Private Equity Unchained

Strategy Insights for the Institutional Investor

T. Meyer

• Publisher: Palgrave Macmillan
• Year: 2014
• Print ISBN: 9781137286819
• eBook ISBN: 9781137286826
• Topic: Business
• Subtopic: Financial Services
• Index: Business

There are significant returns to be made from private equity, infrastructure, real estate and other illiquid investments, but a competitive strategy is essential for investment success and for meeting objectives. This book takes readers through all the considerations of planning and implementing an investment strategy in illiquid investments.

Chapter 1

Introduction

The focus of this book is institutional investment into the private equity market. That is to say, it is concerned with the deployment of capital into the asset class, rather than its investment into specific companies. For our purposes, private equity refers to an institutionalised way of owning a share of a company that is not registered and not publicly traded on an exchange. The process for investing in such financial instruments is not standardised but rather takes place through a negotiated process.¹ It therefore requires a significant degree of sophistication on the part of the investor, let alone the fund manager who will deploy capital.

In practice, this deployment is a search for opportunities in uncertain, under-researched or overlooked niches, where information is proprietary and where there is little or no competition.² It is not for the faint-hearted. The challenge then is how to reconcile these extreme uncertainties inherent in private equity with the needs of institutional investors to define and encompass risks prior to setting out on such a venture. The industry’s structure and particularly the intermediation through funds is, at least in part, a response to these extreme uncertainties.³

It may seem clichéd to say that the lifecycle of such a fund resembles a trade journey into the unknown, but this is much more than a metaphor – the private equity industry’s investment vehicle of choice, the limited partnership, has ancient roots and much in common with traditional ways of financing trade voyages. For instance, medieval Italian merchant families financed trade voyages through ‘commendas’. In this asymmetric relationship the ‘sleeping partners’ (that is, today’s ‘limited partners’) were not liable for debt and stayed at home while the ‘travelling partners’ controlled the venture and set sail to search for profitable business. ‘Travelling partners’ (for which, read ‘general partner’ today) offered skills, experience and the willingness to take high personal risks. At the time of the commenda the high profits were based on venturing across a vast geographical space and there was a concomitant need for trust underpinned by strong alignments of interest.

Centuries later this limited partnership continues to be the structure of choice for skilled and risk-taking professionals to pool funding from wealthy and relatively risk-averse parties for investments in an environment of extreme uncertainty.

Purpose of this Book

This book is primarily written for investment professionals who are already familiar with the key concepts of private equity. However, this is not about the next level of technical detail, but rather how institutional investors can achieve organisational effectiveness in this dynamic and competitive environment. While there have been a number of books published on institutional investment in private equity in recent years, and there is certainly no shortage of books on corporate strategy, there is next to nothing written on strategies for investing in private equity. Meanwhile academia seems far more interested in the deployment of private equity funds and their approaches to value creation and realisation, rather than the initial commitment of capital. Anyone seeking detail on how to develop sophisticated strategies in this area will have been frustrated.

This is also a deliberately un-academic book, because private equity investment is a largely un-academic exercise. The development of an investment strategy involves anticipating and shaping the future, a perspective that is in contrast to that usually taken by academia. Academics seek to understand how and why things work, which is mainly by looking at existing and therefore backwardlooking data. Their financial models may give good explanations of the past but their priority is not necessarily a practical application in the future, particularly when dealing with a highly uncertain subject. Academic results reflect a certain setting, come with a number of caveats, and are thus often contradictory, which make them of limited use for practitioners. In the discussion between academics and practitioners, neither side really understands or even tries to understand the purpose or motivation of the other.⁴

Quick Glossary

When referring to ‘investors’ in this book we normally mean institutional investors and their organisational entity set up for managing private equity investments. These institutional investors either employ professionals as ‘investment managers’ to directly invest in private equity or invest through funds where professional management is provided by intermediaries.

‘Funds’ in a private equity context are usually set up in the form of a limited partnership and are unregistered investment vehicles for pooling capital. Here institutional investors are the fund’s ‘Limited Partners’ (LPs) who commit a certain amount to the fund and do not take an active role in its management. The term ‘General Partner’ (GP) refers to the firm as an entity that is legally responsible for managing the fund’s investments and who has unlimited personal liability for the debts and obligations.

The LPs’ ‘Commitments’ are drawn down as needed. There is little, if any, opportunity to redeem the investment before the end of the fund’s lifetime. A significant part of the capital remains as ‘Undrawn Commitments’ in the hands of the LPs.

‘Fund managers’ are the individuals involved in the fund’s day-to-day management. They form the fund’s management team that includes the carried interest holders, i.e., those employees or directors of the GP who are entitled to share in the ‘super profit’ made by the fund.

There’s No Such Thing as a ‘Good’ Private Equity Strategy

The above statement may seem odd for a book on private equity strategy, but it is important to grasp at the outset. Among private equity fund managers – our ‘travelling partners’ – the concept of ‘strategy’ is often considered abstract and bearing little relation to their business. Indeed most fund managers appear to go without a ‘real’ strategy or confuse strategy with tactics, but are successful nevertheless. It is a corner of the investment world that seems to resist ‘business school’ strategy formulation. One could put this seemingly cavalier approach down to market immaturity. In fact it signals something fundamental about the nature of private equity investment.

Private equity is at odds with most of the rest of financial markets, which depend upon rich datasets, high precision and frequently updated information. In private equity, investments are often made in conditions of extreme uncertainty and, due to the asset class’s illiquidity, decisions are often effectively irreversible.

As an asset class, private equity is competing for funds with other asset classes that appear easier to access, understand, research, monitor and manage. Initially there were few players in an underexplored market that offered rich pickings, now many players have become active with money chasing deals. A few years ago ‘access’ and due diligence were seen as ‘everything’, but now the landscape has become more competitive and these traditional tools often do not lead to the desired outcomes any longer. The institutional learning about private equity investments and improvements of skills in assessing such opportunities have to a large degree been neutralised by increased inflows of capital into the asset class.

Private equity is still under-researched: relative allocations are still immaterial, and regulation is frozen in financial technologies that go back to the middle of last century. While academics claim to have a broad understanding about performance determinants on the level of a fund, significantly less is known about factors affecting how an institutional investor in funds performs. The existing research about investor performance determinants has been described as scattered and contradictory; and studies on how institutional investors in private equity funds can strategically affect performance through defined investment strategies are virtually non-existent.⁵

The thesis of this book is that investors in private equity tend to experiment too little and put too much weight on track record and that they overestimate their skills in evaluating opportunities. Perhaps because of the rich-pickings of the past, LPs still tend to underestimate the value of flexibility and rarely actively look for it.

In addition, where flexibility exists, LPs often fail to exploit it because of operational deficiencies. To be successful in a more competitive but uncertain environment, investors in private equity need to build an investment process that seeks new opportunities and efficiently exploits them by moving as quickly as possible. Here institutions often fail to be sufficiently committed to a private equity programme, and fail to put the necessary organisation, processes and procedures in place to become sustainably successful.

Private Equity Is More Biology Than Physics

Clearly, a step-by-step guidebook with clearly identifiable tasks that can be executed and as a consequence lead to a highly profitable investment strategy is not possible. Rather than with hard facts, we are dealing with a social system and cannot assume that this system obeys physical laws or that there is mathematical logic linking its various parts. More than other areas in finance, private equity escapes the rules of science that could provide the authority with which engineering can proceed. In this respect, private equity investing is closer to a social activity than to science or art, and thus offers parallels to Clausewitz’s characterisation of war.⁶ However, military strategy is an analogy that only applies to some degree. It is rather biological systems that enable growth and survival in a changing and occasionally hostile environment, with a balance between predators and prey that holds useful lessons.

There may be good reasons why ‘strategy’, associated with ‘strategic planning’ and ‘planning’ is not embraced by private equity investment managers. As the key to coping with an uncertain environment is flexibility, any plan carries the danger to take away this hard-fought-for flexibility. Strategy defines the rules, constraints, methods and resources. It cannot be a plan, as this would be too rigid and would quickly become maladapted to an uncertain changing environment. Management theorists like Henry Mintzberg have long argued that emerging strategies are more realistic. On the other hand, investors cannot be too opportunistic, as this often results in herding, essentially having no strategy at all and leading to chaos. Putting day-by-day calculation ahead of mission means that all is tactics but that there is no strategy.

However, it is possible to design and plan portfolios in terms of primary commitments where we are occupying positions in a private equity landscape. Planning aims to minimise search costs, i.e., where to search and how to evaluate opportunities. But one must act opportunistically when managing such a portfolio of positions, i.e., relationships, as it generates options to co-invest or to make secondary deals, or for restructurings, dealing with tail-end situations and fee renegotiations.

Baffling the Boffins

Employees in today’s financial markets would struggle with Aristotle’s assertion that it is the mark of a trained mind not to expect more precision than a subject matter will allow. In institutions that are subject to oversight, and where regulation desires predictability and boards demand an ‘unshakable case’ for investing, it is easier to rely on ‘science’ than to admit to have resorted to judgment as this puts the decision-maker’s career at risk. Conventional business strategies place emphasis upon planning and control. For most managers it seems inconceivable that one can work in any other way. However, putting formalised strategies onto paper will sooner or later give away the fact that you do not know much and have little control about the future. Investment managers may have strong views regarding the future, but why take the risk of exposing yourself by disclosing your thinking? In many situations they are essentially relying on hunches and are unable to describe all the relevant factors. Institutions may trust their investment professionals, but depending on individuals who may or may not be excellent investment managers is an uncomfortable perspective.

As Guy Fraser-Sampson caustically concludes in Intelligent Investing (2013), it is perhaps for this reason that many investors choose not to have an investment strategy: ‘If nobody knows what your objectives are, then nobody can say that you failed to reach them.’⁷ This is not necessarily caused by a lack of decisiveness but it is rather reflecting realism about the future. Despite the assertiveness most investment professionals demonstrate, they may well be aware of the fact that the ability to predict is weaker than most of us would like to admit.⁸ In environments such as the private equity market, which are characterised by extreme uncertainty, actions chosen to achieve objectives cannot be guaranteed to lead to the intended results.

How You Will Benefit

A well framed investment strategy should enable us to identify and achieve an objective with more certainty, quicker or for less cost. These dimensions – predictability, time and costs – are interrelated and not all can be met simultaneously, which is one explanation why there cannot be an ‘optimal’ strategy.

This book is intended to help you define some rules of the game to be followed to ‘deserve’ success in the sense that this substantially improves your chances, but by no means guarantees success.⁹ It is like in chess, where an understanding of the rules, the notation and even memorising the big games of the past does not make you a grandmaster. Nevertheless, it is a start.

Chapter 2

A Neo-Classical Asset Class

Depending on your perspective, private equity investing is either very new or very old. There are repeated examples throughout human history of organisational structures that look remarkably like today’s private equity limited partnership structure and some of which we will analyse in detail later on. Few, if any, have a direct evolutionary link to today’s industry, but they are nevertheless revealing about the nature of private equity investment.

The story of ‘modern’ private equity is very much a post World War II phenomenon and commonly seen as post-1970s. However, even this story is more complex than it seems, and resists the neat evolutionary narrative that is sometimes attached to it – for instance, from junk bond raiders to mega buyout funds say. What follows, therefore, is not an industry chronology but a reassessment of the classic ‘story’ with the goal of enabling a clearer analysis of the fundamental nature of private equity and its long-term cycles.

The Modernist Narrative

David Rubenstein, the co-founder of the Carlyle Group, describes the development of the private equity industry between the mid-1970s and mid-2007 in four different stages.¹ The period from 1974 to 1984 is viewed as the infant industry’s ‘Stone Age’, with small ‘bootstrapped’ deals raised on a transaction-by-transaction basis, with a handful of lenders and largely irrelevant to the financial world.

The ‘Bronze Age’ from 1985 to 1990 saw opportunities arising from the restructuring of bloated US industry, a wider investor base, the junk bond revolution and outsized returns, culminating in KKR’s record breaking leveraged buyout of RJR Nabisco. For the first time the use of leverage drew major adv...

Table of contents

• Cover
• Title Page
• Copyright
• Contents
• List of Figures and Tables
• Acknowledgements
• 1. Introduction
• 2. A Neo-Classical Asset Class
• 3. The ‘Repair Shop of Capitalism’
• 4. Strategy Challenges
• 5. Strategic Asset Allocation
• 6. The Sky is Not the Limit
• 7. The Limited Partnership as Part of Humanity’s DNA
• 8. Do-It-Yourself?
• 9. Economics of Private Equity Firms
• 10. Objectives
• 11. Performance Persistence
• 12. Nobody Knows Anything
• 13. Spreading Risks – Thinly and Thickly
• 14. Private Equity Risk
• 15. Performance Measurement
• 16. The Galapagos Islands of Finance
• 17. The Locust and the Deep Blue Sea
• 18. Don’t Confuse Transparency with Intelligence
• 19. Spreading Risks – Part II
• 20. Open-Ended Relationships
• 21. Hard and Soft Power
• 22. Real Options
• 23. No Plan Survives
• 24. The Heavy Hand of Regulation
• 25. Private Equity Unchained
• Notes
• Bibliography
• Index