Allan Emkin, managing principal at Meketa Investment Group, co-founded Pension Consulting Alliance (PCA) in 1988 and joined Meketa in March after the two firms merged.
He recently spoke with Private Equity International about how the industry has changed since he began his career almost three decades ago.
How have private markets changed since the global financial crisis?
In the last decade, capital markets and their traditional roles have changed. Traditional lenders, for various reasons, have exited the marketplace and private debt has increased. Companies are staying private longer and more money is being allocated to them because their returns have been better.
New asset classes are now part of private markets, including real estate, infrastructure, private credit and debt, and investments in these classes with more inefficiencies will continue to increase.
The market is more global than ever. There is an increasing trend among US institutional investors to commit to assets not only in Europe, but also Asia, Africa and Latin America.
Prior to the financial crisis, even the largest institutions were rapidly trying to allocate to private markets because they were under-allocated on their private equity portfolios. They adopted targets and were not getting to those targets. Today there are many large investors at par or above their private equity targets. In addition, there is an extraordinary demand for premier partnerships with a few GPs.
How are market dynamics shaping the discussion around fees?
The PE fee model, which was developed in the late 70s and 80s, was intended to keep the lights on and profit was supposed to be in the carried interest. Because of increased demand, top GPs have been able to keep the same fee structures, even when there is no rationale for it anymore.
Importantly, because of the extraordinary demand for premier partnerships, LPs not yet near their target will have limited ability to impact terms and conditions and partnerships. Meanwhile, funds with less compelling arguments are not getting the same fees, leading to a more fractured marketplace.
Fee pressure and competition will make it more challenging for private equity to generate the kind of revenue streams they used to generate. In addition, investors/clients have become a lot more structured in their private portfolio construction and have focused on fewer GP relationships.
The next time we have a significant recession there will be a shakeout in both public and private markets. In private equity, only those institutions that were really well-managed and capitalised will be able to successfully implement their growth strategies.
Look at the big players, like Apollo, KKR, Carlyle and Bain Capital. They are good gatherers and know how to cross-sell. They have or are developing debt, real estate, credit and bank loan funds, even hedge funds, and are buying out whole teams to lead these programmes.
The biggest private market fund managers will get treated differently and investors will have to pay whatever they demand. But significantly, a vast majority of private markets managers will not have that leverage, and that will lead to less competition. Eventually, this will not be a ‘win’ situation for most market players.
Are LPs still satisfied by private equity returns?
The premium that most people assumed you would get from private equity returns has been coming down. When I started in the business almost 30 years ago, there was an assumption that over the long term, private equity would generate returns 500 basis points over public markets. Then the assumption went down to 300 basis points over public markets. Now clients are talking about returns of 150-200 basis points over public markets.
Is it still worth doing private equity at these returns? The answer is unequivocally yes. But that’s a dramatic difference from what existed 15 or 20 years ago. That’s a function of having very smart players and lots of capital chasing transactions.
LPs have to achieve the goal of being fully funded and recognise they are not going to get there just using public markets, given today’s expected rate of return. They have to be mindful, however, of this perception of ‘smooth returns’ from private markets.
We’re seeing increasing LP demand for co-investment. Do you see the dynamics around that changing?
LPs want to improve fee structures in the market, and co-investments are a way to accomplish that. However, there is not an infinite supply of co-investment opportunities. Their availability is a function of the size of the transactions, and the funds that are investing in those transactions.
It is hard to see any economic reason why GPs are willing to do co-investments; undoubtedly, a GP will choose full fee and carried interest as compared to very little returns, if any, on co-investments.
One thing I can promise you is that big GPs are extremely talented and creative to figure out a methodology to make more money and generate more business; they will accomplish that objective in co-investments as well.
But LPs are also collaborating, and these will increase. Big institutional investors that have the resources to develop new and innovative ways of deploying capital will commit resources to do that – whether that’s forming partnerships, putting together club organisations or GPs coming up with a group of LPs that are treated differently.
LPs will do whatever they can to improve the alignment of interest and terms and conditions of partnerships but will be limited by demand and supply.
LPs need to understand better the legal structures to operate in this market. They should actively support ILPA so that there is more information and more consistent reporting from GPs. That will help LPs develop a highly-informed and knowledgeable base from which to negotiate terms and conditions.
Do LPs see private equity as a safer bet in the event of a downturn?
When the stock market goes down precipitously, everyone knows what happens to Apple, GM and IBM. No one really knows what happens to a company in a private equity fund. Their valuation model tends to remove peaks and valleys in private investments, resulting in a much less volatile asset class in the performance reports.
But stability is an illusion in private markets. These investments, unlike public markets, are not marked to market on a daily basis. That makes them appear to be much less volatile and makes them a great diversifier, at least from a performance measurement perspective.
Almost without exception, the highest expected rate of return with commensurate risk is private equity. Even though investors have a lower expectation for the premium they will get from PE than in the past, it is still justified to commit significant resources and increased allocations to the asset class.
LPs need to build more expertise and more oversight – through internal staff or external consultants – to conduct due diligence and increase their understanding of private markets.