PRIVATE EQUITY

"Nobody in my generation ever started out in private equity.  We got there by accident."

David Bonderman, Founder of private equity firm TGP Capital

 

Privos 2017 Private Equity Update

Overview

Many of our family office partners are active in global private equity world-wide either as GPs running their own family office owned private equity funds, or as outside family office LP investors committing capital brand name private equity funds. 

According to Preqin, 2016 was another stellar year for private equity and the total AUM for the industry now stands at $2.49 trillion as of June 2016 (the latest data available), an all-time high.  It is our view that private equity is well positioned for another strong year in 2017, despite continuing economic concerns and wider political volatility.

Privos private equity outlook for 2017 is that family offices will continue to invest in private equity in increasing numbers this coming year, for in low interest rate environment the asset class will continue to appeal to investors looking for high absolute returns and portfolio diversification.  Preqin advises that a record number of private equity funds are currently in market: 1,829 funds are seeking an aggregate $620 billion. This will bring challenges, particularly for first time and emerging markets managers, in competing for investor capital as well as in meeting the demands of an increasingly sophisticated investor community.  However, with the majority of LPs sitting very liquid as a result of continuing distributions and looking to maintain, if not increase, their exposure to the asset class, fundraising has rarely looked so appealing. A significant proportion of assets invested prior to the Global Financial Crisis (GFC) are yet to be realized, so should market conditions remain favorable it is likely that the fervent exit activity will continue in 2017.  While pricing remains a very real concern, fund managers have record levels of capital available to them and our survey results indicate that many are looking to increase the amount of capital they deploy over the next 12 months.

For family offices active in private equity, we refer you to the thinking of Tim Jenkinson, Professor of Finance and Director of the Private Equity Institute at Oxford University Said Business School:

The 'impact' of private equity is being felt in most businesses and, directly or indirectly, on vast numbers of individuals.  But very few people know how it really works.  What is the relationship between investors and funds?  How are deals structured?  What are the strategic issues in this fast-developing area?  How have things changed for private equity since the financial crisis?” 

Businessweek has called private equity a rebranding of leveraged buyout firms after the 1980s. The most common investment strategies in private equity include leveraged buyouts, venture capital, growth capital, distressed investments, and mezzanine capital.   Private equity has also been described as the risk capital that investment funds place in unlisted companies.  

According to the International Finance Corporation (IFC), a member of the World Bank Group, private equity investment in Emerging Markets stands at approximately $320 billion today of the $2.7 trillion global total.   As 90 percent of the developing world's jobs are created in the private sector, global family offices who own funds and portfolio companies help build dynamic job creating companies that drive economic growth.

At Privos, our family office partners invest in private equity to generate returns despite high competition for quality investments around the world.  However, many family offices find the current world of private equity confusing and tough to navigate due to aggressive investors, challenging exit markets, massive new regulation, and difficult questions concerning leverage and fee structures.

Generally, it is difficult for a family office to see clearly inside the “black box” of private equity and truly understand what is happening in the industry.  Certainly, family offices in today’s turbulent markets are using private equity as a transfer mechanism to transfer wealth between generation.  Yet, for a family office to become a truly successful private equity investor, it must become an expert in the drivers of private equity strategies, learn the skills needed for each type of investment, and figure out the best way select funds and assess performance. 

In 2017, private equity is a significant and accepted part of the global economy with a seat at the table of corporate governance.  It is the glue of ownership and control and can add tremendous value and impact to a family office portfolio companies. 

It is imperative for family offices investing in private equity, or thinking about making their first investment into a private equity GP,  to figure out a way first to understand the complexities of private equity investing and then to appreciate what the future of private equity is heading in the coming years.

Put simply, questions your family office LP should be asking before you commit to a private equity investment includes easy questions such as how is the fund and deal structured, who will be the key players in any deal, and when and how you should plan your exit.  Those are easy, basic questions.  The harder questions that you must dig for answer include if the fees you are paying are too high, where will the GP find the best investment opportunities, how long has the team been together, is the fund the “dreaded new manager fund,” has the fund manager hawked a piece of the GP to secure a seed investor, does the fund have Frontier or Emerging Market risk, how does the fund deal with currency risk, how do you think about exit premium, does the fund incorporate ESG factors, and is the fund a signatory to UNPRI (what is UNPRI anyway and why does it matter?), does the fund have in house marketers or are they relying on placement agents?   

Our View

At Privos, our people have deep experience in private equity.  For starters, our family office partners start, own, manage, and invest world-wide in private equity.  Family offices allocate capital to private equity which complements bank lending, bond markets, micro finance, and other forms of financial products.  Family offices participating in private equity drive both profitability and development impact throughout the world.  

Our people work with both family office private equity GPs and LPs world-wide on a wide range of significant and highly confidential matters.  Our family office partners both run leading global private equity firms and invest in private equity as an asset class.  In emerging markets, our family offices have witnessed a wave of successful buyouts, exits, and new funds coming to market; however, challenges remain with inconsistent deal flow, a scarcity of bank debt, and a lack of good international investment grade quality assets that can survive deep due diligence from the investment community.  

Our family office private equity team is headed by a former senior Merrill Lynch investment banker who, while at Merrill, lead a 40+ team of structured finance bankers at ML Global Bank Group responsible for over $8 billion of group assets under management, handling global deals in oil and gas, professional sports, franchise & beverage, sponsored lending (banking, for example, McDonalds & Exxon Mobil).   So, when one of our family office partners from around the world has an urgent and highly confidential private equity need, our people, who have worked on both the private equity deal side and IR side for leading global private equity firms, can get the deal done.

Fundraising

Our global family office partners are seeing a significant number of leveraged buyout firms, or 23%, that are expected to go out of business in coming years, according to the latest survey of 120 global institutional investors conducted by London and New York-based secondary private-equity firm Coller Capital.  The poll confirms and bolsters past theories, following up on a study from Boston Consulting Group from this past December that predicted between 20% and 40% of the 100 largest PE firms could disappear in the coming years.  So, what is happened to these private equity funds, the so-called GPs?

Coller’s survey found that 28% of the world’s venture capital firms and their leveraged buyout peers won’t be able to raise new funds over the next seven years. As a result, these groups will be forced to stop investing since there won’t be capital available to finance new deals. Institutional fund managers have reported declining fund returns. For example, Coller’s survey noted that 37% of respondents reported average private-equity returns of just 16%.

To make matters worse, a substantial majority of institutional investors, 84%, declined to provide their existing fund managers with capital for new funds over the past year and 20% plan to reduce allocations to private equity in the next 12 months. North American-based investors comprised the highest percentage of refusals at 92%, while 82% of European institutions and 70% of Asia-Pacific investors made up the remainder.  The moves are an effort by limited partners, as investors in private-equity funds are also called, to rebalance their asset allocations.

Some have gone further. Harvard Management Co., for example, sold off some of its interests in funds to select buyers known as secondary market private-equity firms.  And, large buyout funds, those with capital of $7 billion and larger, experienced a 35% decline in their valuations, while middle-market funds valued up to $500 million only declined by 8%.

Other institutional LPs are whacking GP head count in the most vicious and aggressive ways, sending shock waves through their GP managers.  For example, according to a recent article by the Wall St. Journal:

The California Public Employees’ Retirement System, or Calpers, will tell its investment board on June 15 (2015) of its plans to reduce the number of direct relationships it has with private-equity, real-estate and other external funds to about 100 from 212, said Chief Investment Officer Ted Eliopoulos….The reduction in outside managers won’t fundamentally change Calpers’s investment strategy, or the percentage of assets managed in-house versus externally. The remaining 100 or so outside managers will simply get a bigger pool of funds varying from $350 million to more than $1 billion, Mr. Eliopoulos added. The goal, Mr. Eliopoulos said, is “to gain the best deal on costs and fees that we can.”

Calpers to Cut External Money Managers by Half [WSJ]

International family office LPs are also seeking to reduce their investments in private equity because of a lack of return on their investments. BCG reports that some 74% of respondents are expecting distributions — capital culled mainly from initial public offerings of private-equity-owned companies or corporate sales — to deteriorate over the coming year. A mere 25% think conditions for exits via IPOs or M&A transactions will improve.

Default Rate on Capital Calls Increasing

In the meantime, limited partners may also prevent their buyout fund partners from executing transactions. In North America, for instance, investors forecast an average 13% default rate on capital calls over the next two years. By comparison, only 8% of European investors are expected to default and Asia-Pacific limited partners are projected to have a 7% default rate.  However, with the slow growth of China and the current price of oil on the world stage, we predict that defaults will increase.

Challenges in Attracting Capital:  Family Offices as the New Solution for Private Equity

Today, in the current geo-political reality, private equity is finding it harder than ever to attract capital in these uncertain times.  There are many reasons for this, according to a recent study by Grant Thorton.  One is that the number of private equity firms looking for capital continues to increase, thus creating more competition, as larger traditional institutional LPs pull back on relationships.  As a result, GPs have been desperate to find alternative pools of capital and are relying less on traditional institutional LPs and more on family offices - both single family offices and multi-family offices - to fill the gap.   

Private equity is facing new challenges today around the world.  When HMC and Calpers reduce head count, GPs start to panic, especially those managers with less than $5B AUM.  Further, a private equity fund that has a 10 year lockup and two 1-year extensions will certainly face headwind resistance by family office LP investors who view a decade as a long time to keep their capital locked up, especially following the raw experience of the global financial crisis.  Further, most investors would prefer a more liquid structure; thus, there is a trend in the family office LP world to move away from blind pool investing.  Separately, institutional investors like banks and insurers are also withdrawing from fund investing.  

In addition, international family offices are following suit with the more sophisticated LPs looking to invest directly into deals and not into funds. Large single and multi-family offices are co-investing and doing direct deals with institutional money, even sovereign wealth funds which is a rather new trend.  For instance, an Asian sovereign wealth fund will now, in this new world order, partner with a leading European family office and do a direct deal into a E&P deal in Brazil in 90-120 days in some instances.  Scary but true for private equity GPs left on the sideline. 

And, with the bigger funds getting larger and larger, the landscape for a family office owned middle market private equity fund is getting trickier to navigate.   Thus, family offices GPs are looking at a wide range of creative solutions to the liquidity crisis in middle market private equity, including buying and running operating businesses as well as the frequent use of a special-purpose acquisition company (SPAC).  Family offices turn to Privos for creative help with these complex opportunities.  

In addition, family offices running private equity funds as GPs need to deliver high quality cash on cash multiples over a long duration.  A solid track record and experienced team can result in a family office GP fundraising success story.  As LP investors, family offices think about private equity in broad categories including large buyouts, small buyouts, venture and growth equity, credit / special situations, developed markets, and emerging markets.  Family office LPs are looking to invest with the right PE team for 20 years or more and are generally looking to bet on the right "jockey" and increasingly are becoming more and more agnostic as the "horse" or fund, as their deal team and IR professionals comes knocking.

As an investment, private equity plays an important role in a family office's long-term portfolio.  Following the financial crisis, family offices are re-examining their entire investment strategy.  Today, family offices are looking for a closer relationship of trust and loyalty between with their GPs; they no longer want to see delusional valuations of a GP's portfolio companies or deal fees that are not transparent.  The illiquidity premium for private equity has been driving family offices to negotiate fee structures more aggressively, not unlike pension funds and institutional LPs .  The trend today is for family offices to invest with real specialists - dedicated, sector-specific funds - with a long track records and world class teams.  Family offices investing in private equity and venture capital funds are also demanding more transparency, reporting, and understanding from their GPs.  They are no longer happy to sit back and let the returns roll in; rather, they are looking to invest with world class GPs who understand the unique, sticky, long term virtues that a family office LP adds to a fund.  And, family office LPs are demanding ESG and sustainability best practices from their GPs, not just lip service from the deal team.  Family offices won't engage with a GP that doesn't embrace the principles of UNPRI.

For our family office partners running private equity funds, the global regulatory environment is making it more difficult to operate their business. GPs are struggling with how to reduce marketing time to raise a new fund from two years to a fraction of that time, given the time and expense associated with raising your next fund.  Issues such as appropriate pay, regulations coming out of Brussels and Washington, Solvency II rules, Volker, FCPA, OFAC, managing advisers and gatekeepers, and a host of other complex issues pose increasing challenges for our family offices GPs who run private equity funds.  Conversely, institutional investors and other LP investors are demanding more specialist fund managers with a longer track record and credibility operationally and financially.  Pension funds, such as the Dutch and Canadians, have deep teams of operational people in house who challenge the assumptions made by the promoters and again demand ESG related investments across an entire portfolio.  In light of such stress, our family office partners work with our people to help their private equity funds succeed in these challenging times.

Private Equity Secondaries

Private equity secondaries firms attracted a record level of investor capital in Q1 2017, according to new data from Preqin, as six funds raised $14 billion - surpassing the sector’s previous all-time high of $13 billion reached in Q4 2014 and outpacing the $10 billion raised in the previous two quarters combined, as reported by Fin Alternatives.

Strong performance is driving investor satisfaction and commitments, Preqin noted in its first quarter Secondary Market Update. Median net IRRs for private capital secondaries funds exceed 15% in each vintage year from 2008, the company said, while among 2014 vintage secondaries vehicles, the median net IRR is 19%. In comparison, median net IRR among all private capital funds of the same vintage is 9%.  

Other highlights from Preqin’s Private Capital Secondaries Fundraising report:

  • The largest vehicle to reach a final close through Q1 was Strategic Partners Fund VII, which secured $7.5 billion of investor capital, while three more funds raised more than $1 billion in capital commitments.
  • There are currently 48 secondaries vehicles in market targeting a combined $34 billion. This marks an increase in the number of funds, but a decrease in the aggregate capital targeted compared to the end of 2016, when 44 funds sought $38 billion.
  • Secondaries funds currently in market are targeting more mature regions: 52% of funds will focus on North America, and a further 40% will focus on Europe.
  • Performance within the industry is robust: secondaries funds of each vintage year 2008-2014 are generating double-digit median net IRRs, and surpassing wider private capital returns in corresponding vintage years.
  • When asked what multiples they anticipated from investments made in 2016, the largest proportion (43%) of secondary buyers expected multiples between 1.3X and 1.5X, in line with the average for previous vintages.

“Q1 2017 proved to be a landmark quarter for the secondaries industry,” said Patrick Adefuye, head of secondaries products for Preqin, in a statement. “Investors have committed a record level of capital to funds as the potential for accelerated cash flows and outperformance of traditional private capital vehicles [prove] to be driving factors behind the current market expansion. Heightened competition, more aggressive buyers and the increased use of leverage may provide notable challenges, as in the wider private capital universe, but managers remain confident that the future of the secondaries market is promising,” he added.   Founded in 2003, Preqin is a leading source of information for the alternative assets industry, providing data and analysis via online databases, publications and bespoke data requests. More than 47,000 professionals in 90 nations use the company’s products.