Elevation Partners: The Ups and Downs of Private Equity

"I don't know how many of you have a day job," says Chubby Wombat, leaning into the microphone between songs. "But I do, and right now it sucks." Chubby Wombat is the lead singer of a Grateful Dead-style jam band called Moonalice. He has long gray hair and wears a Philadelphia Phillies baseball shirt with the number "Four 20" on the back. Tonight's venue is Slim's, a warehouse-style concert space in San Francisco's SoMa district, with brick walls and a black ceiling studded with spotlights. There are maybe 200 people in the crowd, mostly folks who look like they have a Volkswagen bus somewhere in their past, or possibly out in the parking lot.

Wombat, you might have guessed, is a stage name. In real life, this man is Roger McNamee, managing director of Elevation Partners, a private equity firm that manages a $1.9 billion fund. McNamee is a Silicon Valley legend who ran a successful tech fund for T. Rowe Price (TROW), invested in Intuit (INTU) while at Integral Capital Partners, called the top of the dot-com bubble, and co-founded Silver Lake Partners, the highly successful tech-focused private equity firm.

As Chubby Wombat, McNamee is on a roll. Moonalice has served up 292,000 downloads of a catchy ditty called It's 4:20 Somewhere. It's a hummable tune about getting high—"4:20" is stoner code for smoking time—that has bucked the odds and found an audience. It's the breakthrough every artist dreams about, and tonight is particularly special for the song and the band. It's Apr. 20...4/20. Tickets to the show are...$4.20.

As good as life is for Chubby Wombat, Roger McNamee might have a few good reasons to complain about his day job. Like many of its peers in the private equity world, Elevation Partners, the firm he founded with a roster of Silicon Valley talent and a rock star named Bono, has been struggling. Elevation's largest position is in Palm (PALM), a $460 million bet that the once-dominant phone maker would not only survive but prosper with a hot new model. After Palm's chief executive officer, Jon Rubinstein, announced in late March that the company would miss already grim estimates, three analysts set a coroner's target price: $0. Palm was ultimately saved by Hewlett-Packard (HPQ), which offered $1.2 billion for the company on Apr. 28, enabling Elevation to escape with a narrow profit well below its original expectations.

Elevation's other high-profile problem is a 40 percent stake in Forbes Media, which Elevation bought in August 2006. Although the company is private, and thus hard to value, Elevation's estimated $300 million stake in the magazine and its Web site is well underwater. McNamee's conviction that growth in online advertising would outstrip the decline in print revenue has not been borne out. Last year he stepped down from the board, with his partner Bret Pearlman taking his place. At Forbes, major cost-cutting initiatives have ensued.

Not surprisingly, certain indelicate elements of society (cough: blogs!) have been making a fine sport of McNamee, Wombat, Elevation, Bono, and Palm. In March a site called 24/7 Wall Street ran a story titled "Bono Becomes the Worst Investor in America." That sparked a flurry of mainstream coverage everywhere from The Wall Street Journal to the Times of London and a frenzied trade in plays on U2 lyrics, mostly a long the lines of "Bono's Investment Firm Still Hasn't Found What It's Looki ng For" and "Palm Sale Is No Beautiful Day for Bono."

The West Coast office of Elevation Partners, where McNamee sat down for an interview the week before HP made its bid to take over Palm, is on Sand Hill Road, the Wall Street of Silicon Valley, a world away from Slim's. It's a place of quiet opulence, more like a spa than a financial office. You park in a little lot, under drooping trees and blooming shrubs, and proceed through a spacious lobby of pale pink marble with glass doors at the back that open onto still more gardens. There are photographs by Ansel Adams on the walls and a little sign that directs visitors to the right if they wish to visit the West Coast office of Kohlberg, Kravis & Roberts, and to the left for Elevation.

Out of his Wombat gear, McNamee still looks more like a professor of comparative musicology than a private equity baron. His hair hangs to his shoulders, and he wears a lavender shirt and a blue tie with pink bunnies. His playful appearance is quickly forgotten when he starts talking. In a nearly three-hour-long interview in the firm's conference room, McNamee and co-founder Fred Anderson, another Silicon Valley legend, give a rigorous, highly detailed picture of Elevation Partners and its dealmaking style.

"From the beginning, Elevation was a new approach to private equity," says McNamee. "The world did not need another high-leverage buyout fund. It didn't need another firm practicing venture investing in the traditional way."

McNamee is referring to a not-so-secret truth in Silicon Valley: Private equity and venture firms have been delivering low or negative returns for years, and certainly nothing like the 20 percent the sector has historically used to justify itself to investors. In focusing on deep involvement with a few operations, Elevation may also be bowing to reality, and following a trend. "What ended up happening is the private equity game got so much more competitive. Pure financial skills, crunching the numbers and structuring the deals became a commodity, so now firms are differentiating themselves through their operating skills," says Josh Lerner, a professor of investment banking at Harvard Business School. Nor is Lerner surprised by Elevation's duds. It's the missing win that is the problem. "It's always a skewed system of deal returns. You can have seven losers, but you have that one Google (GOOG), that makes up for them."

It is safe to say that investors knew they would be getting something different with McNamee. He has been touring in various bands for years. His driver calls his Wi-Fi-enabled bus "the office." McNamee has no children and considers his band family, a statement that doesn't seem disingenuous when one learns that his wife, Ann, sings in the band.

Most of the firms that compete with Elevation spread their bets around, with each partner overseeing three to six deals. Elevation's idea was to distill the approach, finding the most talented people in the business and focusing big bets on a small number of companies. When McNamee and Elevation's co-founder, Marc Bodnick, started staffing the firm in 2004, one of McNamee's first calls was to Fred Anderson, who as Apple's (AAPL) chief financial officer during its financial crisis in 1999 helped the company stave off bankruptcy. Elevation's other partners include Pearlman, who came over from Blackstone Group (BX), the giant New York buyout firm, and, of course, Bono. Bono, McNamee says, is very much involved in the fund: "He participates in all the investment activities, but he is magic with respect to internal partnership issues and opening doors."

In November and January, Elevation brought in two more Silicon Valley veterans, Rajiv Dutta and Avi Tevanian. As chief software technology officer at Apple, Tevanian oversaw the development of Mac OS X, the software behind everything from Macintosh computers to the iPhone and the iPad. "He's the greatest software architect of all time, period," says Anderson. Dutta is an eBay (EBAY) veteran as well as the former president of PayPal and Skype. The team, if nothing else, suggests that McNamee's night job as Chubby Wombat poses no threat to his credibility as a recruiter. The hiring of Dutta and Tevanian is also a signal that the firm wants to raise money for a new fund. But the Palm debacle has put whatever plans the firm had in that regard on hold.

"Our goal was to be two standard deviations off the mean, ideally to the right," says McNamee. By that he means to the right of the big bell curve of investing, where above-average returns show up.

Elevation will eke out a profit from Palm, thanks largely to Pearlman, the Blackstone vet who works in Elevation's New York office. If McNamee is almost comically West Coast, Pearlman, with his crisp white shirt and Bit loafers, is cut from central casting, too. In an interview in the company's Midtown office, a Zen-like retreat set in a skyscraper, Pearlman explains how he set up the firm's investment. If the other partners are visionaries, he is the worrier who thinks about how things will go wrong. "If you asked everyone at the firm who the most skeptical partner was," says Pearlman, "I'm sure I would fit the description."

Of the $460 million Elevation has put into Palm, only a fraction of it is in common shares. The initial $325 million investment was in convertible preferred shares at $8.50 a share. The remaining $135 million that Elevation invested was in a combination of convertible preferreds, warrants, and common shares. With HP offering $5.70 a share, one can do the math and arrive at an investment valuation for Elevation of $485 million, or about 5 percent over its total outlay.

That, however, is nowhere near Elevation's original lofty vision. McNamee and Anderson argue that Palm built a better phone based on an innovative Web-based operating system—and phone geeks seem to agree—but they picked the wrong carrier, Sprint (F), which soon headed into crisis mode itself.

Even amid slugglish sales at Sprint, Palm's stock rallied last year as excitement built around an expected partnership with Verizon, a deal Palm CEO Rubinstein finally announced at the Consumer Electronics Show in January. Later that month the Pre and Pixi phones debuted on Verizon, and the launch was a disaster. The carrier was unprepared or unwilling to put its marketing dollars and sales force behind the Pre, focusing instead on its own new brand, the Droid, featuring devices powered by Google's Android operating system.

On Palm's quarterly conference call in March, Rubinstein told investors that the training of Verizon sales staff had been inadequate. He said the problem was being remedied with aggressive training efforts at hundreds of stores nationwide a day. But the market had spoken. The stock had lost three-quarters of its value in six months.

"We thought [the Verizon launch] was going to be our coming-out party," says McNamee. "Everything was teed up that this was going to be the beginning of a huge ride."

Even as the company whiffed on its projections, Pearlman's structure saved Elevation's investment. The firm's other deals have similar backstopping. The Forbes position is known to have a put option embedded, meaning it can be sold back to the family at a preset price, though Elevation won't reveal the price or exactly how it works.

"We did not make a minority investment without a plan to exit," says Pearlman. "While we have a long time horizon, if we are going to make an investment with a family, we are going to, at some point, make sure that we have an ability to realize some liquidity."

The fund's $100 million investment in Move.com (MOVE), the real estate listings site that has staggered along with the housing crisis, is also in convertible preferred shares, which pay an annual dividend of 3.5 percent.

As troubled as these recent deals have been, Elevation's early success has given the firm some margin for error. In 2005, Elevation invested $300 million in video game makers BioWare and Pandemic Studios, a stake it sold three years later to Electronic Arts (ERTS) for $620 million. And the firm has made two well-regarded investments, through back channels, purchasing a $100 million stake in the user-review site Yelp! and $90 million worth of shares in Facebook. Elevation hasn't discussed its involvement with Facebook, but, based on more recent transactions, its investment looks to have doubled.

The firm has deep ties to both companies and acts as much like a partner as an investor. McNamee has advised Facebook CEO Mark Zuckerberg since shortly after he came to Silicon Valley with a business model born in a college dorm room. As Chubby Wombat, he uses Facebook to advertise his gigs and serve up downloads of his song.

Similarly, Elevation was in touch with Yelp two years before making an investment, when partner Marc Bodnick met with Yelp's founders to offer advice. "They certainly offer as much as you want," says Yelp CEO and co-founder Jeremy Stoppelman, talking about Elevation's team. "They have a very senior, strong team with deep knowledge in company building. To the extent you ever have a need, they're there." When some employees wanted to cash out, Stoppelman allowed Elevation to buy in.

In McNamee's view, the close relationships with these companies are the key to Elevation's future, boosting the value of the first partnership in its final years and providing the starting point for the second, if it gets funded.

Halfway through the first fund's 10-year life, Elevation is at a juncture that will test the validity of its model, or at least whether partners will be willing to hang in for the next one.

"While there are no guarantees," says McNamee, "our returns are much better than people realize. But we live in a world of the blog, where it's shoot first, ask questions later."

Later that night, on stage, Chubby Wombat announces that Moonalice's hit song is near 300,000 downloads. "When we get to 420,000 downloads," he says, "we're going to give ourselves an award." He also notes that the band has brought 420 cupcakes to celebrate. Then the group launches into a blues number that includes a goofy jab at leveraged buyout firms. ("They put you out of work, but it makes your stock worth more.") All silliness aside, it's a surprisingly decent tune. McNamee is a good singer, and he has hired a skilled, professional band, including a guy who played bass for Jefferson Airplane. In the end, leading a firm like Elevation is like leading a band. You get talented people together, work hard, and hope for a hit.

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