Monday, November 20, 2017

Private Equity's New Competition?

PE Hub posted a Reuters article, Private equity to face competition from investors, says Carlyle Co-CEO:
Private equity firms are awash in cash, with nearly US$1trn of available capital, but the industry is facing internal competition as limited partner (LP) investors seek to play a more active role in buyouts, according to David Rubenstein, co-founder and co-CEO of the Carlyle Group.

The structure and composition of private equity funds will change significantly as LPs that would previously have invested in the funds increasingly branch out into arranging buyouts themselves, Rubenstein said.

Rubenstein was giving his views on the future development of private equity firms, based on his 30-plus year career in the industry, at the SuperInvestor Conference in Amsterdam this week.

“I expect we’ll see longer duration funds become more prevalent, with consequently lower fees for LPs and carried interest for general partners [private equity firms].” Rubenstein said.

Many LPs are looking for longer-term investments with lower return targets, which will ripple through the conventional buyout community, Rubenstein said, adding that more permanent capital will also be sought to match longer investment duration needs.

Several LPs that would have previously invested in private equity funds, including Canadian pension funds PSP Investments and the Canadian Pension Plan Investment Board, have built their own operations to buy assets in recent years and some European firms are also looking at co-investment buyouts.

NEW CAPITAL

Rubenstein predicted that sovereign wealth funds will replace US public pension funds as the largest source of capital for buyout firms, and said that retail investors will also play a more significant role going forward.

“Individual retail investors will be the biggest new entry as regulations relax on investing in private equity,” he added.

He also highlighted private debt as a significant growth area and predicted that it could grow to rival private equity. Private debt, which includes direct lending that targets small and medium-sized companies, currently has US$600bn of assets under management, according to Preqin.

While the global private equity industry currently has nearly US$1trn of ‘dry powder’ available to spend, the breakneck development of the shadow banking market means that sponsors now form a smaller part of the investment world, other delegates said.

Rubenstein is expecting public and political opinion, which has been highly critical of private equity’s role in turning around underperforming companies via debt-financed buyouts, to relax as knowledge of how the industry works develops.

“A lot of people still don’t really understand what private equity does,” Rubenstein said.
Private equity firms are gearing up to lobby hard against proposed US tax reforms that could curb the private equity industry’s profitability and make buying and selling companies more difficult.

Rubenstein said that a proposed cap on the tax deductibility of interest payments exceeding 30% of income is unlikely to have a significant impact on private equity firms, as debt forms a smaller proportion of buyouts than in the industry’s early days.

The bill also includes a tightening of the carried interest loophole, which allows private equity managers to have their profits taxed at a lower capital gains rate than income tax rate if they hold a company for more than one year.

“I think we can expect some effect there,” he said.
Ed Ballard and William Louch of Financial News also report, David Rubenstein’s five predictions for the future of private equity:
“God looks favourably on the founders of private equity firms.” That was the conclusion of David Rubenstein as the Carlyle Group co-founder reflected on his generation's staying power, reports FN's sister publication Private Equity News.

Over the past three decades, Rubenstein has been an enduring presence as the business of buying and selling companies has transformed from a niche Wall Street practice into a gigantic industry commanding hundreds of billions of dollars and spanning asset classes.

The late phase of his career—and those of his peers such as Stephen Schwarzman, Henry Kravis and David Bonderman—is now coinciding with sweeping realignments in the industry. Addressing the SuperInvestor conference in Amsterdam, he made five predictions for the future of the buyout business.

US public pensions will lose the top spot…

Saudi Arabia’s pledge to commit $20bn to a Blackstone Group infrastructure fund may show the way the wind is blowing. “The US public pension funds … have been the biggest source of capital for PE firms for much have the past 30 years. I don’t think they will be for the next 30 years,” Rubenstein said. “I think the sovereign wealth funds and the national pension funds will replace the US public pension funds as the biggest source of equity capital.”

...and so will the US

“The biggest source of capital is from the US, the biggest deals are done in the US and more capital is invested in the US than in any other part of the world,” Rubenstein said. “This will change dramatically.” He predicted that the private equity investment will become much more balanced between developed and emerging economies.

Private credit will equal private equity

Private equity funds raised £347bn last year, far surpassing the $97bn raised by debt funds, according to Preqin. But, as Rubenstein said, “private credit is something that more or less started with the great recession...It will become as big as PE over the next 10 years in terms of dollars committed.”

Private equity firms will consolidate

Although the industry is awash with capital, there is never enough to go around. A Preqin survey published in August found four in five private equity fund managers say there is more competition for capital than there had been a year earlier, while just 1% reported a decrease. Ultimately that dynamic will force many small independent firms out of the market, Rubenstein said: “I think you’ll see some of the larger firms increase their market share due to their increased capabilities to raise capital. You’ll see more acquisitions of smaller firms and more consolidation within the industry.”

Long-term funds will become commonplace

“The business model hasn’t changed that dramatically over 30 years, PE still uses the same basic model with a few variations," Rubenstein said. "We’ll see more and more longer term funds where people hold onto capital which is invested over 10 or 15 years where they’ll take lower carry and pay no fee on committed capital.” Like several rivals including Blackstone Group and CVC Capital Partners, Carlyle has recently raised a longer-life fund as buyout firms look for ways to compete with patient investors such as pension funds. Meanwhile, specialists have sprung up such as Castik Capital and Core Equity Holdings.

Last month saw Carlyle pass the leadership torch over to a new generation when the Washington, DC-based firm announced that Rubenstein and his co-founder William Conway will become the firm's joint executive chairmen. They are being replaced as joint CEOs by Carlyle veteran Glenn Youngkin and Kewsong Lee, who joined the firm in 2013 from Warburg Pincus.

Looking back on his career, Rubenstein also recalled some notable investing mis-steps — including passing up an opportunity to invest in Facebook.
And Javier Espinoza of the Financial Times also reports, Private equity model ‘starting to look like spent force’:
The private equity model “is starting to look like a spent force” because more competition and record cash available is leading to lower returns as operators are forced to take on more risk, an adviser to the industry has said.

Professor John Colley, associate dean at Warwick Business School, said the recent collapse of British carrier Monarch Airlines and the potential surrender of UK care homes operator Four Seasons to lenders exposed a weak model of ownership.

In a recent article, Prof Colley argued that private equity’s modus operandi may have run its course, likely to hit managers but also large pension funds, which have increasingly raised their allocation to the asset class.

In the US alone the average US pension fund had 7 per cent of its asset allocation in private equity as of last year.

However, industry insiders have argued that private equity has and will continue to deliver the goods for its investors.

In Prof Colley’s article, published by The Conversation website, he wrote: “The sector is known for turning round companies, slashing costs, increasing cash flow and using debt to reduce tax and mitigate risk, but the model is now looking fragile.”

He added: “An oversupply of rival funds and investor money looking for opportunities is forcing investment in higher-risk business and the acceptance of more marginal returns.”

Prof Colley, who advises various private businesses at board level, said private equity groups were putting up with higher costs in the companies they bought partly because of high valuations in the stock market.

Because of these dynamics, he argued, “it may well be that the model has run its course and is ready to be replaced by something else”.

His comments were in stark contrast with some of the industry’s most ferocious defenders.

Speaking at a trade conference in Amsterdam, David Rubenstein, the billionaire co-founder of the Carlyle Group, said the model of private equity had worked “pretty well” for both managers and investors and that was likely to continue for the next three decades, with minor adjustments.

Mr Rubenstein said: “The basic model of [private equity] has worked. Very few business models have survived for forty years or so. The private equity model is unique in the history of money management.”

The model of asset management charged no carried interest — the cut managers share with investors — for 200 years, he said, but private equity in the 1960s changed it because “money would be committed but not actually invested and more or less 20 per cent of the profits would go to the [manager]”.

He added: “That basic business model with permutations and changes is still the model we use today. Carried interest when it is earned and realised has produced enormous amounts of profits for managers but also has led to large profits for [investors].”

Mr Rubenstein said if carried interest were to disappear the industry would not attract the talent or capital and the returns would not be as good.

“The model has worked pretty well,” he said.
Indeed, the private equity model has worked exceptionally well, allowing Mr. Rubenstein and his co-founders and other private equity titans to amass a fortune over the last three decades.

Not surprisingly, Mr. Rubenstein is defending the industry that has been so good to him (and to investors but mostly to GPs). Others are equally vocal in defense of private equity as they willfully ignore the industry's leveraged asset-stripping boom.

For those of you who don't understand how the fee structure works in private equity, it's similar to hedge funds, meaning 2% management fee and 20% carry (performance fee) with the big difference that the 2% managagement fee in private equity is typically charged on committed, not called capital, and typically declines over the life the fund (see here for more details).

Another big difference between private equity funds and hedge funds is the former charge a 20% performance fee only after clearing a hurdle rate (typically 7-8%) which is why it's a popular asset class at endowment funds like Yale and at large public pensions like CalPERS.

All those fees add up, however, which is why many large Canadian pensions have developed an extensive co-investment program where they invest in top PE funds but also co-invest with them on larger transactions to lower overall fees.

In order to do this properly, Canada's large pensions have hired experienced professionals which they pay extremely well to be able to quickly analyze co-investments and invest alongside their GPs when nice opportunities arise. This is one form of direct investing which lowers overall fees (there are no fees on co-investments but to gain access to them LPs have to invest in funds first where they pay big fees).

Another form is when the life of a PE fund comes to an end and instead of a traditional exit (ie. selling to strategic or via public markets), one or more portfolio companies are auctioned off to the highest LP bidder which can keep that company on its books for a lot longer. This too is a form of direct investing where once the company is bought by a pension, it pays no fees to the GP.

All this may sound complicated but it's also important to note private equity's J-curve effect, meaning private equity fund investments initially have negative returns and accumulated negative net cash flows for a relatively long time period, which investors have to bear in mind when setting up a new program or approving new investments.

Now, will Canada's large pensions bypass private equity funds? No, I've already explained that Canada's large pensions can never compete head-on with private equity in the best deals because the first phone call bankers and business CEOs make is to Blackstone, KKR, Carlyle, TPG and a handful of elite funds, not to CPPIB, PSP or Ontario Teachers'.

However, Canada's large pensions are increasingly sourcing some deals on their own, bypassing fees to PE funds. For example, the Ontario Teachers Pension Plan announced Friday that it has purchased the P.E.I. company Atlantic Aqua Farms, the largest grower and processor of live mussels in North America.

Now, the purchase of Atlantic Aqua Farms marks Ontario Teachers' first venture into the realm of aquaculture, and falls under its natural resources mandate to invest in the global food basket, with an eye on sustainable sources of food production, so technically it's not a private equity deal but it's still a private market deal where they're not paying any fees to a GP.

The key advantage Canada's large pensions have over private equity funds is they have a much longer investment horizon and can keep private companies generating excellent cash flows on their books for well over ten years (after 3 years of a fund's life, PE GPs are already looking to raise money for their next fund, which sometimes brings about a misalignment of interests).

And in private debt, both CPPIB and PSP Investments can compete with top private equity funds as they have hired exceptional teams working on a credit platform (so they get paid exceptionally well) which only focuses in this area.

Now, KKR, Blackstone and other large private equity shops are finding ways to lock up client money for longer, but Carlyle doesn’t seem to be in a rush to do the same:
The private equity behemoth, where co-founder Rubenstein is the chief fundraiser, can revisit investor wallets with relative ease, he said Tuesday.

“We have a pretty good ability to get capital when we need it and we really haven’t struggled to raise capital in any recent time,” Rubenstein told investors and analysts while discussing third-quarter results. “We are always looking at different permutations of how you can raise capital, but I’d say right now the model that we have is one that we’re reasonably comfortable with.”

Long-dated and permanent-capital vehicles can reduce the frequency of fundraising, permit longer investments in assets worth holding on to, and generate more predictable fees. Carlyle does have a longer-life private equity fund, championed by co-CEO designate Kewsong Lee. The pool is doing “quite well” and will likely have a larger successor fund, Rubenstein said.

But the appeal to Carlyle doesn’t seem to be as great as, say, at KKR, where a new pair of long-term investor agreements was the centerpiece of the firm’s earnings call last week. The partnerships secured $7 billion in fresh capital.

“When you have a reputation as we do, and as other peers that we compete with do, and you go out and raise a successor buyout fund, while you have to go out and raise it, it’s -- I won’t call it permanent capital -- but it’s very likely you can raise these funds for quite some time into the future,” said Rubenstein.
The appeal of permanent capital to investors is they can commit more for longer and obtain lower fees and Carlyle might not be in a rush but it will follow suit (see above, second article).

Anyway, Mr. Rubestein, Mr. Conway and Mr. D'Aniello are passing the torch now so they aren't going to be running the day-to-day operations at the world's most connected private equity fund.

Carlyle will hand its incoming co-chief executive officers bonuses and stock that will add several million dollars to their annual base salary of $275,000 (now you know why Mark Jenkins left CPPIB to join Carlyle and why one senior infrastructure officer at OMERS is joining Blackstone to help them with their new infrastructure fund which will be headed up by ex-General Electric exec Steve Bolze).

So maybe there is some truth, private equity has some big competitors in the pension space, but let's not forget who the real kingpins are and who has the deep pockets to attract top talent to their shops (remember what Mark Wiseman once told me: "If I could hire and pay David Bonderman, I would, but I can't, so in private equity, we will always pay fees and co-invest with top funds").

David Rubenstein, co-CEO of Carlyle Group, recently discussed the company's succession plan, on "Bloomberg Markets: Middle East" from the Saudi Future Investment Initiative in Riyadh. Watch this interview here.

Below, CNBC's Joe Kernen reports Carlyle Group announces a significant change in leadership as both David Rubenstein and William Conway are giving up their roles effective January. Read more about this succession plan here.


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