To see this article in digital magazine format, click here.
Scene: Two men driving down a sunny residential street, selling fresh fish from their Model T Ford truck.
Oliver Hardy: “For the first time in our lives, we’re a success. A nice little fish business, and making money.”
Stan Laurel: “You know Ollie, I’ve been thinking. I know how we could make a lot more money. If we caught our own fish, we wouldn’t have to pay for it. And whoever we sold it to, it would be clear profit.”
Hardy:
[Halts truck] “Tell me that again.”
Laurel: “Well, if you caught a fish, whoever you sold it to, they wouldn’t have to pay for it. And the profits… would go to the…fish… If you caught…”
Hardy: “I know exactly what you mean. Your idea is to eliminate the middleman. That’s a pretty smart thought. Here we are making pennies, when we should be making dollars. With a million-dollar idea like that, what we’re going to do is get ourselves a boat.”
Institutional investors, like Laurel and Hardy before them, have seen success from their allocations to private equity in the last decade. And they are not stopping there: With returns from the public markets as weak as they have been, many sponsors are thinking not just of increasing their holdings of private equity, but also concentrating their crews of managers, and some are even moving themselves closer to the investment process, with hopes of better return economics through more direct participation and lower fees. Eliminating the middleman by building their own fleet did not end well for Laurel and Hardy (in Towed in a Hole, from 1932), and some consultants and managers, highlighting the complexity and special knowledge needed for more direct private equity investing, caution that it might not be the right course for institutional investors either.
“Let’s say private equity managers target returns of 20% to 25% gross,” posits Andrea Auerbach, head of US private equity research at consultants Cambridge Associates, in Boston, Massachusetts. “If a pension plan’s target for private equity is the return from the public equity markets plus, say, 5%, then even if private equity managers don’t earn their full return, those results are still quite appealing.”
The private equity returns investors realize typically embody a number of such “ifs.” From 2000 through 2010, the public markets returned 7.7% annually for large cap stocks (the S&P 500) and 6.6% for the broad market (the Russell 3000). Private equity performed far better, and at the same time far worse: According to ThomsonOne, the median manager returned a total of just 2.8% annualized over those 10 years, while the first quartile manager delivered 11.7%.
From the perspective of individual institutions: as of June 30, 2011, the $49.5 billion private equity AIM Program of CalPERS had generated a 10-year time-weighted return of 9.0% (trailing its custom benchmark result of 10.3%); Teachers’ Private Capital, the C$12 billion private equity arm of the Ontario Teachers Pension Plan, returned 19% for the year ended December 2010, more than 10 points above its benchmark; for the four years then ended return was 2.6% annually, versus its benchmark return of -1.2%.
Due to the return dispersion among private equity managers, the 12- to 15-year lockups it entails, and the blind pool nature of private equity funds, manager selection carries greater weight than for most asset classes. “The irony of private equity is that there is a large risk of over-diversification,” notes Monte Brem, chief executive and founder of Stepstone Group, of New York, London, San Diego, and Beijing, and advisors to institutions on $40 billion of private equity assets. “You can realize a lot of alpha if you select managers very well, but if you don’t have the right resources to identify and get into top quartile managers and funds, you should not be investing in private equity at all. Diversification drives you toward the median, and if you are going to achieve median returns private equity is not an attractive investment.”
These challenges notwithstanding, allocations to private equity have been creeping up. In their latest tally, researchers at Greenwich Associates found that private equity made up 3.1% of US corporate pension plan assets in 2010, down from 4.4% in 2006. But at public pensions, private equity rose to 7.3% of assets from 4.3% over the same time. At US colleges and universities, NACUBO and Commonfund report 12% of endowment assets were in private equity in fiscal 2011, up from 7.4% in 2006. “The fundamentals say private equity is a good place to be, and the performance is compelling, so allocations to private equity are increasing,” notes David Hutchings, head of private equity in the San Francisco outpost of consultants Albourne Partners.
While investors formed lines around the block to apply to private equity managers during much of the last decade, the current environment for fundraising is said to be muted. Morgan Stanley reports that while managers gathered successive records of $666 billion and $680 billion in fresh capital during 2007 and 2008, for 2009 through 2012, new funds are pegged at no higher than about $300 billion each year (although analysts project a recovery to a $460 billion year in 2014).
Some managers capitalized on those years of excess demand by hiking fees and otherwise stacking the deck against investors, and the shift in the supply-demand balance from the weaker fundraising climate has emboldened investors. “When we get clients together, we hear a bit of anger from them, and there is a determination that it’s not going to happen again this time,” says Albourne’s Hutchings. He commends the efforts of the International Limited Partner Association in developing principles, released in 2009 and 2011, for improving private equity’s practices in fees, governance, and transparency.
Emotions aside, many institutions ranged too far in their private equity investing and over-diversified in 2002 through 2007. Now they are adjusting by concentrating their investments with smaller groups of managers, and the greater selectivity and a small pool of new capital have created tough conditions for managers. “As much as we would like to think that our industry is immune to the laws of supply and demand, we are not,” says Bob Brown, global head of limited partner services at Advent International, a global private equity firm with $26 billion under management. “That is probably the biggest issue facing private equity managers over the next few years.”
“As industries evolve, they go from a growth phase, and then into maturity, and the fight for market share leads firms to evaluate their own market position,” Brown observes. “Firms have to replenish their managed assets in a market that is half the size, and to stay constant you have to double market share today. These are secular headwinds that our industry has not faced before, and firms are trying to figure out what steps to take.”
A few private equity managers have entered into special arrangements with large public pension plans. The Texas Teachers Retirement System, for instance, has expanded its strategic partnership program, begun in 2007 with managers of traditional assets into private markets, committing up to $6 billion through 2015 to private equity giants Kohlberg Kravis Roberts & Co and Apollo Global Management. Blackstone Group has similarly secured as much as $1.8 billion from the New Jersey Division of Investment.
Brown sees a sharp delineation of private equity managers’ strategies for their own businesses according to their ownership structures—that is, private versus public. “The big special deals have been done with the public firms. The well-positioned, pure-play private equity firms haven’t done those kinds of deals, and I expect that they wouldn’t.”
He explains that the share prices of the public firms are driven more by today’s growth in assets under management than the back-end upside in earnings that can come from the long and arduous work of transforming companies. That squares with the reckoning of Morgan Stanley’s analysts, who say that about one-third of the value of public-held private equity managers is the present value of estimated carried interest, while two-thirds is the more visible management fee. Managers’ business models have adjusted accordingly: “When you are a traditional private equity partnership, you act as an investment organization, but when you go public, you are forced to become a sales organization,” Brown concludes.
At Stepstone Partners, Monte Brem cautions about the quality of opportunities coming out of strategic partnership arrangements. “Institutions have decided to invest a certain amount, and think they may as well invest it through a strategic partnership, and get lower fees. But the minute you start putting money into funds because you have to, you start to rationalize investing in what might be lesser funds.
“This makes no sense, because the real discipline that investors have over their managers is the ability to invest in one fund at a time, and only if their funds continue to be attractive. Take that away, and you remove a large part of the incentive for top performance,” Brem adds.
Private equity managers are not the only ones going through a change in business models. Observers commented on an industry-wide move to consolidate investments with fewer managers, toward upgrading to managers with superior performance, and perhaps the ability to negotiate lower fees.
Some investors are bolder: Taking a cue from the success of private equity investors such as the Ontario Teachers Pension Plan, which has run its own in-house private equity operation for about 20 years, investors are looking for ways to insert themselves closer to the front end of the investment process. That is, eliminating the middleman.
This can take the form of co-investment in individual companies alongside managers or, for some plans, even originating their own private equity deals. With co-investments, capital is deployed more quickly; the fee meter doesn’t run until the investment is made; and unlike a conventional fund, investors can choose what projects to participate in. (aiCIO invited several state pension organizations to comment on their investment plans, but none accepted.)
“Building in-house expertise was a theme we picked up in the middle of last year,” notes Stephen Ziff, a partner at London-based Coller Capital, specialists in secondary market trading of private equity interests. Twice a year the firm publishes the results of investor surveys in its Coller Private Equity Barometer.
Ziff adds: “Investors are becoming more sophisticated in terms of the resources they have in-house, and they are fee conscious, so they are looking to make commitments to funds, but also to make co-investments on the side, where they have the ability to put more capital to work, but on different economics.” Similarly, the specialist private equity researchers at Preqin find that well over half of investors who already co-invest, or invest directly, expect to increase such investment this year.
And there are plenty of opportunities. “Over the years, we have generated a significant amount of opportunities for our limited partners—for every three dollars of fund commitments, we’ve offered LPs one dollar of co-investment,” says Tom Franco, a partner at private equity manager Clayton Dubilier & Rice, New York.
Co-investing, however, is a whole new kettle of fish. “An investor may hear about the greater number of co-investing opportunities, but on the other hand it is an entirely different process,” contends Auerbach of Cambridge Associates. “With a conventional fund, you have 12 to 18 months to spend thinking and checking and debating before you make the decision. For a co-investment, or straight-up equity investment, you might have four weeks. An institutional investor suddenly needs to play hurry-up offense, perhaps with limited information, and take the opportunity to a committee that may not be comfortable co-investing with a sponsor, or direct investing without a sponsor at all.”
Establishing the in-house expertise can be a challenge as well. Consultants point out that maintaining a top-quartile private equity portfolio also calls for top-quartile internal resources. “It would make sense if pension funds were willing to pay people enough. If you want them to win on the front lines, you have to pay them at market rates, which in the US today is about $1 million a year. I don’t see any pension fund in the US getting comfortable with that,” says Stepstone’s Brem.
Several consultants also pointed out that co-investment opportunities tend to show negative selection bias—that is, they’re not the best deals. One remarked: “When a group of managers deciding on a deal is still sitting at the table after an hour, the worst thing to hear is ‘why don’t we share half of it?’”
Add to these concerns the political considerations that could influence the acceptance or rejection of a particular opportunity, and the added responsibility and reputation risk from an investment board’s decisions to invest a lot of capital in a small number of deals. Laurel and Hardy not only lost the boat they bought; they lost their truck too. Sometimes a middleman may not be such a bad thing.