The Future of Private Equity
Michael Athanason and Federico Jost
KKR’s Americas XII fund attracted a record $13.9 billion in commitments in 2017, reflecting a generation’s growth in private equity—a long way from its first fund, in 1978, which raised $30 million.
In 2017, private equity (PE) broke all previous records, raising $435 billion, despite challenges to put all that money to work. We are in the midst of an environment of high valuations and fierce competition coming not only from PE funds managed by general partners (GPs) but also from corporate strategic investors and limited partners (LPs).
Preqin estimates that $970 billion in ‘dry powder’ held by PE fund managers is the most ever recorded. Many investors question whether fund managers will be able to generate the same returns they have historically delivered given competitive factors seen and yet to be seen. The saying “Too much capital chasing the same assets” has become a common phrase at industry gatherings in recent years.
The asset class has progressed even more in the past two decades, weathering several crises—from the dot-com bubble’s burst to the 2008 global financial crisis—yet valuations of private holdings have seen unprecedented appreciation.
Let’s look toward the next stages of private equity through the lens of a few maturing trends and try to forecast what’s next.
Seismic Shifts in LP Behavior
Since 2012, LPs have allocated large sums to private equity seeking better yields than those in the public equity and debt markets. Larger LPs, such as Teacher Retirement System of Texas and CalPERS, have started to rationalize their portfolios and concentrate their investing activities in large and well-known GPs, including Apollo Global Management and The Blackstone Group. This is a marriage of convenience.
Through this union, GPs have gathered more capital with less effort, while LPs can streamline their investment and monitoring processes. In short, LPs are able to make commitments between $100 million and $1 billion, instead of their traditional $20 to $100 million, which means fewer funds to manage. Large GPs developed valuation-monitoring teams that were able to provide all the (ad-hoc) data to LPs for their reporting needs. Finally, LPs concentrated their relationships in return for the option to be invited to future co-investment opportunities, which can lead to better returns via lower management fees.
With giant GPs and LPs fusing their strategies and relationships, the middle-market GP field has opened opportunities for smaller LPs to enter into alternatives investing and to invest into funds that generally provide returns that are above those of larger managers. This middle market of growth and emerging companies is where all the hard-won value mining and corporate restructuring is happening, and the returns are there to show it.
In 2016-17, LPs also favored more timely and aggressive strategies. Private debt and venture capital (VC) saw an increase in LP investment, primarily due to market dynamics and large returns in the VC space. Fund managers, such as Oaktree Capital, Ares Management and Apollo (leaders in the private-debt space), have become ‘go-to’ lenders for many companies. Their returns have been stable and better than those of other non-private debt lenders in the market.
VC firms, such as Founders, Scale Ventures and Sequoia Capital, have benefited from notable exits from unicorns that delivered sizable returns, such as Airbnb, Facebook, HubSpot, Box, Instagram and LinkedIn. We expect LP investment into private debt and venture capital to continue, with demand even increasing until market dynamics change.
LPs moving towards GP – By acquiring them or mirroring them
By 2005, some LPs started investing in GPs, or working as their own deal manager. This trend later slowed and even reversed, as LPs including CalPERS sold off their manager interests in hedge funds. In 2017 and early 2018, there was a strong resurgence in activity as more LPs acquired stakes in PE and hedge fund managers.
The attractiveness of this investment approach is to capitalize on returns GPs generate for themselves, to strengthen the relationship with a manager, to obtain better terms than in the market and sometimes to set up an investment platform and move to active direct investing in the future. Investing in GP stakes can generate above-average returns if the investment is valued properly at all times – at both entry and exit.
Finally, lets pull back the curtain on the ultimate game. LPs have been increasing their allocations to direct and co-investments – collaborating and even competing with GPs.
Preqin's 2012 survey on co-investments reported that 37% of the LPs responding to the survey were actively and opportunistically co-investing. By 2015, 50% reported active or opportunistic co-investing, and another 22% were considering co-investing. According to Brian Gildea, managing partner at Hamilton Lane, a global private investment management firm, “LPs are interested in co-investing on the basis that it will improve returns through lower overall costs, create faster and more targeted deployment of capital and allow them to have fewer overall relationships.”
Co-investments continue to grow and can be supportive of GP investment strategies as they provide multiple sources of funds to make new investments. With LPs now increasing their allocation to direct investments at the same time, this may present a new challenge for GPs as some investors in their funds now could be competing with the GPs to buy the same assets.
Increasing competition for the same assets in a market of high valuations backed by so much ‘dry powder’ can result in assets becoming more expensive than desired and, as a consequence, lower returns in the private equity space. LPs can offer higher prices for investments because they cut out the middle man (the GP), and they have lower return target and more patient return horizons.
Stephane Etroy, CDPQ’s Head of Private Equity comments: “ In the past few years, we, at CDPQ, have shifted our strategy to do more direct investing because we generate better returns net of fees for our pensioners. Another reason is, as a long-term investor, we deploy capital directly when we believe that we have a strong alignment of interest with entrepreneurs or with the companies we invest in, and with whom we’ll have a partnership for 10+ years.”
Direct and co-investment strategies require specialized skills that are difficult to develop. Some large LPs have spent years building dedicated teams that execute proprietary deals. Examples abound in real estate, real assets (such as timber, farmland) and, of course, infrastructure, ranging from roadways and bridges to water services. Infrastructure is such a popular direct investment by all types of LPs that “infrastructure GPs” are well familiar with LP competition on deals.
Will the same thing happen to private equity GPs? Maybe not, because PE opportunities are spread across all industries and geographies. However, the effects of LP direct and co-investment expansion will certainly be felt by GPs when it comes to competing for big deals.
LP direct investing takes commitment and confidence. It’s not for the fainthearted. There is concentrated risk in these big-ticket investments, and the risk needs to be actively managed. Just like with GP investments, this means careful due diligence – financial, operational and commercial, along with rigorous valuation to get deal pricing correct.
Few LPs can maintain multiskilled teams needed to accomplish this oversight. Instead, they use small teams of portfolio managers that, in turn, choose specialist external diligence, consultancy and valuation teams to manage all these functions that were previously underrepresented in the LP staffing model. The Canadian pension fund investment model is the global benchmark. They employ experienced dealmakers and support teams to manage investment processes, but also reach out to consultants who have deep experience in niche industries and are able to mobilize in real time.
GPs and LPs will continue to face challenges. They’ll need to plan and execute strategies to make sure their investment process is in line with their mandate and that external advisors are aligned to support their investment strategies. If all this works out, they should be able to generate stronger returns despite a more competitive environment.
Federico Jost is a managing director of Berkeley Research Group, based in New York, and oversees portfolio and transaction valuation assignments for GPs and LPs.