The Threats Facing Private Equity?
When I started working in London in the early 1990s, I came across the book The Insider’s Guide to Raising Venture Capital. Back then, venture capital referred to both start-up financing and leveraged buyouts. While the book is now out of print, one of the key questions asked by the author was “what is a safe level of debt?”, to which he candidly answered “a level which can be serviced in a recession.”This is another excellent guest comment from Sebastien Canderle.
It was important to make LBOs recession-proof because economic downturns impact profitability and loan repayment. Many private equity-backed businesses had collapsed in the aftermath of the late-1980s buyout bubble, succumbing to extreme leverage as the economy headed south.
How things have changed! Nowadays, recessions are seen as opportunities for PE fund managers to glide from amend-and-extend agreements to covenant-loose restructurings. Post-financial crisis, many financial sponsors were able to push back the debt maturity wall faced by their portfolio companies as imprudent lenders struggled to survive. Admittedly, the PE firms’ efforts were helped by the central banks’ decision to keep interest rates close to zero, the ideal scenario for operators that use debt on an industrial scale.
Yet, despite their financial engineering prowess and the current economic boom, fund managers have recently seen a number of high-profile transactions crash unceremoniously. Two PE-owned retailers that folded in the last 15 months are Toys “R” Us, sponsored by KKR and Bain Capital, and British discounter Poundworld. PE firms can take the blame for these companies’ downfall, but the reason they went bankrupt is not macroeconomic. The economy is far from being in a recession. Overindebted businesses are facing a new foe: market disruption.
Some content distributors, including EMI Music, collapsed shortly after the 2008 financial crisis. As content increasingly became digitised, users started buying (or pirating) movies and songs directly from the Web. But the number of victims that have fallen to technological disruption has recently reached a crescendo. Amazon was blamed for the bankruptcies of brick-and-mortar retailers Toys “R” Us, Gymboree and Rue21.
Other retail chains, such as TPG-backed Poundworld, were unable to handle disruption with a distinct political flavour. Management blamed Brexit and the ensuing sterling devaluation for the collapse of the business earlier this year, although previous entrepreneur-owner Chris Edwards argued that the new team did not understand the discount model, so other factors could have played a part.
The retail crisis is far from being the only sign that disruption is spreading. Traditional media outlets have also been affected. First, advertising spending moved online, turning Facebook and Google into giant ad platforms. As advertisers followed viewers to the Web, many buyouts of advertising specialists, such as outdoor operator Clear Channel and radio broadcaster iHeartMedia in the US, suffered greatly. The latter filed for Chapter 11 six months ago, a full decade after its acquisition by Bain Capital and Thomas H. Lee.
Content production is not being spared. Today, Amazon and Netflix are successful film producers, dealing a blow to content providers like Univision, an American TV and radio broadcaster targeting the Hispanic population. Univision has been under PE-ownership for 12 years and counting; its IPO has been withdrawn twice already. The financial sponsors, including TPG, Thomas H. Lee and Providence Equity among others, seem stuck with this corporate zombie as valuation multiples for media assets have come tumbling down.
Disruption in all its forms is a formidable threat to cash flows. The pace of change has risen markedly in recent years and is forecast to stay on an upward trajectory. To address this point, PE firms will need to develop a new skill set. Financial innovation is useless when a business model is being disrupted. Instead, transformational re-engineering of an operational nature is indispensable. To individuals who spent the last decade honing negotiation skills to push lenders into a corner during economic slumps, this is a huge challenge. Disruption is often structural rather than cyclical. Renegotiating covenants and loan maturities won’t accomplish much when a business is affected by a fundamental and permanent business model redefinition.
This is not good news for private equity. After laboriously adapting to the unpredictability of economic cycles, the industry must now tackle a more persistent threat. Unless it acknowledges this fact, LBO zombies and bankruptcies are likely to become more frequent. That leaves fund managers with a much tougher question to answer: what is a safe level of debt in the face of disruption?
You might recall Sebastien wrote another guest comment for this blog over two years ago on private equity's misalignment of interests.
Having worked at top private equity funds, he knows what he's talking about and I encourage my readers to read all his books on private equity which you can order here.
As for the subject he covers above, it's painstakingly clear that private equity funds are not prepared for the growing threat of disruption.
Some of these high-profile deals which he discusses above were so blatantly evident disasters to me. For example, why did private equity ever get involved with Toys "R" Us? That company was in a death spiral for years and no PE giant was going to turn it around.
We live in an age of major disruption. This truism holds true for every business out there, for PE funds and their large pension and sovereign wealth fund clients plowing billions into this asset class.
Quite worryingly, even though private equity deal valuations are ticking up and firms are increasingly turning to debt as a means of funding deals, institutional investors remain bullish on the asset class.
Worse still, performance persistence in private equity is diminishing. Further, the returns themselves are not what they used to be. And in even further bad news, new research from a leading Massachusetts Institute of Technology academic shows that co-investment vehicles may not be a panacea for these problems:
In private equity, the flow of capital and the number of funds have both doubled in the last two decades, hurting the persistence of returns, which until now has been thought of as the defining aspect of private equity.Professor Schoar sounds like a very smart lady who really understands her subject matter.
New research by Antoinette Schoar, chair of the finance department and the Michael M Koerner Professor of Entrepreneurship at MIT Sloan School of Management, shows that persistence of returns from private-equity funds in the last decade has gone down, undoing the seminal research she co-authored with Steve Kaplan, from the University of Chicago, that showed “returns persist strongly across funds raised by individual private equity partnerships”. See Private-Equity-Performance-Returns-Persistence-and-Capital-Flows
“I deal with LPs [limited partners] frequently that say there has to be persistence in returns, given our earlier research, which showed that top-quartile funds had a 33 per cent chance to stay in the top quartile,” she says…But [this persistence we saw in the 1990s has gone down over time.]…The question now is, why is this happening and what implications does this have for investors in private equity?”
Schoar’s new research shows the variance in returns between the top and bottom quartiles still exists, but the persistence has decreased.
“Being in the top quartile is still as important as before, but because persistence is going down, you can’t rely on a top-quartile fund in 2000 staying top quartile. What this means for investors is your life is even more difficult.”
Schoar attributes this change to the evolving nature of competition and the available capital.
“Private-equity fundraising over the last two decades has increased. The capital under management and the number of funds have doubled,” she says.
These structural changes to competition and available capital in the last decade have caused the top funds to grow at a much quicker rate than they have in the past, she says.
“There is more competition, but the concentration of [assets] in the hands of the biggest and best-performing funds is also growing more quickly than we saw in the 2000s,” Schoar explains. “You could say it is efficient that this happens, because we want capital to be with the best performers. But it also means the top funds have to expand their investment portfolios.”
The very nature of venture capital and private equity, where illiquidity is greater and opportunities are tougher to scale, means the marginal returns to capital go down, even at the top performers, when funds become larger.
“This is a very strong relationship – when the fund size increases, the marginal return on the funds goes down. Research suggests this is something that has accelerated in the last decade,” Schoar says.
More bad news – a co-investment warning
Sounds grim. And Schoar says co-investment as a solution is uncertain at best.
The recent trend of investors favouring co-investments, special-purpose vehicles and direct investment in private equity is a result of the changing trends in performance and persistence, she says.
Within the changing landscape of private equity, it seems that many LPs have been tempted to get involved in the investment process by going into co-investment because persistence and performance are going down.
“But our data suggests we should be very cautionary about it because we see massive variances in the performance of co-investment,” Schoar says, “and the timing [often] seems quite detrimental to the fund performance.”
Schoar and fellow author Josh Lerner, from Harvard Business School, are now working on new research examining co-investment returns. Using data from State Street, they have access to 1500 main funds and their co-investment vehicles.
“Our results were really stunning, we didn’t expect them,” she says. “The variance is humungous.”
While the research, including determining the drivers of this variance, is a “work in progress”, she says some of the reasons for the poor performance of some co-investments is bad timing.
In addition, the co-investment deals are particularly large, in some cases three times as large as the investment the same entity makes in its main fund.
“For an LP, the co-investments are even more difficult to diversify than normal” in private equity, she says.
Schoar states that, in some ways, the large variance in co-investment returns should not be a surprise, because of the nature of co-investment vehicles.
Much of the decision-making “goes back to the investment team at the LP…So one should be careful to see whether the LP is big enough, sophisticated enough and has the internal resources to make that trade-off.”
She also warned LPs looking at co-investment to think about when general partners are most incentivised to include LPs in a co-investment.
“The incentives might not be aligned,” she says.
Let me add my two cents here. No doubt, performance persistence is still there among top private equity funds but it has come down considerably as billions keep flowing into the asset class.
If you also factor in "disruption" and the inability of top funds to adapt to major disruption, then it shouldn't surprise us that performance persistence is withering.
As far as co-investments, I'm all for them because they reduce overall fees but I have a caveat. If the LPs don't have highly experienced teams, they shouldn't be co-investing alongside the private equity funds.
I'd love to see if professor Schoar's research looks at Canadian versus US public pensions when looking at the variance of returns in private equity co-investments. I suspect Canadian pensions have been much more successful with their co-investment programs because they hire people who are able to quickly ascertain whether a co-investment is worth it and they compensate these people properly.
Lastly, Julie Segal of Institutional Investor reports, The Threat Facing Private Equity in 2019:
Even as private equity firms are flush with cash and continuing to raise capital, they’re facing the rising risk in 2019 that increased interest rates will push up their costs and drive down values, according to a new report.I hope you enjoyed this comment on the threats facing private equity.
Private equity firms have a record $1.14 trillion in dry powder, or cash waiting to be invested, according to the annual global asset management outlook from Moody’s Investors Service. While business conditions remain strong for private asset managers, they could face headwinds next year in the form of rising interest rates, the report said.
“Higher interest rates may raise the cost of financing assets, while simultaneously driving prices lower,” wrote the authors of the report.
Even with an aging bull market and rising volatility, the asset management industry is likely to be stable next year, according to Moody’s. The firm expects asset managers’ revenue growth to continue — even if not as strongly as in previous years — but the increase in stock and bond market volatility may drive redemptions from investors.
Although asset managers are facing a tougher future, with fee pressure and an aging client base, they have gotten better at controlling their costs with technology and other measures.
“Cost management, supported by technology substitution, has preserved operating profit margins per dollar of AUM [assets under management],” wrote the report’s authors. The next market downturn will put these changes to the test, they wrote.
Moody’s says regulatory efforts, particularly in the U.K., to protect investors with increased disclosures of fees and performance, could be a potential drag on managers’ revenue by pushing down demand for certain products.
“U.K. regulators have been very keen to raise the question about whether a user of asset management services is getting what they’re paying for,” said Neal Epstein, senior credit officer and one of the report’s authors, in an interview. “They’re asking questions like why should products have such a uniform fee structure in a competitive market and why are margins high if people are getting products that are very hard to distinguish from passive.”
When investors buy products based on a benchmark, “the more you spotlight performance comparisons, the harder it is for all of these asset managers to look good,” Epstein added. “Not everyone is above average. In the U.S., regulators have been willing to let the market determine this. “
Epstein said domestic regulators have been instead focusing on issues such as liquidity and the potential of open-end mutual funds to withstand a “run” — that is, if an asset manager can handle a critical mass of investors redeeming from their funds in a short time period.
Asset managers made a number of acquisitions this year, many focused on expanding their reach geographically, and to add alternative investments such as private debt as well as data science and other technology capabilities. Moody’s expects more acquisitions to come next year.
Epstein said asset managers are modestly leveraged and have the flexibility to make acquisitions. In addition, the business case for consolidation remains strong, including expanding into alternatives or in fast-growing areas of the world like Asia.
“It really is symptomatic of the underlying story: that asset managers have to adjust to changes in the underlying markets,” said Epstein.
Please remember to support this blog by donating or subscribing via PayPal on the right-hand side, under my picture. I thank all of you who take the time to do so.
I also thank Sebastien Canderle for his insightful comments on private equity.
Below, Mark Thierfelder of Dechert LLP discusses the firm's new report on global deal making and the state of private equity. Read a previous comment of mine on private equity going public.
And an older clip (September, 2018) where Joseph Baratta of Blackstone joined 'Squawk Box' to discuss private equity deals like Blackstone-Reuters and how Blackstone is viewing the news deal. Listen to his comments, very interesting.
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