A Bad Omen For Private Equity Returns?

Sebastien Canderle, a consultant, university lecturer in private equity and author of Private Equity’s Public Distress, sent me a guest comment, A Bad Omen for Future Returns in Private Equity:

A recent report by research firm Preqin (the 2016 Private Equity Compensation and Employment Review) received some well deserved attention. Apparently, the year 2015 has already seen more private equity General Partners raise their first fund or at least reach their first close than the previous record year of 2007 had witnessed. For Limited Partners currently participating or planning to participate in this segment of the alternative investment sector, this growing number of GPs is bad news. The healthy clearing-up of underperformers that had taken place in the years since the financial crisis is poised to be undone. The weaklings that rightly failed to raise follow-on vintages after 2008 are being replaced by new managers with questionable or unproven track records.

We can understand why GPs are finding it hard to resist the call of 1.5% to 2.5% in annual management fees they can suck out of their closed-end funds. For LPs, however, caution is de rigueur as the upside is far from obvious.

If market data stating that, historically, half to two-thirds of GPs failed to meet the hurdle rate are to be believed, there is no apparent reason why the new breed of PE fund managers will do better than their predecessors. For this to happen, several conditions would have to be met.

First, deal opportunities would need to be more compelling than in previous decades. There is serious doubt that it will be the case in North America and Europe, two continents where there is saturation of fund managers and structural over-intermediation of M&A transactions. There remains an oversupply of funds chasing too few deals. The newcomers certainly won’t remediate this situation. The permanently high number of secondary buyouts is just one indicator that GPs have run out of fresh targets. A second clue is the persistent high multiples assigned to LBO targets.

Second, the first-time GPs would have to possess unique and superior investment skills compared to those of the previous generation. Given that the vast majority of newly established funds are being run by executives who used to work at existing GPs – in some cases they even come directly from old GPs who failed to raise a new fund on the back of poor performance – LPs need to query why these new managers should be expected to do a better job than when they worked at their former employers.

Third, to outperform their peers, the new generation would have to have received better training. Given that most have the same educational and professional background (ex-investment bankers, accountants and consultants, and MBA degrees) as the existing managers, doubt also exists about their ability to bring a new approach to deal making, portfolio management and value creation.

Fourth, the lack of market branding means that most new GPs will struggle to attract the best deal flow. Thus, many of them will be left with complex transactions or those that their better established rivals are not interested in because of low-return prospects. Beggars can’t be choosers. Desperate to do deals just to show that they are active, first-time managers will not be able to be as selective as more prestigious PE houses. That cannot be good for expected returns.

Last, in view of the mess created during the bubble years, the upstarts would require better risk management than GPs that have already run several vintages. It is very unlikely to happen for two key reasons: small funds (most of the first-time GPs will only be managing a few hundreds of millions at best) will not have the capabilities to establish best-practice corporate governance and investment discipline; and deal doing rather than risk management will be top of the agenda as they try to prove themselves. In short, their risk profile is likely to be worse than old-time players.

What should LPs still keen to invest in the space do to limit the risk of seeing this new breed of private equity managers underperform as so many members of the previous generation did?

They should impose strict discipline, for a start. The best way to do so is by sitting on the GP’s advisory board in order to regularly monitor the GP’s investment and portfolio management practices. Similarly, co-investing alongside General Partners gives LPs the opportunity to assess whether the GP’s due diligence process is thorough enough. But the best way to improve performance is to make sure that fund managers receive proper training. Traditionally, transaction experience had mattered a great deal more than classroom lectures. For that reason, on-the-job learning and one-day seminars had been the preferred methods to acquire new techniques and stay up-to-date with the latest developments. Given how competitive and mature the space has become, that approach won’t do anymore. Since few GPs will ever be willing to spend a meaningful proportion of management fees in training staff, they will have to be compelled by their Limited Partners. The latter can make the payment of fees conditional on a minimum allocation towards an annual training budget. Naturally, the quality of these training sessions will need to be monitored. If there is one thing that the recent fee scandal has shown, it is that GPs cannot be trusted to be acting in the interest of their investors. There is little evidence to suggest that this year’s swarm of first-time managers will behave differently, even though it would be a sure way for them to differentiate themselves from the old guard.

I thank Sebastien Canderle for sending me this very informative comment. Sebastien worked for four different GPs during a 12-year stretch, including Candover and Carlyle in London. At the moment, he continues to advise on due diligence and also lectures on the topic at various business schools (you can contact me if you want to reach him).

What do I think of his comment? In 2012, I wrote a comment on the changing of the old private equity guard welcoming new and smaller GPs whose alignment of interests are typically better than the large behemoths looking to gather assets. In fact, at a recent conference in Montreal set up by the U.S. Department of Commerce ("Montreal Trade Mission"), I met a few of these smaller American GPs which actually do what private equity people are supposed to be doing, namely, less financial engineering like dividend recaps and simply rolling up their sleeves to help bolster the operations at private companies.

But I agree with Sebastien's comments, there are many new GPs popping up in recent years and while some are excellent, the majority are questionable. Above and beyond that, this is a brutal environment for even the best private equity funds. Some even think it's time to stick a fork in private equity and that it's the end of PE superheroes. Moreover, I expect more regulations to hit the industry as news breaks of private equity funds stealing from clients.

As far as limited partners (LPs) are concerned, it's high time they wise up too. When I see a CalSTRS pulling a CalPERS on private equity fees, I cringe in disgust. I can write a book on the nonsense that goes on at public pension funds investing in private equity (everything from fees to benchmarks). To be sure, private equity is a very important asset class but the large "brand name" funds have been getting away with murder and it's high time limited partners take their fiduciary responsibilities a lot more seriously and squeeze these funds hard on fees and investments, or better yet, just go Dutch on them like Canadian pension funds have been doing for a long time.

[Note: The largest U.S. public pension, the California Public Employees' Retirement System, said on Tuesday that it had paid $3.4 billion to private equity firms in profit-sharing over the past 25 years - a big step to opening the curtain on an industry known for its lack of transparency and high fees. Will others follow CalPERS' disclosure lead?]

Below, Blackstone President and COO Tony James says stock market valuations are ahead of themselves and "a bit of a correction" is coming. I prefer when James talks markets instead of retirement policy but I don't see any correction in stocks as long as Mario Draghi's worst nightmare doesn't come true. However, I have noticed a big correction in Blackstone's shares (BX) which are way off their highs this year (click on image):

And it's not just Blackstone's shares. All the private equity funds I track in the stock market are down this year, not as much as some hedge fund stocks I track, but still down a lot (click on image):

The good news is these shares pay out nice dividends and I expect U.S. public pension funds chasing their rate-of-return fantasy to keep plowing into large, brand name private equity funds no matter how bad the environment gets. But don't rush out to buy these shares just yet as there are strong secular headwinds impacting the private equity industry which is a bad omen for future returns.