Private equity (PE) is perhaps the only asset class to have almost routinely outperformed the S&P 500 over the last several decades. A track record like that is hard to ignore. As a result, PE firms are now a $500 billion-a-year industry that has become a big, fat target.
The industry faces a number of challenges from pension funds and insurance companies, which are among the largest investors or limited partners (LPs). Some LPs are trying to negotiate better deal terms, resulting in lower payouts to PE partners. A few others are trying to cut PE firms out of the picture entirely and make turn-around investments themselves.
Those were among the highlights presented at the Wharton San Francisco Capital Summit, hosted earlier this month at Wharton’s San Francisco campus. The day-long event drew some 100 attendees, who learned about trends in the industry from speakers and panelists from a range of PE firms, from some of the oldest and best-established to boutique operations trying out new approaches.
Many of the speakers noted that to the extent the PE industry might be affected by these trends, it will likely only be felt most by mid- and small-sized companies. Industry giants like Blackrock, Carlyle, KKR and TPG are expected to continue to dominate the industry and, if anything, their position is likely to be enhanced, in part because of the preference of Asian and Middle Eastern sovereign investors to deal with well-known brand names.
The interest in PE is global, according to Bill Halloran, a Bain & Co. partner, in part because of the industry’s long history of outperforming the market and also because of the current environment of historic low yields on U.S. treasuries. The degree of interest varies by country. Pension firms in the United States on average have about 7.5% of their portfolio allocated to PE, while in Japan the percentage is less than half that.
Among the reasons for the strong interest by domestic pension funds, notes Halloran, is that so many of them are undercapitalized and thus in danger of being unable to meet their obligations to future retirees. They are therefore making investments in asset classes like PE with higher yields in the hopes of making up the shortfall. While the higher returns of PE come with higher risks, “it’s the only way they think they can close the gap,” said Halloran.
One of the biggest issues affecting the industry involves LP efforts to invest in PE under more favorable terms, essentially by eliminating PE firms as the middleman. Currently, PE firms, like firms in venture capital, usually charge two different fees: The first, a fixed percentage of the total amount under management; the second, a percentage of profits made from a deal, following an exit (sale of a portfolio company by the PE firm), assuming those profits reach a certain threshold.
LPs are attempting to make these terms more advantageous in two ways. The first is by “co-investing.” This means, for example, that if a PE firm is arranging a buy-out of a public company, the LPs would participate directly in the deal as an additional investor but without their funds being subject to the normal PE firm fees. They would, in effect, make any profits from the transaction without having to share their cut.
“Canadian funds that are trying [direct PE investment] are paying their top partners at rates comparable to a Goldman Sachs, and thus can be expected to achieve comparable levels of financial performance.” –Pascal Villiger
An even more radical approach is called direct investing. It is currently popular with pension funds in Canada, and occurs when a pension fund makes a transaction by itself, such as taking a company private without involving a PE firm at all.
Speakers disagreed about how effective that latter approach would be. Susan Long McAndrews, a partner at Pantheon Ventures, predicted it would be “almost impossible to successfully pull off” except by possibly three or four pension funds in the entire world.
Pascal Villiger, managing director with Medley Partners, a San Francisco-based PE firm, wasn’t as pessimistic, saying that the Canadian funds trying this direct investment approach are paying their top partners at rates comparable to a Goldman Sachs, and thus can be expected to achieve comparable levels of financial performance.
Another issue that divided participants was the extent to which the hundreds of billions of dollars invested in American 401(k) funds should be available to PE firms. Currently, they aren’t, though Monte Brem, partner and CEO at StepStone, a global PE firm, predicted a movement towards allowing private investors to put money into PE directly. A prerequisite: the ability to provide a daily price for PE investments, just as for stocks and mutual funds. While that is currently impossible, efforts are underway to tackle the technical issues associated with that sort of price transparency, he said.
Villiger took a different view, saying that the PE industry already had more money than it knew what to do with. “The industry already has plenty of capital. Too much capital tends to diminish returns. It will be like venture capital during the late 1990s, when a lot of capital was sloshing around and a lot of companies got funded that shouldn’t have been funded.”
Targeting Trophy Names
There was one issue on which speakers agreed: That the biggest PE firms are likely to continue to grow in size and importance. One of the major reasons for this is that sovereign wealth funds in Asia and the Middle East, which typically invest on behalf of a government, are attracted to trophy names in PE and are unwilling to trust their money with smaller, less familiar firms.
“We [the PE industry] have been written off time and time again but we are still here because we consistently beat the market.” –Brad Coleman
“Much of the foreign capital is going to the big funds, something that is a reflection of cultural preferences,” said Villeger. “Small- and mid-sized funds are constantly frustrated because they just can’t get their products placed overseas.”
Another trend benefiting the bigger PE firms is the fact that big pension funds, such as the California Public Employees’ Retirement System (Calpers), are cutting back on the number of PE firms they are doing business with, mainly out of a need to simplify decision-making. Like foreign investors, they are likely to consolidate their investing with bigger-name establishments, the panelists said.
One of the public relations issues that has always plagued PE involves the effect on the companies they make investments in. While PE firms make profits for themselves and their LPs, critics contend such profits are often achieved on the backs of the firms receiving PE investments. It is not uncommon to hear stories of such firms being saddled with debt as a way for PE firms to monetize their investments.
But some evidence that PE overall is beneficial was provided by Gary Pinkus, a McKinsey director, who cited a study by his firm indicating that companies that are successful in transitioning to a more efficient operation often credit the guidance they received from the PE investors. “The role that PE plays in transforming companies is an important part of its advertising for itself, so it’s nice that it’s true,” Pinkus said.
But that might not be enough to stave off political changes that may affect the industry’s rates of return. One example: Corporate debt is now allowed as a tax deduction, which is one reason that debt-based deals are as common as they are, said speakers. There are occasionally efforts in Congress to eliminate that deduction, and should one of them bear fruit the entire PE landscape could change dramatically.
But on the whole, speakers were upbeat about PE. If anything, predictions were for a continued bright future, especially for the bigger firms. Brad Coleman, global head-alternative assets group at CitiGroup, showed a series of headlines from recent decades, each using some recent fiscal crisis to predict an imminent end to PE as an asset class. “We have been written off time and time again but we are still here because we consistently beat the market.”