Kevin Albert, a partner at Pantheon in New York, spends more than half his time on the firm's efforts to create products that cater to the defined contribution pensions market. Bob Brown, meanwhile, has spent the last two years running and building strategic advisory and placement agency BearTooth Advisors from offices in London and New York.
But 20 years ago, the pair worked together in the private equity group at Merrill Lynch, one of the earliest placement agents raising funds for the managers that have since become goliaths of the industry.
This month Albert and Brown took an hour out of their hectic schedules for a transatlantic phone call to discuss just how much the private equity world has evolved since those heady days. Private Equity International listened in.
Bob Brown: Wow, things have changed since our working together in the mid-90s. Kevin, when did you actually start in private equity at Merrill Lynch?
Kevin Albert: We began raising a venture capital fund for a Merrill Lynch-managed entity in 1982. Through that process we engaged with the Securities and Exchange Commission to actually write the law for business development companies. Then I did mezzanine funds for Tom Lee and for Equitable Capital.
I was mainly involved in private equity fundraising in the early 1980s from the standpoint of using the Merrill Lynch retail system. Late in the 1980s, that business merged into the private placement department, where I joined Phil Pool, who had begun in around 1986 to raise money from insurance companies for more traditional private equity funds.
Some of the first clients were Tom Lee and Leonard Green – although that firm was called Gibbons, Green and van Amerongen back then – and Charterhouse. When the two [Merrill] groups merged in the late 1980s, it became the group that you joined that raised money institutionally. Pension funds started participating, although we kept that heritage of always taking the best funds, peeling off a piece and distributing them through the Merrill Lynch retail system.
There's a lot of talk these days about raising money from retail or individual investors. We actually did some of it before we did institutional fundraising at Merrill Lynch, and then it became part of the institutional fundraising group that we had.
BB: Isn't it funny how things cycle back through? It started out as high-net-worth individuals, it became heavily institutionalised, then the feeder funds came back again in a material way, and now the family offices are becoming much more impactful.
Today people talk about record levels of capital available for deals. I recall when we were raising Bruckmann, Rosser, Sherrill & Co I at $370 million in the mid-90s, people were talking about too much money chasing too few deals. I don't think anyone's ever stopped talking about that. Do you see any difference between the question that was being asked then and the question that's being asked now, and the implication of it?
KA: It's always been a worry but it's never been an issue. The private sector – companies that either have gone private or don't ever want to go public – has grown quite dramatically. Just using the US as an example, the number of public companies in the last 10 years has been halved from 9,700 to 5,000 or so. Those companies didn't vaporise. Some of them did get merged into other companies, but the vast majority ended up private.
Just as the amount of capital raised for private equity [has increased], so too have the opportunities. We've gone into different markets; people have developed different strategies. The structure of a private equity fund, where the sponsor puts up a fair amount of capital, and the incentive fee, really urges the manager not to be fully invested at any one point in time if it doesn't make sense.
This dry powder is going to be invested, I think, mostly sensibly, either when individual anomalies pop up that fit the model of that private equity firm, or there's going to be a bump in the night one of these days and valuations will change a lot and then a lot of it will get put to work pretty quickly. These guys are pretty good, pretty savvy market timers.
BB: I remember coming to you and saying, 'As I go out and try to teach people why private equity is good and convince them they should create an allocation, what are the elements that are most important?' And you said, 'There are three key elements to this: one is higher expected returns; the second is alignment; the third is the lack of correlation.'
With mark-to-market and other new elements, that third piece seems to have gone away to some degree. Does that have longer-term implications for the asset class itself?
KA: I don't think it throws a spanner in. It is different. In the 90s, which was the big explosion of participation for pension funds globally, that was viewed as being a good thing – an asset, a reason to do it. Back then, everybody talked about it as an asset class: 'It's a different asset class, it's like real estate, it's uncorrelated'.
What we've learned – and I've learned it in spades here at Pantheon as we've tried to move private equity into the 401(k) market and we've had to develop the ability to estimate a daily value – is that particularly when you're looking at buyouts, these companies are private, but they're [still] companies. There's really no difference other than that some are private and some are public, and therefore their value does change. One of the best ways to measure that change is to look at what happened in the public market for an identical company or a company in the same cohort.
Everybody now is focused on alpha. In the US you have mostly underfunded pension plans – some grossly underfunded – and private equity is the main tool these institutions use to try to make up as much of that as they can. With the sole exception of a handful of quarters, private equity has been the best, most predictable generator of alpha in DB plans for 35 years.
Now, the reasons to do it are: it's highly selective – a GP doesn't have to make 100 different investments, they can do two or three a year in industries they've got a lot of expertise in or a view as to how to deal with a company; they're changing the governance of the company to super-charge the incentives of the management team; and they have the ability to control that company, take out extraneous cost, and focus the capital on either innovating within the company using R&D or by doing some M&A or selling off certain divisions.
Every year the allocations seem to inch up, and every year the type and amount of institutions seems to expand, although it's obviously expanding much slower than it was in the 1990s. You joined at the absolute most perfect time. Those were the glory days for the growth of the industry. It was good for placement agents, and I think we took pretty good advantage of it.
BB: Back in our days together at Merrill Lynch there were very few – if any – multi-product firms. Today there are certainly quite a few. Is there a place for more or do you think there'll be more specialist managers?
KA: It's a harder call to make. I think there is a place for multi-product firms, and the ones that are out there have proven there are LPs that love to consolidate, whether it be because if they're bigger with one manager they get more attention, they get more client service, they're able to negotiate the fee better, [or because] it's easier to interface operationally and deal with one firm and know their compliance and their operations.
On the other hand, I don't think anybody, even at those firms, will ever be able to say with a completely straight face 'we have top quartile strategies in everything'.
For the vast majority of LPs who want to try to have top quartile managers only, they're not going to gravitate toward that. They might do one or two funds with those big asset management firms, but they're going to shop around for the rest of them in the other strategies.
BB: As the market has matured, more data has become available on the outperformance of first-time and specialist funds. Twenty years ago it was hard to get those funded because people wouldn't want to take on specialist risk. I remember when we first met with Roger McNamee in '98 at Silver Lake, one of the big issues there was 'are people really going to buy a tech-focused fund?' At the time, every PPM said 'you can't do technology buyouts'.
What do you think about these firms that have been built over the recent years? Is some of this outperformance measuring increased risk-taking versus some of the more tried and true firms that may be taking a more risk-adjusted approach because they've lived through these cycles before?
KA: I've always gravitated toward good first-time funds, and by 'good' I mean the people had some investment expertise from a prior role, they could demonstrate they weren't an ex-M&A or operating guy who thought he could be an investor.
Most had left good positions, and the fact they were putting all their eggs in one basket modulated their willingness to try and just take a shot and do something too risky. That's probably one of the reasons why first-time funds end up performing pretty well: the bright shining lights are on them, they've got to do well or it's going to be a one-time only fund. While I think the bigger, more established funds certainly have gone through cycles and learned a lot of lessons, there's also the danger of complacency and having made a lot of money and not wanting to work as hard as maybe they did when they were young firms.
It's tricky picking a good first-time fund, there's a little bit of art involved in it, and some science – less science, though, than looking at an established firm – but there's a place for both. It's gratifying to see the data about how first- and second-time funds perform very well. But they're still the hardest to get done!
When you joined the business it was really prior to GPs valuing their investor base as much as they do now. One of our big clients at that time, which was an established firm with a very good investor base, would hold an annual meeting and at the end the managing partner would get up and say “Thanks for coming, I'll see you next year”. And he meant it. He meant he didn't expect to have any interaction with any of those people for another year.
From that point on, the industry has gone through this wave of there aren't that many new investors anymore, certainly not like there were in the early 1980s, so if I lose 10 investors, I've got to find 10 new investors, and that's going to get harder and harder to do'. That put into motion the establishment of internal IR groups, and a lot more hand-holding and contact. When we hit the global financial crisis that went into overdrive because LPs wanted all kinds of interaction and information.
It was pretty easy to get signed up as a placement agent in the early 1980s because people wanted to grow their funds and they also needed to replace LPs they hadn't taken good care of. That's no longer the case. What's it like to be a placement agent? How has your role changed with GPs that have an internal group?
BB: In '99 when I went to Carlyle, no one was thinking about going in-house or developing an in-house fundraising team. Today some would say, 'Why would anybody ever leave an in-house team?' I've had the fortune of working at two great GPs, Carlyle and Advent, and it was at Advent where I learned first-hand that sometimes the best manufacturers of the product are not always the best marketers of that product.
We are right now going through what I think is the most formidable stage of maturation the industry has seen, and we are going to go through the same elements of maturing that every other industry goes through. One of those is that having a great product is not enough alone.
First, you have to identify that there is a customer, and who it is. I think our industry's getting better at that, but I think there's still an incredible disconnect that the people that pay the management fees are the customer, and if you don't listen to them, you're dead.
As it relates to the agency business, in some ways that has created a much more robust opportunity set. New firm formation is at levels it hasn't been in the past. Some of these players, having been at big proven firms, know they are battling against 100 fundraisers at these institutions upon which the sun never sets. It's very, very competitive, and it remains a market share game.
These teams that are forming today are looking to create firms for the next generation. That means they're asking questions like 'what are best-in-class practices for reporting? What are best-in-class practices for staying in touch with your investors? What are best-in-class practices for AGMs? How do we best analyse, monitor and confirm our product's efficacy?'
A part of what we do now at BearTooth is work with people not just on the raising of the funds but strategies around where they want their firm to be in 10 years' time, how they're going to work and grow their investor base, and how to build the right functions.
KA: This phenomenon of recapping funds and buying out investors and resetting the clock, what impact will that have when those funds need to go out and raise a regular fund? Are you going to have a market where even people that haven't performed at exemplary levels – some of the firms that are doing these transactions actually have performed ok, but some haven't – are constantly going to be able to reinvent themselves through these secondary-type transactions?
BB: We've reviewed a number of these deals post-restructuring. I would say in order for those firms to be able to raise a successor fund and have a continued following and growing base, a lot needs to have changed. They were restructured for a reason. If that reason has been ignored and not addressed, that's something we're not going to want to spend a lot of time on, because we don't view that the market's going to want to spend a lot of time on it.
There are circumstances, however, where the teams have been restructured themselves in addition to the capital base being restructured. Maybe that sector that did poorly is no longer a focus and they're focusing just on those that have done well.
But you will lose a certain percentage of the existing base, because they invested in you for one thing, and even though you've changed and may be ok, that's not why they bought you.
It's still largely unproven. I would bet that the vast majority of those firms that have gone through those restructurings have yet to actually come back to market.
THE END IS NIGH?
Why the decline in NAV isn't a disaster
BB: Evidence shows NAV in the industry is actually declining. Back in the 90s, fundraising was going up every year, and I remember people would ask you in meetings, 'When's the fundraising market going to come to an end?' and you said, 'When the public markets drop, resulting in a denominator effect'. Even though there's record levels of dry powder, because NAV has come down, will that denominator effect be somewhat less impactful in any market downturn?
KA: A lot of the NAV decline is due to the huge spike in fundraising in 2006-2007 that was locked up longer than typical because the global financial crisis came along. Everybody thought it was going to be a disaster and there was going to be hundreds of bankruptcies, and at the end of the day there really weren't. Most of those funds ended up producing pretty decent returns. They probably weren't the best vintage funds of most managers, but they weren't awful; people didn't lose money, for sure.