6 Things to Know About Private Equity

This article explores six factors and trends in private equity that can influence individual funds as well as the overall asset class.

When it comes to private equity investing, the funds, their strategies, and accessibility to investors vary widely. While some private equity (PE) funds focus on leveraged buyouts, others might specialize in corporate restructuring, governance overhauls, or industry-specific expertise. Investing in some PE funds may be the exclusive purview of large institutional investors, while other funds may be accessible to high-net-worth individuals or even the general public (via public securities).

But when looking at private equity, there are some factors and trends that may be worth understanding. The factors examined in this article are:

  1. How PE firms add (or extract) value may differ
  2. Some charge consultant fees — which can be a slippery slope
  3. LPs taking GP Ownership Stakes are on the rise
  4. Fund sizes are trending larger
  5. There have been some recent high-profile private equity scandals
  6. Big PE firms have been pursuing the public markets

These factors and trends can change the incentives that drive decisions within PE firms. Changes in decision-making, of course, can have profound effects on a fund’s outlook, performance, and longevity. By understanding some of the nuances in private equity, a prospective investor can better assess their interest in a specific PE fund. Or their interest in private equity overall.

 

1. How they add (or extract) value may differ

Broadly speaking, the specific strategies of private equity funds typically lean into either financial or operational engineering. Both terms encompass a wide range of activities.

Financial engineering — at its core — revolves around accounting tactics and financial optimization in order to leverage value (which may include fundraising). This is the stereotypical domain of ‘cost cutting’ strategies that have made certain PE firms notorious. But that’s only one possible component of financial engineering. Other strategies focus on tax optimization within companies, changing capital structures and fundraising strategies (sometimes tied to ‘leveraged buyouts’), renegotiating partnerships and supply-chain agreements, or just better accounting practices in general.

Operational engineering — while it may occasionally overlap with the former — is focused on diagnosing and fixing strategic issues within a company (rather than financial or accounting issues). PE firms employing these strategies are frequently looking to add and create value (or ‘operating leverage’), with an eye towards company growth.

One possible model is finding companies that have either plateaued (or perhaps have anemic growth) due to a key issue in which the PE firm happens to have expertise. As an example, let’s consider a hypothetical enterprise software company. This company has a quality product, some good customers and predictable revenue, but they’re just not growing. A sales-focused PE Firm somehow discovers this company and diagnoses a specific problem — the company needs to change its sales strategy and shift from pipeline management (perhaps driven by the founders) to a professional enterprise sales team. The PE firm decides to take some form of ownership stake in the company while helping reinvent its sales team. They identify a top-tier enterprise sales pro to join the company, ramp up sales, get back to growth and create operating leverage.

The operational engineering model was helped made famous by the venture capital firm Andreesen Horowitz (‘A16Z’). The VC firm looks to provide full-stack advice and services to its portfolio companies across a host of operational issues as a way of creating value. Its genesis is rooted in the idea of surrounding companies with affordable, high-quality operational services so they don’t have to burn time (and money) bidding on payroll or HR systems, head-hunting for certain executives, etc.

Following in the shoes of A16Z, we have observed a rise in PE firms running operational engineering strategies. Whatever the approach, the strategy is typically aligned (or, at least, marketed as if it aligns) closely with the backgrounds and beliefs of the fund managers.

 

2. Some charge consultant fees — which can be a slippery slope

The charging of consultant fees started in a good place of helping portfolio companies buy and hire affordably. With any new business, consider the learning curve in terms of buying certain services: how many times do you need to buy an HR tool or hire a CFO if you get it right the first time around?

If you have a professional investor with skin in the game (ergo, a PE firm), they may help you get a CFO and do it on a cost-efficient basis. It may be that you don’t need a full-time CFO, but you need someone with CFO skills — in which case hiring a part-time consultant may be the correct fit for your company. That consultant may charge you consultant fees (this is also an example of operational engineering.) Of course — these consulting relationships can be very necessary and helpful, spurring companies into newfound growth and generating returns for all parties.

However, there can be a perverse incentive to abuse these consulting relationships. Some consultants may be closely affiliated (or even work for) the same PE firm that encourages you to hire them. If a set of consultants hired by a portfolio company ramp up that company’s burn rate but don’t kill it…after a while, those consultants can become another in-house revenue source for the PE manager. This can be a prime scenario for abuse.

“A fundamental challenge to this is that revenue is changing hands,” explains Different CIO Harold Hughes. “And whenever there is revenue changing hands, there’s an incentive to misuse or abuse the transaction. The risks compound when PE funds bring in their own operating executives and charge fees to the companies, forcing the companies to use those specific executives (as opposed to outside or unaffiliated consultants).”

In any situation — when a PE firm brings someone into a company, who exactly are those executives? If a PE firm recommends a third-party service provider, who exactly is that provider? Look closely and you might see a revolving door. This issue in PE gained particular attention in 2014, when the SEC’s Andrew Bowden expressed concerns around this observed trend, among other issues such as extensive monitoring fees or other undisclosed administrative fees.

 

3. LPs taking GP Ownership Stakes are on the rise

Institutional Limited Partners (LPs) are increasingly buying ownership of the General Partners (GP) that manage private equity funds. Buying ownership of a GP essentially allows an investor to access the asset and its performance without having to pay management fees. As an example, let’s say an institution buys 20% of a GP at a PE firm. Going forward, that institution can basically take 20% of the firm’s management revenues (including a pro rata percentage of management fees).

As an LP, owning GP stakes can reduce the cost-basis of owning an asset. In other cases, it can be an investment strategy to generate returns through firm cash-flows such as with Goldman Sachs’ Petershill.  

But a risk with selling GP ownership stakes is if it can influence incentives.

Now, business owners (in this case the GPs of PE funds) are generally entitled to recapitalize and take some cash off the table. One thing you may consider is whether such an arrangement — by its structure or its size — changes any of the incentives for success. If you’re an LP in a PE fund that sells part of the firm to someone else, do you understand how you might be affected?  

Put differently — if a GP sells xx% of their firm, are they still incentivized to show up to work every day? Are they still going to invest the way that you want them to? They may, they may not. As an example, let’s say a GP takes $150M off the table in exchange for 20% of the PE firm. Three of the partners split that money at $50M each. Do each of those partners still want to be ‘masters of the universe’, or is that plenty of money for them to hit the beach? What’s their ‘number’?

Someone may say their ‘number’ is $200M, after which they’ll retire. But priorities can change over time. And ‘cash in-hand’ versus ‘cash-imagined’ feels differently in your pocket. Someone who sets their personal assets target at $200M may find themselves quite satisfied at $20M. What if this person turns out to be a key partner at a private equity fund you’ve invested in?

 

4. Fund sizes are trending larger

According to Preqin, PE fundraising in 2019 is averaging $1.6B raised per fund and trending up (compared to a 2010 recessionary average of ~$450M per fund). This is driven in part through mega-funds. In tandem, dry powder has also increased

A pro for larger funds is their size enables them to pursue more and/or larger deals, potentially offering them greater flexibility to implement their investment strategy. In some cases, these larger funds are pursuing private equity buyouts of scaling software companies from VC firms (a rising trend as startups have stayed private longer). Moreover, if a fund has ample capital in reserve at the right time, it can be well positioned to go on a buying spree in the next recession and access deals at lower valuations.

However, bigger funds can face bigger challenges in generating returns for their LPs. Having a bigger fund doesn’t mean your performance economics scale linearly; at some point, the economics are capital constrained. If you’re a $25B PE fund (as compared to say, a $500M fund), there are simply fewer companies in the world that are large enough to fuel the desired M&A or revenue needed to meet performance expectations.

There is also such a thing as fund size and strategy fit. Some investment strategies just don’t make sense for certain fund sizes. And some management is better suited to certain fund sizes and strategies than others. While PE funds that have grown in size have seemingly convinced their LPs that the step-ups are warranted, it’s unclear which (or whether any or all) are justified.

 

5. There have been some recent high-profile private equity scandals

Scandals can and do happen across asset classes, but a few recent ones in private equity have been particularly high profile and may be worth understanding.

A major ongoing scandal is the implosion of Abraaj Capital. Dubai-based Abraaj was a firm focused on emerging markets private equity that managed ~$14B across multiple PE funds. In 2018, several major LPs in Abraaj’s funds became suspicious of the firm’s activities. An audit of Abraaj uncovered inflated valuations, misuse of funds, and a host of other issues that’s since led to the firm’s demise. The scandal is ongoing, with the recent arrests of Abraaj founder Arif Naqvi and others. This has had a knock-on effect with private equity in emerging markets, with reduced buy-out and fundraising activity.

Another ongoing concern is the college bribery scandal around Bill McGlashan and private equity firm TPG.  McGlashan was a partner on the firm’s Growth and Rise funds but was fired after he was arrested in March 2019 for allegedly paying a bribe to get his son into the University of Southern California.

Part of the scandal’s ripple effects is its implications for impact investing: at $2B, the Rise Fund is the largest dedicated impact PE fund to date. Led in part by the musician Bono, the fund sought to generate financial returns for its investors while creating positive social and environmental impacts around the world. Within the ESG community, the Rise Fund has been a beacon of hope and potential — fueling discussions on ESG as an investment strategy. This scandal broke coming off an appearance about impact investing at Davos by Bono, ample news about the fund’s Y Analytics platform, and in the midst of raising a second investment vehicle. Moreover, as a major advocate of “doing well by doing good”, Bill McGlashan is now widely viewed as a hypocrite. This is a setback for impact and ESG investing, and remains to be seen whether it has lasting implications for the strategy or private equity in general.  

When considering scandals and trying to understand the incentives that fueled misuse or abuse, it’s important to understand that there is no certainty over the human behavioral causes of fraud. But “high-profile or high-stress situations may at times cause an individual’s ego to negotiate with their ethics. Look — when you invest with somebody, you’re trusting them, and there’s no magic fund size to predict your chances of something going south,” explains Different CIO Harold Hughes.

“Let’s say someone runs a $200M fund that has two “winners” in its portfolio…and those winners start to fall apart. But the CEOs tell the fund GPs what they want to hear, ‘We can repair this, it’s ok, it’s just a setback.’ In this situation, the GP might say to themselves ‘Well, it’s just a setback, why do I have to mark it down this quarter? Why don’t I just wait one more quarter, and next quarter I’ll be out of the woods.’ But then you’ve created a fraud, with an excuse that you negotiated with yourself,” continues Hughes.

“While many GPs may not set out to conduct fraud, some GPs may encounter a set of circumstances so dire and/or so fast moving that they negotiate with their ethics, instead of their LPs. Whereas they could have negotiated with their LPs from the beginning.”  

 

6. Big PE firms have been pursuing the public markets

Traditionally operating purely in the private markets, the last decade has seen multiple large PE firms list on the public markets. The decision to go public can be fueled by many incentives, including raising additional investable capital, providing better liquidity to existing shareholders, generating a liquidity event for PE partners and employees, and/or tapping into a broader pool of investors (such as individual retail investors and defined contribution plans). It may be worth considering whether any single incentive is driving a PE firm’s decision to go public…or put differently, ‘What is my capital being used for?’ Am I just providing liquidity for partners, and/or am I getting a good deal?

Publicly traded private equity firms include:

  • The Blackstone Group L.P. (NYSE:BX),    2007 IPO
  • KKR & Co. L.P. (NYSE:KKR),   2010 IPO
  • Apollo Global Management LLC (NYSE:APO) 2011 IPO
  • The Carlyle Group (NASDAQ:CG)  2012 IPO

With Softbank being the most recent high-profile private equity firm to explore an IPO. Note that these firms represent a tiny fraction of the overall universe of private equity funds. The exact number of active PE funds is constantly in flux as some funds close and new funds appear, but an early 2018 estimate reports 2,296 PE firms at that time (this is distinct from VC funds, which are sometimes grouped as a subset of PE).

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