Private equity: build or buy?
Private equity as an asset class looms ever larger. Hardly a day passes when a headline does not announce a significant deal involving a private equity firm as buyer or seller. As buyers, over the last three years, private equity firms, capital-rich after record fund-raisings in the boom times, took advantage of diminished valuations as bubbles burst, and faced less competition to acquire assets than normal from trade buyers lacking cash or stock price ‘currency.’ As sellers, the same firms - now owners of all manner of assets, some household names - have timed their exits shrewdly as public markets revived and good gains became achievable.
Such prominence for private equity is not limited to deal-making. By the standards of managers of publicly-quoted equities, the management fees and profit shares earned by private equity managers (whether as general partners of funds investing directly in deals, or as asset managers running a private equity fund of funds) are high. At its most extreme, the difference in fees can amount to more than 20%, or 2,000 basis points. An active manager of public equities might earn fees of 0.75% or 1% of assets, at best, while the general partner of a profitable private equity fund could, over time, earn annual fees of 1.5-2% of assets, as well as a 20% carried interest on the increase in asset values. Private equity funds’ fees are also uncommonly ‘sticky’, as performance is hard to quantify quickly, and so there are far fewer changes of manager in a mandate’s mid-stream than in the publicly-quoted world.
In light of private equity’s profile and profitability, it must merit consideration by diversified asset managers as an addition to families of funds, or to competencies that today concentrate on managing public equities and fixed income securities.Yet adding private equity as a product or competence may not be simple. Its structures and styles differ materially from those of the publicly-quoted world, and it operates at a pace and with practices often out of sync with public market equivalents. Also, the private equity fund of funds arena, the most natural entry point for an asset manager seeking exposure to the asset class, has only a handful of big players with brand names. Therefore, buying market share could be expensive, and building it from scratch or from a small base could require an intolerably long investment period.
When a firm managing public equities wins a new account, in most cases within minutes or hours of receiving the associated cash it has put it to work via a portfolio of quoted securities. Public markets are typically deep and liquid enough to permit immediate investment, and most managers maintain ‘model portfolios’ - chosen after researching available opportunities and amended when necessary - that can be duplicated right away when fresh capital is ready to invest.
By contrast, general partners of direct private equity funds are normally permitted as long as five years to source, evaluate and negotiate investment opportunities to match their committed capital. Managers of private equity fund of funds (as noted above, probably the most desirable acquisition for an asset management group seeking a presence in the private equity asset class) typically have a three year investment period during which to select underlying funds to back. Those underlying funds are then each allowed their five-year investment period (as noted above), meaning that an investor in a fund of funds may not fully invest its commitment for as long as eight years. It may be another seven years thereafter before all gains and losses on the assets held by the underlying private equity funds are recouped and recognised.
From the perspective of most managers of public equities, then, private equity redefines the meaning of ‘long-term.’ Private equity also requires different skills of its managers. Clearly, general partners of private equity funds making direct investments are far more active as owners (since they normally hold a majority of the shares) than institutional shareholders in a public company, where owning more than 5% of the stock would be exceptional. Given that disparity, comparing an asset manager investing passively in public equities with a private equity fund of funds manager is likely more apt, since the latter also has no direct control over the ultimate assets.
While broadly their investment perspectives may be similar, the investing environment and disciplines of a manager of public equities and of a private equity fund of funds differ significantly. A manager in public equities is normally hired with a specific mandate (often concentrating on a particular geography or market sector) and held to beating a benchmark that has quantitative integrity. By contrast, private equity fund of funds managers’ mandates are typically broadly defined - sometimes even globally, in other words encompassing a potential universe of all private equity funds of whatever stage, place or maturity - while accurate benchmarks are hard to find, thanks to limited data and a lack of comparables. Also, at the push of a button, a manager of public equities can sort investment opportunities using a wealth of publicly available and accurate information. A private equity fund of funds manager, instead, must laboriously build up market knowledge and make choices by visiting dozens of private firms managing funds that require little or no public disclosures of their holdings or returns.
In light of these many differences of investing structures and style, not to mention the compensation and back office complexities they bring, integrating a private equity offering into an asset manager’s family of funds is not straightforward.It is therefore perhaps not a surprise that, to date, most asset management groups have not moved far along the private equity route, and the most notable acquisition of a private equity fund of funds specialist - that of Pantheon, late last year - was completed by an institution already familiar with private equity through its own activities, Frank Russell.
An asset management group attracted to private equity and able to overcome the obstacles of differing disciplines could face the traditional choice – whether to build its own operation from scratch, or to buy an established player. As noted above, the most likely entry point would be to establish or acquire an asset management firm operating in this field, in other words a private equity fund of funds manager. The build vs buy choice could be affected by unusual dynamics in the private equity fund of funds world, all relating to constraints of supply – of people, places to invest, and players.
With respect to people, as in many niche industries, in the private equity fund of funds world the number of highly experienced executives is small. The best of them are likely to be well rewarded both by current compensation as well as long-term incentive schemes where they presently work; as such, they may be hard and costly to displace.
Equally, there are limitations on the quantity of elite, direct private equity funds that fund of funds can back; it is a feature of the private equity asset class that the dispersion of returns between its best and worst performers is far greater than among managers investing in publicly-quoted securities.
Naturally, the best performers attract the strongest support, and those investors, fund of funds as well as other institutions, that have backed the top talent over the long-term have natural advantages of relationship and recognition in securing their position in successor funds.
In the fund of funds world, the number of players with a proven track record - and therefore, typically, a brand name in that business and an ability to attract capital through thick and thin - is very small.
Figure 1, prepared by the London-based private equity advisory firm Altius Associates, demonstrates the recent ups and downs in capital committed to private equity fund of funds. At the peak, in 2000, over 50 firms raised nearly $18bn (E14.6bn) for fund of funds. As market became tougher, these sums shrank in 2003 to just under $5bn raised, by just over 20 firms.
Figure 2, shows how concentrated a market the private equity fund of funds world has become: the top 10 managers command over a 50% share of the $114bn in total commitments to these vehicles as of the end of 2003. General market information and intelligence indicates that the larger, more proven, more established funds of funds managers succeeded in raising capital in the hard times, while many of the smaller firms with lower profile and less provenance have struggled to attract investor support.
Because of the dynamics of the private equity industry, and based on this recent evidence, it would appear difficult, even with a name earned in other markets, a big cheque book and patience, for a new entrant to gain traction in the fund of funds world easily. Buying an established business may be a better route but, again, supply is limited – of the top 10 firms with high market share collectively, not all are independent, as some are subsidiaries of global investment banks or insurance groups. Direct private equity investments, whether in start-ups or leveraged buyouts, have always benefited in generating exceptional returns from barriers to entry and inefficiencies. These same market dynamics may constrain asset managers’ ambitions as they seek a presence in the private equity fund of funds business.
John Barber is a director of Helix Associates in London