Friday Letter: More but less of the same please

A seasoned private equity practitioner who spends considerable time scrutinising the industry recently confessed to PEO that the practice had, in truth, fallen far short of the theory.  

The conversation had been about venture – European venture in particular – and we recalled this practitioner’s marked enthusiasm for what he saw as a re-invigorated (and usefully chastened) community of venture managers. If you had asked him in 2005 about the logic of investing in this segment of the asset class, the reply would have been robustly affirmative.

The problem is that the realities of venture investing – and, it should be noted, the tendency for LPs to invest in packs – has meant that there are too few venture managers in Europe who have the breadth and depth of capital and talent to deliver the goods for the long term. Our practitioner reckoned that there were four such venture GP groups in Europe.

“Even if these guys aren’t in an investment in the opening round, they’ll be turning up in the follow-ons because they have to. Other funds can’t and won’t be able to carry a portfolio company to exit, so at least one of these “big four” are going to come in. And this means as an investor in one or several of these four managers you’re going to see an unwelcome degree of concentration. European venture has become badly bifurcated.”

From a limited partner’s perspective, there is only small merit in allocating often piecemeal portions of your capital to small, early-stage venture groups. The sums involved mean that even impressive multiple returns (and let’s not start talking about the next Google) are not going to register significantly when you next report to the trustees. And if the managers are diluting down in follow-on rounds as portfolio companies travel the sometimes far longer than expected road to a successful exit, then the proposition loses even more of its lustre.

If instead you look to put more meaningful amounts of capital to work with the big four, then you are going to first, join the queue and second, be ready to deal with the aforementioned concentration. Some LPs are now questioning whether European VC has the diversity as well as muscle to make it a credible long-term destination for their capital.

The irony of course is that these sceptics should shoulder some of the responsibility for this situation, having helped create the bifurcation by concentrating their capital on the emerging four in the first place. Diversity of choice has been lost in the name of predictability: the big get bigger and the small struggle.

A similar scenario may well be working itself into the light amongst the big buyout groups at present. In Europe, reliable sources report that Cinven, Charterhouse and Permira all have scrums of eager investors gathered around their new fund offerings – despite being at different stages of the (pre-)marketing process – and that their final close totals will be capped – and leave some investors disappointed.

Other large LBO players active in Europe have closed new funds already, and so the prospect is that the small coterie of mega-buyout groups will continue to have mega-pools of capital to put to work. And it seems reasonable to predict therefore that two phenomena that tend to set limited partners teeth on edge – the secondary buyout and the club deal – will become more frequent as further billions of Euros are invested by these groups. Problems of LP over-concentration seems a danger here also as this group of managers hunts across the corporate landscape.

Which takes one back to our practitioner’s complaint of practice falling far short of theory: if the asset class is to remain healthy, limited partners are going to need to invest boldly, encouraging a diversity of managers across a range of segments of the industry. Otherwise the same names will deliver them the same (and often lower) returns.