Friday Letter: Survival of the fittest

Critics of the private equity model frequently suggest it is an easy game with easy profits. Investors are falling over themselves to hand cash to managers who then throw it at target companies, whose management capitulate at the prospect of the gravy train making an unscheduled stop at its door.  

After a couple of years the private equity managers cash in, bank the profits and the process begins again. Success breeds success and right now the industry has more money than it knows what to do with, so the critic’s refrain runs.

From the outside it can all look so easy. But the reality is very different. 

It is easy to forget that built into the private equity model is a brutal mechanism, which ensures the unsuccessful managers perish. With the exception of publicly listed evergreen vehicles such as KKR Private Equity Investors, firms have to raise their entire capital from scratch every five years or so.

If investors are disenchanted then the chances of raising a new fund and refreshing the manager’s capital base are slim. It is not a perfect system. Weaker managers do survive, which is why investors’ returns remain widely dispersed. But poor performers will not survive indefinitely. Adapt or die, as Darwin might have put it.

This ethos runs through the core of the best firms. Take Permira for instance, currently the proprietor of Europe’s largest buyout fund: ahead of its most recent fundraising, the firm had a long look at its partnership structure. A couple of partners left the firm, making room for juniors to push through the ranks.

It is a tough coalition of mutual interest that glues the top partnerships together. Private equity professionals are not in it for the love.

Industri Kapital knows how painful natural selection can be. A couple of years ago, it nearly lost the battle for survival, when investors decided it was not fit for the mega-league of firms. Now, although widely perceived to have bounced back from its troubled fundraising that ended in 2005, the firm is still adjusting to its new circumstances.

This week, as PrivateEquityOnline revealed, the firm showed just how little sentiment buyout teams can afford even in a booming private equity market. Ahead of its imminent fundraising IK’s partners decided to shrink their numbers more closely to match the economics of a mid-market firm.

A source close to the firm told PEO that the two departing partners would obviously have preferred another solution – presumably, for two other partners to walk the plank. But Thomas Ramsay and Kamal Samir, at least, will live to fight another day once their gardening leave is up. Indeed if they choose to go it alone, they will provide the fresh variety from which investors may like to take their pick.

Darwin would be proud.