Thursday, March 14, 2013

Standard Private Equity Losing Its Luster?

Ronald J. Sylvestri, Jr., President of Quail Ridge Asset Management, wrote an op-ed for Forbes, Why The Standard Private Equity Fund Is Losing Its Luster:
Save your tears, but it’s not easy being a middle market private equity firm these days. Due to significant structural hurdles and headwinds facing U.S. private equity funds—not to mention an increasingly challenging political and economic environment—a growing number of savvy private equity managers are responding by becoming more entrepreneurial and thinking outside of the proverbial box. The current problems and structural issues are not going away anytime soon. As a result, private equity managers are left with little choice but to adapt to these evolving conditions.

There are a number of reasons why the standard private equity fund is losing its luster. The biggest issue the industry faces is liquidity where a 10-year lockup with two 1-year extensions is the norm. That is a long time to keep precious capital locked up, especially in a bad economic cycle during which a fund can’t exit its investment. Most investors don’t like the 10-year lockup and would rather opt for a more liquid structure. LP’s seem to be moving away from blind pool investing, and opting for more flexible vehicles and structures. The industry’s investor base is changing: Institutional investors like banks and insurers are withdrawing from fund investing. To attract different sources of money, the industry may need to offer different structures. The latter is particularly true with family offices: as they get more sophisticated, they also want to go direct into deals and not into funds. Looking forward private equity firms needs to be more agnostic about how their vehicles are structured. Their job should be not to preserve the existing fund model, but to make sure that investors’ capital is delivered to companies in need of investment in the most efficient way possible.

Then there is the actual cost of raising a fund, as well as the overall fund structure—this includes paying investment professionals, analysts, marketing and investor relations professionals, fundraising people—it’s a very costly infrastructure. When you factor in some of the other common expenses like expensive commercial office space, perhaps sky-high midtown Manhattan office space, along with expensive travel, and the costs quickly add up. In addition, it can easily take up to two years to raise a new fund. Time is money and many investors simply do not have the time nor patience to wait this long. And then as funds have be registered with SEC, there are growing legal and regulatory costs to consider. At the same time “fee compression” is revealing itself more and more frequently.

Right now, it’s the bigger funds that are getting bigger, while the smaller, emerging managers are starting to disappear altogether. Among the biggest funds, Blackstone just raised a $13 billion dollar real estate fund, and then CalPERS recently made a $400 commitment to Riverstone, a multi-billion dollar fund.

Notably, the political tide in Washington is not helping matters. The lower tax rate on “carried interest” was never popular, and last month, Sen. Carl Levin (D-MI) reintroduced legislation supported by the Obama Administration that will classify carried-interest investment income as ordinary income for tax-reporting purposes. As in past versions, the “Cut Unjustified Tax Loopholes Act” submitted by Levin would raise taxes on the carried interest income of investment partnerships from the capital gains rate to the ordinary income tax rate of 39.6%. We are talking about a major tax treatment sea change.

So what’s the alternative? As private equity funds search for different structures, holding companies like Warren Buffett’s Berkshire Hathaway spring to mind. Private equity people are now looking to buy operating business and run them, and use the subsequent cash flows to buy other businesses. Another noteworthy structure is the special-purpose acquisition company (SPAC) which may be a key component of the next evolution.

SPACs are simply a vehicle that facilitates an IPO for unique companies that might not otherwise be able to get through the IPO queue in a timely manner. It’s a great way for a private company to go public without the headache of going through the SEC registration process. Several well-known companies have gone public through SPACs in recent years, including fashion retailer American Apparel, along with the well known New York cupcake chain, Crumbs Bake Shop. SPACs can truly be a viable alternative for small, rapidly growing companies looking to tap the public markets, and have ongoing access to capital via the capital markets. SPACs are a viable alternative that bring together an experienced and industry specific management team for an offering to public market investors.

Importantly, private equity as an asset class is not over; rather investment professionals are changing the way they do business with an eye towards adapting to changing times via specialized vehicles, separate accounts, and in some cases listed vehicles. After 2007 liquidity is king, and flexibility is important. The talent within the space bodes well for future adjustment, but for now the funds in their present structure seem to be losing their luster.
Very interesting article which got me thinking maybe there isn't a changing of the old private equity guard.

Indeed, while small funds are struggling to survive in a cutthroat environment where "liquidity is king," larger and more established funds are getting bigger, moving into other alternative asset classes like hedge funds and infrastructure. Also, there is no doubt that private equity kingpins were the real fiscal cliff winners.

And now private equity is going retail. The Carlyle Group's decision to let investors buy pieces of the firm's funds with as little as $50,000 is no doubt aimed primarily at tapping a broader range of investors, it may also bolster private equity's political clout.

The article above mentions that banks and insurers are exiting private equity -- most likely because they are preparing for new regulatory capital requirements -- and that long lockups and fund structures do not appeal to many investors, including family offices. True but pension funds are taking on more illiquidity risk but are demanding tougher terms and more bespoke investing solutions.

One CIO of a large US public pension fund told me he sees the big behemoths getting larger by investing in various alternative investments to cater to institutional clients. "The name of the game is asset gathering. It doesn't matter whether it's private equity, real estate, hedge funds or infrastructure. The KKRs and Blackstones of this world will make huge profits by growing their asset base and delivering tailor-made solutions to their clients."

No doubt about it, while standard private equity is losing its luster, the traditional private equity powerhouses have expanded into other more liquid alternative investments and are lowering the barrier of entry for every day investors to grow their asset base and make a killing off fees.

Below, CNBC's Kayla Tausche reports that private equity firms are looking to increase their asset base. Interesting comments on the performance of the shares and their funds of funds.