The mindset in private equity investing doesn’t seem to have changed much since I first wrote about investing in private equity funds for Financial Poise five years ago.
According to Preqin, assets under management of private market funds (private equity, private debt and private real assets) have reached $4 trillion and $2.5 trillion in private equity (PE) alone. Including capital invested under the radar directly in private companies through co-investments and segregated accounts, we estimate the PE figure to have reached $2.8 to $2.9 trillion at the end of 2017.
Over the last 10 years, investors enjoyed attractive returns on private equity investments. Record net distributions were reinvested and allocations to private equity were increased to compensate for the low-yield environment. New commitments (“dry powder”) reached roughly $900 billion, an all-time high outstripping the record $678 billion of 2008.
Record net distributions were reinvested and allocations to private equity were increased to compensate for the low-yield environment.
That said, the ratio between dry powder and amount actually invested fell from an average of 90% over 2000-2005 to 46% over 2011-2016. Some of this dry powder has been used to transfer assets from funds to funds (in secondary LBOs, for example).
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However, this attractiveness creates increasing challenges. First, the speed of accumulation and the concentration of capital have adverse effects. Moreover, a prolonged period of benign investment conditions for investors leads them to forget basic rules.
Finally, fund managers have yet to assume their mantle as a major source of corporate financing with all the associated consequences.
In 2017, Apollo collected $24.6 billion and CVC $18 billion for respectively the largest ever US and European LBO funds. Large investors collectively decided to concentrate their investments in a smaller number of funds. The aim is to gain better fund terms and reduce costs notably by free-riding fund managers through co-investments.
This herding behavior has multiple detrimental effects.
First, by investing larger amounts in larger funds, investors force fund managers to focus on larger deals. Private markets are not scalable: fund and deal sizes are correlated. Because the number of new investment opportunities does not depend on the amount of capital available, an inflation of valuations in large and mega LBOs has occurred.
First, by investing larger amounts in larger funds, investors force fund managers to focus on larger deals.
Though fund managers have historically shown a certain discipline in deploying capital, 10 years of abnormal market conditions have put pressure on them to collect more capital (or be ignored) and deploy it in a short amount of time. Their freedom, a condition to generate higher returns, has been significantly reduced. The consequences will be disappointing returns and possibly an increased number of bad deals.
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To avoid this, fund managers have adapted.
For example, many LBO funds have engaged in so-called “buy and build”: acquiring platform deals and then making add-on acquisitions. Smaller assets are less expensive in both absolute and relative terms and benefit in aggregate from a multiple expansion effect. The synergies are also converted into profits at exit.
Benign investment conditions have also lured investors into disintermediation. The clearest example of this can be found in start-up investing. A long-standing myth is that there is not enough capital to fund them. As a result, financing channels such as equity crowdfunding and initial coin offerings (ICOs) have popped up, as seen in the graph below.
Fig. 1: Sources of start-up financing
* Figures for 2017. ** Figures for 2015.
Source: Wellershoff & Partners, CB Insights, WBAF, ACA, Foro Excala, ABAN, Arabnet, Crowdexpert, EBAN, Massolution and Coindesk.
Start-ups have a 50% chance of survival during their first five years. The amount of capital invested does not change these odds. In fact, at the scale of industrial sectors, the contrary applies. The more capital is invested, the more competitive the environment for start-ups becomes. This increases the chances of failure because it takes longer to establish a viable business and recoup investments. Excessive venture investments in such markets lead to an immediate price war between start-ups, from which they might never recover.
Expertise provided by active investors, such as venture capitalists, is in short supply. It enhances the chances of success, but is not scalable. Disintermediation deprives start-ups from such input while also degrading their market conditions.
According to a Wall Street Journal analysis, $2.4 billion was raised privately in the US in 2017, while $2.1 billion was raised in public markets. This drew the attention of regulators, as the SEC investigated broker-dealer rules infringement and hidden fees charged to investors. The government agency also investigated the ill-conceived European AIFM Directive.
This regulatory pressure can only worsen if the fund managers do not engage constructively and pragmatically with political and regulatory bodies at national and international levels. Fund managers command power on large swaths of developed economies and will suffer the backlash of preeminent failed operations. They need to prove that they are a force for good in finance, act responsibly and pre-empt contentious debates by offering innovative, concrete and attractive solutions to political, regulatory and social representatives.
Fund managers have demonstrated an ability to adapt to new conditions in the past, and need to once again in order to go beyond simple lobbying and whitewashing. This is the price they pay for a thriving private equity investing sector.
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Cyril Demaria specializes in private equity and combines practical and entrepreneurial experience, academic knowledge and lecturing experience. He is Head of Private Markets at Wellershoff & Partners, where he focuses on top-down buy-side research and advisory. Previously, he was Executive Director in charge of private markets research at the Chief Investment Office of UBS Wealth…
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