally overpaid at the peak of the market,” he said. “The fees were an entirely unwarranted windfall....."
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Andrew Ross Sorkin, A Financier Peels Back the Curtain, New York Times, September 22, 2009


Warren Buffett has long been critical of the private equity business.

“In 2006, promises and fees hit new highs. A flood of money went from institutional investors to the 2-and-20 crowd. For those innocent of this arrangement, let me explain: It’s a lopsided system whereby 2% of your principal is paid each year to the manager even if he accomplishes nothing – or, for that matter, loses you a bundle – and, additionally, 20% of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. For example, a manager who achieves a gross return of 10% in a year will keep 3.6 percentage points – two points off the top plus 20% of the residual 8 points – leaving only 6.4 percentage points for his investors. On a $3 billion fund, this 6.4% net “performance” will deliver the manager a cool $108 million. He will receive this bonanza even though an index fund might have returned 15% to investors in the same period and charged them only a token fee.

…. the 2-and-20 action spreads. Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the money.”
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Warren Buffett, 2006 Letter to Berkshire Hathaway Shareholders

"Some years back our competitors were known as “leveraged-buyout operators.” But LBO became a bad name. So in Orwellian fashion, the buyout firms decided to change their moniker. What they did not change, though, were the essential ingredients of their previous operations, including their cherished fee structures and love of leverage.

Their new label became “private equity,” a name that turns the facts upside-down: A purchase of a business by these firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing. A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. Much of the bank debt is selling below 70¢ on the dollar, and the public debt has taken a far greater beating. The private equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private."
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Warren Buffett, 2008 Letter to Berkshire Hathaway Shareholders