By Matt Williamson.
(Founders Trust is a direct buyer, not a Private Equity fund. Here we discuss the Private Equity industry, and its potential future.)
What is the Future of the Private Equity Funds?
For the last 50 years, private equity (PE) has grown from an obscure strategy used by Wall Street mavericks to an industry that manages vast amounts of money, employs hundreds of thousands of employees throughout its holdings, and attracts some of the best human capital to work in it. The question is, are we approaching cataclysmic changes in the PE industry, and has the investment community been paying attention that that?
Even more, will PE funds continue to be a vibrant investment option in the next 10 to 15 years, as they are now? As you look ahead, and consider the past, you might be wondering what the future has in store for the large PE firms, and for the smaller ones.
The industry has come a long way from when the founders of KKR were applying their niche strategy for deals in Bear Stearns, inspiring the founders of Blackstone, Carlyle, and other PE pioneers to start and grow their businesses, shaping today’s established private equity industry.
Some call PE an asset class. Some, like Warren Buffett, call it a compensation scheme.
Nevertheless, what we call PE today is really not any different from what the successful families have been doing for hundreds of years – holding privately, equity stakes, in real businesses and real estate assets. Families used to hold for long periods of time, but today, PE funds are often looking for a 3-5 year exit, in order to realize profits.
Using relationships with their bankers to finance these businesses and assets, and not having to report on a quarter-to-quarter basis, has been the tactic of family holdings. In fact, new or existing partners taking each other out has been the usual exit strategy, while expanding to other businesses and industries has been their diversification strategy.
These strategies created the large conglomerates, not only in the 1970s, but long before that.
A note about diversification: the reason private owners don’t diversify is not because they’re unsure about the future of their current business. Instead of diversifying broadly for the purpose of ‘diversification,’ what they do is to add to their existing holdings where they see profit opportunity, when they see that one business will benefit from the other, for vertical or horizontal integration, for economies of scale and economies of spatial concentration, for strategic reasons or because they can acquire a business at a good price, or for other objective reasons. Their knowledge leads them to add a new business to their holdings.
This comes in direct contradiction with what the mainstream business schools are teaching today, which is to invest in many businesses and in many sectors because you don’t know which ones will perform well, and which ones will not perform well.
- The question is, has today’s PE industry reached maturity stage?
- Have the PE companies become so large that they profit from their fees so much that there is no alignment of interest with their limited partners? Meaning that LPs & GPs are supposed to make profits together from their successful investments and they feel the pain together in the unsuccessful ones? Instead of just profiting from fees, regardless of performance.
- Do the PE owners have their own money in these funds, or not anymore?
- Is the fact that PE firms are taking themselves public, an indication that the owners (founders) are getting ready to exit?
- And who is going to stay in? The actual capital is already coming from limited partners. If the general partner’s capital is coming from third party investors, too, how does the incentivization and alignment process works at this stage?
- Will the employees of these firms own 51 percent of the stock to ensure enough ‘skin in the game?’
- Are the founders exiting because the industry will not be so profitable in the future?
- Or is it because, if the original founders leave, they don’t know how the organization will perform?
- And, if the founders are not comfortable, why would the limited partners be confident enough to keep investing in these private equity firms?
Is this the reason that it was recently announced that small private investors will be allowed to invest in PE via their retirement accounts? Why now? They should have been able to do that 30 years ago when the university endowments started investing in PE. If the founders want out (which is not a bad thing by the way, since at some point you deserve and need to have an intelligent exit) will they stay around for a while to make sure the C-suite is ready to run the show alone?
These are valid questions that we need to spend time trying to answer.
Will family offices and high-net-worth individuals (someone who hasn’t decided yet to convert his personal wealth to family wealth and maybe hasn’t decided to get the family office infrastructure yet) keep investing in private equity funds, or have they seen that they can do better by having their own analysts in-house and investing in their own deals? Will they keep control of their capital and choose to partner only as part of a joint venture in club deals with the PE firms, and negotiating the terms they choose for each deal? Even more, have the family offices developed the deal flow they need to satisfy their appetite for investing? They answer is yes; the family offices have satisfactory deal flow.
Interestingly, some of the large PE funds don’t get this deal flow, because their minimum requirement for equity investment is so large that for their operational economics to work, they have to deploy their equity in very large amounts. That disqualifies them from the majority of the deals today, both in real estate and in corporate deals. That leaves them competing with other large PE funds for only a few large deals. This means fierce competition among them for these very large size deals, and this pushes prices to higher levels. And if you think that these PE funds are Joint Venturing for these deals so that they don’t have to compete anymore, and they don’t push the prices to higher levels, that’s a kind thought, but their problem is not solved. They still have the problem of deploying their capital in large chunks of equity.
For these reasons we believe that there is a good chance that large PE funds will disappear the next 10 to 15 years, or they will not play the role they have played the last 50 years in our financial system.