This week, I would like to focus on a recent development observed in the world of private equity, as reported by the Financial Times. Since my years at TowerBrook, I have maintained a special interest in the sector, and I would like to share it with you today.
The principle of investment companies known as “private equity” firms is simple. These entities (managed by “General Partners”) raise financial commitments from investors (“Limited Partners”), mostly institutional, and pool them into closed funds, usually for a period of about 10 years. During this time, the funds identify and invest in a limited number of companies (usually no more than twenty for mature companies), aim to develop them and improve their operational performance before selling them, generally at a profit. The return on investment is enhanced by the use, to varying degrees depending on the era (and interest rates), of debt, which is repaid by the cash flows generated by the acquired companies.
The private equity industry in the form of leveraged buyouts made its first breakthrough in the 1980s, mainly in the United States, a period illustrated by KKR’s acquisition of RJR Nabisco and the subject of the book Barbarians at the Gate, before experiencing a dark period in the 1990s. Since the early 2000s, the industry has seen a new rise, this time globally. Benefiting from low interest rates, investment funds have been able to, like real estate investors, burden their acquisitions with increasingly large debt loads, obtaining very enticing returns on investment for investors, in the order of 10% per year, sometimes more. The number and size of funds have thus tended to increase, to the point of reaching more than $13 trillion by the end of 2023. Taking advantage of their success, investment fund managers have been able to impose remuneration structures to their advantage, generally composed of a fixed percentage on the amounts committed by investors (generally between 1.5% and 2%) and an additional bonus in case of annual return on investment above a certain level (the famous carried interest, primarily responsible for the tremendous enrichment of some of the great magnates of private equity).
The Financial Times explains that, despite this historical success, private equity is not spared by the tightening of financing conditions and the rise in interest rates. Funds can impose a lesser amount of debt on acquired companies, which impacts acquisition prices downwards, as noted by McKinsey for instance. However, for the time being, and after more than a decade of almost generalized frenzy, sellers have not yet adjusted their expectations. As in real estate, the volume of transactions has thus dropped over the past two years.
This “freeze” has two consequences: (i) sellers have difficulty parting with their portfolio companies and thus returning money to their investors and (ii) investment funds have never had so much money waiting to be deployed – called “dry powder” in jargon. In total, money tends to circulate less quickly than before.
However, this slowdown can be problematic for some institutional investors, who need the liquidity generated by their investment in the funds to meet certain expenses. For example, pension funds must pay the pensions of their insured. Insurance companies must be able to face claims. And, in the present case, the assets of these investors are partly either locked in portfolio companies in private equity funds waiting for resale and/or as commitments to funds for future acquisitions and can be contractually mobilized at any time. However, even if the funds are not deployed, they are subject to significant fees (up to 2% per year) mentioned earlier…
Beyond the speed of fund returns, investors are also becoming increasingly wary of the health of the economy. In that context, it is interesting to note that the stock market rally that we see in the United States on indices like the S&P 500 is largely attributable to the excellent performance of a handful of companies (Apple, Microsoft, Amazon, Alphabet etc.), known as the “Magnificent 7“, and that the health of the rest of the companies is at best stable, at worst in decline. Announcements of layoff plans are multiplying, and not only in the tech world, the subject of my first post more than a year ago already: Universal Music, Electronic Arts, UPS, Citi, to mention the most recent announcements.
To avoid paying relatively high fees in a difficult economic environment, investors now favor the “deal-by-deal” financing structure, in which the “General Partner” collects commitments for a given acquisition, and not for the establishment of a fund and a portfolio of companies. This allows investors to pay fees only for the duration of the investment to which they have specifically subscribed and to have better control over the type of company acquired: they are free to pass if they think the company does not have the prospects described by the General Partner.
In conclusion, this article aimed to lift the veil on a mysterious industry because it is secretive, and to show that the current climate we all perceive has repercussions at all levels of the economic sphere. This new context profoundly and rationally transforms behaviors and will certainly lead to an evolution in the private equity profession. The decades dedicated to pure ‘financial engineering’ are over (and those pursuing in that direction may face significant risk in the future): to continue to exist, investors will indeed need to be more selective, more persuasive, and, above all, demonstrate more positive impact on their investments.
P.S.: As you have noticed, many of the charts used in this post are from the excellent “Private Equity Midyear Report 2023” by consulting firm Bain & Co., which I strongly encourage you to read here.