Is the traditional private equity model broken? That’s the burning question Private Equity International wants to ask when visiting the Brussels headquarters of long-term fund manager Core Equity Holdings.
It’s a question the firm is well-placed to answer. The Bain Capital spin-out held the final close on its debut fund in September, having raised just over €1 billion for a long-term vehicle. For a firm with no track record that did not use a placement agent for the fundraise, the haul is either a testament to limited partners’ belief in the strategy, or in the firm’s founders, or both.
“There really hadn’t been innovation in the industry for quite a while now,” says Thomas De Waen, one of the firm’s four founding partners. De Waen and his partners believe the traditional private equity model – the GP-LP structure, five year investment period, five year harvesting period – is a 40 year-old piece of technology that in some cases no longer works.
“The forces that have made a success of the industry also mean that we need to see change. Returns were driven by increasing multiples, but that’s going to go away,” he adds. “If you want to keep on generating the returns people have come to expect, you need to find a different mousetrap.”
Core Equity’s founders believe they have found that mousetrap. Core Equity Holdings Fund I has a 15-year life structure with two one year extensions. It aims to invest between €200 million and €500 million of equity per investment across three to five deals and will focus on consumer goods and retail, industrials, healthcare and business services, planning to hold each asset for at least 10 years – double the conventional period of most buyout funds. “We’re not a deal shop,” De Waen explains.
In doing this, the firm believes it can gain deeper expertise in the particular industries it focuses on and will be able to deliver better returns than it could using a short-term private equity model, and higher returns than longer-term infrastructure-like funds.
To the firm’s founders, the traditional private equity model isn’t broken, but there is a segment of the market that is hindered by the 10-year-life fund structure that forces managers to sell assets before they’re ready to be sold.
“Why would you sell a business that you know, a team that you like, a strategy that you’ve helped devise, [when] you keep generating the sorts of returns you want to generate?” says partner Alain Stoessel, describing the firm’s motivation behind its strategy. “Why would you sell that to turn around and go buy a business you know very little about, with a team you don’t know, with a strategy that’s unproven? It makes no sense.” The reason managers do this is merely to create liquidity for fundraising, he adds.
Sitting down with partners De Waen, Stoessel and Marc Valentiny, who between them have more than five decades of combined experience in private equity, most of that together at Bain, it’s clear they’re convinced the traditional buyout model is in need of an overhaul.
“Quite often we found ourselves in situations where the structure of the funds we were involved in dictated the decision making at the investment level,” De Waen says, speaking about the partners’ prior experience. “You ended up selling something too soon, or not buying in additional businesses to combine with the one you already had.”
To get around this, the founders wanted a fund structure that did not dictate the firm’s investment decisions and had as few structural constraints as possible. The resultant fund, which retains the traditional GP-LP structure, has thrown the industry standard 2 and 20 model out the window. The fund has a “hard hurdle” of 5 percent, meaning LPs don’t pay carried interest to the GP on the first 5 percent of returns. The firm has also done away with the GP catch-up, so there’s no period in which profits are returned solely to the GP. Finally, carry is set at 27.5 percent, so Core Equity reaps a bigger share of profits as long as it outperforms the industry average and delivers more to its LPs.
Such economics are designed to ensure better alignment between the GP and its LPs, according to Valentiny.
The fund can also recycle up to €250 million in profits from its portfolio companies representing 25 percent of the fund.
“Whenever you have a deployment of resources that delivers value beyond your investment horizon, it creates tension, it creates a conundrum,” Valentiny says. “The horizon gets closer as time passes, and what’s a five-year horizon out of the box quickly becomes a two-to-three-year horizon.”
The traditional private equity model may not be broken, but it is destined for change, according to Valentiny and his partners. Entry multiples for investments in European assets have more than doubled over the past 15 years, according to data from S&P Global Market Intelligence, and managers have been able to make money “very easily” through a combination of using leverage and selling assets high multiples on the back of that.
“That might or might not continue to be true in the future,” Valentiny warns. “We think it’s going to be harder to sustain that indefinitely.”
Core Equity’s strategy is not without its doubters. Market sources PEI spoke to highlighted several challenges, such as the response from potential acquisition targets.
“When you’re going in to bat against private equity, how is a management team going to look at the Core Equity model versus a KKR-like approach?” one London-based source asks. A management team with a chief executive who wants to do the right thing for the business but who is also focused on monetising his or her own financial position is likely to be more attracted to the traditional model that plans to float the business in three years than a long-term fund that plans to hold the asset with the possibility of an exit after a decade or longer, the source points out.
Asset concentration is another concern. A 17-year fund that invests in between three and five assets is under more pressure to acquire and build the right assets than a 10-year fund that is diversified with a dozen or more investments, sources point out. And shorter holding periods also force sponsors to be more focused, they say.
On the first point, Core Equity admits the long-term model isn’t for everyone. “Initially we had a bit of resistance,” De Waen says. “The first deal we looked at, in the meeting, the chief executive said, I’ve had eight owners in the last 20 years and I like it that way. He had had 20 years of successive LBOs and didn’t want long-term.”
Educating the market was a particular challenge, especially within the intermediary community and management teams, De Waen says. “They’ve grown up in that environment where churn is good. You have to educate them and say, yes, churn is good, but also long-term can be good in a different way.”
Core Equity isn’t the only player in the longer-term part of the market. In the US, fellow Bain spin-out Golden Gate Capital manages evergreen funds that allow it to hold assets indefinitely, while in Europe, Luxembourg-headquartered Castik Capital is able to hold investments for up to 10-years having similarly raised €1 billion in 2014 for the strategy. In September news emerged that Cove Hill Partners, a start-up manager also helmed by a Bain Capital alumnus, had raised its first fund: a $1 billion 15-year vehicle backed by endowments, foundations and family offices.
While Core Equity is yet to make its debut investment, it is watching 10 potential opportunities that it hopes to convert into a deal over the next year or so, and has a pipeline of as many as 500 opportunities, according to Valentiny.
A key element of Core Equity’s strategy is its investor base, its partners say. The fund has attracted a mix of North American and European endowments, foundations and large family offices – sophisticated institutional investors who are “very long-term minded,” according to the partners.
“Fifteen years is a very long time,” says De Waen. “Stuff will happen. It’s important we have the opportunity to sit around the table and have commercial discussions with a bunch of people who are structurally very similar. They hold permanent capital and they all know each other. It’s a true partnership. It’s impossible [to do that] with 300 LPs.”
So what if factors such as internal strategy or personnel changes, or issues such as the denominator effect force LPs to part with their stakes over the next 17 years? Any LPs wishing to exit the fund must gain the GP’s consent within the first 10-years, and after that period, the LPA has a facility built in whereby its managers will organise a market for any LPs that desire to sell their stakes, De Waen says.
Existing LPs in the fund will always have the right of first refusal, Valentiny stresses, in order to keep the LP base homogenous.
The future for Core Equity looks bright. The firm was set to move into bigger offices in Brussels after the summer and has just hired a vice-president and two principals, bringing the total headcount to 16.
The firm may occupy a lonely space in the European long-term hold market and is yet to announce its first deal. But if its fundraise is anything to go by, the challenges it faces with its long-term structure will be overcome.
“That team is one of the most creative bunch of individuals in the market and they’ve got huge amounts of experience,” says the head of private equity at a London-based law firm familiar with Core Equity. “I’ve got no doubt that they will solve those issues.”
Time, of course, will tell. The market will just have to wait a bit longer than usual to find out.