Making private equity work

When the private equity bubble burst, some investors in the asset class took to their heels and never came back. Those who stayed are taking steps to understand where they went wrong. Philip Borel finds out what these LPs are doing as the market recovers - and learns that not all classes of LPs are the same when it comes to manager selection success. Who would you predict is the more successful investor type: funds of funds or endowments?

The exuberance of the late 1990s took a heavy toll on private equity investors the world over. For some, the past five years have been a disappointment, with too many returns having fallen far short of forecasts and too few funds offering real prospect of delivering IRR-transforming home-run exits late in their life. Today a recovery is under way, but it is not complete. A number of LPs may even be disillusioned enough to never regain their faith in the asset class at all. Whatever private equity can do for them today, it may be a case of too little, too late.

That said, during the past 12 months or so, there has been a noticeable change of sentiment across large sections of the buy side. Limited partners are reporting that for the first time since the bubble burst, their investment portfolios have been generating distributions. In many cases these are meaningful. Recent news in October for example that leading groups such as KKR and Carlyle have been returning record amounts of capital to their investors over the past year and a half – $9bn (€7.2 billion) and $6.6 billion (€5.3 billion). Respectively confirmed that GPs are currently in harvesting mode – with the leading performers achieving impressive results. Numbers such as these are a clear signal that the industry has turned the corner.

Cash coming back in will no doubt ease the pain of those LPs who have endured long spells of capital just being drawn. Indeed, sceptics are already referencing a proverbial lack of institutional memory, warning that as distributions materialise, the pain of the recent past will soon be forgotten altogether.

Others are not sure of that though. “Sophisticated investors want to know where they went wrong”, says Josh Lerner, Jacob H. Schiff Professor of Investment Banking at Harvard Business School and long-time anatomist of all things private equity. “Many have come to the conclusion that the experimentation of the late 1990s wasn't particularly successful. Now they're really addressing the issues”.

For some the urge to learn from past mistakes is fuelling renewed efforts to look at private equity through the prism of Modern Portfolio Theory (MPT). This is despite the fact that private equity is notorious for resisting the use of the analytical concepts that are fundamental to making investment decisions in other asset classes. The appeal of applying popular tools from the MPT toolbox to private equity is beguiling – for reasons of benchmarking, for performance reporting purposes and for reasons of efficiency. As one London-based placement agent comments: “If private equity could be made to fit inside MPT, a lot of investors in the asset class would be comforted – not least because it would make their lives simpler”.

Not every investor is trying to go down this road of course. “We've been using quantitative metrics for years to better understand how exactly the value in our portfolios is being created, but I still don't see much of the quant stuff that people are now talking about”, comments a New York-based veteran fund investor. “Many people have been going from their guts for a long time. Perhaps that's just the way”.

Nonetheless, many limited partners determined to take a more public market style approach to private equity are devoting more time and money to develop the required techniques. These LPs want to be able to more accurately capture, categorise and interpret historical performance data; use the results to construct meaningful benchmarks; map cash flows on a forward-looking basis more reliably; and use risk-return optimisation models to help them find their way to private equity fund investment's Holy Grail – a fund portfolio that perfectly matches its proprietor's specific risk/return profile.

People are now seeing that 30 relationships in Europe for example perhaps isn't the right number

Loren Boston

Christophe Rouvinez, a partner at alternative investment specialist Capital Dynamics based in Zug, Switzerland, gives an example of how this is being attempted in practice. He says his firm runs “statistical what-if scenarios” to better understand the direct consequences of asset allocation rules over long periods of time and the risks associated with them: “We'll benchmark a portfolio as is, then adjust certain variables such as the number of commitments per year, the commitment size, more venture, less buyout etc. We then benchmark the adjusted portfolio to see if the adjusted investment policy yields any statistical improvement in terms of return distributions, cash flow curves and so on”.

What a more widespread push into quantitative analytical methods does not mean though is that private equity has fallen under the spell of positivists and econometrists. Few involved in private equity investing declare any wish to purge the asset class of any decision-making processes that cannot be described entirely in scientific terms. Even the most ardent quant enthusiasts will readily admit that whatever their models say, mastery of complex mathematical concepts alone does not make a successful private equity investor.

Erik Hirsch is chief investment officer at Bala Cynwyd, Pennsylvania-based veteran investment advisor and alternative asset manager Hamilton Lane. Hirsch's group has spent the past two years ramping up its systems and processes aimed at data capture and interpretation. The result is a sophisticated box of analytical tools helping the firm craft optimised portfolio solutions for its clients. Nevertheless, Hirsch insists that the firm's modelling is only as good as the market knowledge and expertise of the people who operate it. “Feeding historical data into the model often spits out totally unrealistic numbers. You need to be realistic and overlay what the model says with a view of what's happening in the market”.

Another seasoned fund investor also points to the limitations inherent in treating private equity as if it was something that it isn't: “Dialling in different levels of risk and return is tough. You can't mark to market, your data is patchy, you simply cannot optimise the market, and it's a mistake to think that you can. What you want to do instead is use theoretical insight to fine-tune around the edges”.

These are views that few people in the industry will take issue with. No one argues that quantitative methods should be used to try and fundamentally reinvent the investment approach to the asset class. Instead, the idea is to better understand the dos and don'ts of private equity fund investment, and to more accurately measure and contextualise the results it produces.

Nonetheless, some of the staple ingredients of many private equity portfolios are currently more in demand than others. LPs investing in buyout funds for example are frequently eschewing those with a generalist investment strategy – because too many such funds now are thought to be active, to the detriment of the returns they can be expected to achieve. Instead, as evidenced by Rhode Island-based telecom specialist Providence Equity's Partners recent $4.5 billion blow-out fundraise, it is managers offering expertise in certain industries who are finding it easier to attract the buyside's attention.

Another hot topic is vintage diversification and the ways in which the secondary market can best be used to achieve this. Limited partners without extensive prior experience of the secondary market are emerging as keen buyers of partially or even fully funded partnership interests. These so-called non-dedicated buyers of secondary positions are interested in some of the defining characteristics that such positions exhibit, namely speedier cash flows relative to primary (unfunded) investments, and less risk thanks to a degree of visibility onto a secondary interest's underlying assets.

It is also worth noting that non-dedicated buyers may be approaching the secondary market for different reasons: either in order to retrospectively alter the average age of funds in an already assembled portfolio, or in order to move a bundle of new fund commitments faster up the J-curve.

Whether the benefits of using secondary investing in this way are compelling to a given investor depends on their specific risk and return preferences: capital invested in private equity for the genuine long haul in order to maximise cash returns is less likely to rush into this part of the market, whereas LPs who care primarily about high IRRs will be more interested in using it. Hamilton Lane's Hirsch observes that most of his clients fall into the latter category. “Most of them now want vintage diversification”, he says, adding that his firm “certainly ranks the lack of it as one of the more serious mistakes people have made in the past”.

In addition to entering the secondary market in order to buy, investors are also beginning to wake up to novel opportunities to act as sellers – not to offload huge chunks of capital committed to private equity, mind you, but as vendors keen to dispose of individual fund interests (so long as the price is right) that no longer fit the criteria they use to optimise their asset mix. “We're getting a lot of enquiries from institutional investors on this topic”, confirms Rouvinez at Capital Dynamics.

Colin McGrady, co-founder of private equity focused investment bank and secondary advisory specialist Cogent Partners in Dallas, sees this trend too: “We see pensions with huge portfolios approaching the secondary market now for the first time”, he notes. Again, these pensions aren't coming to the market as wholesale sellers. As McGrady points out, what the pensions specifically want to do is to reduce the number of active general partner relationships in their portfolios.

McGrady's comment mirrors what is arguably the most noteworthy buy side trend unfolding at this stage of private equity's evolution: every source interviewed for this article agreed that manager reduction was looming larger than ever on limited partners' minds. The development is a reflection of the ever-increasing numbers of managers competing with each other in every substrategy of private equity.

In the large buyout space, the rise of clubs deal, where equity sponsors team up to jointly fund acquisitions, has come to symbolise general partner proliferation more than any other market phenomenon. Many LPs consider this proliferation excessive and are increasingly wary of owning a competitively priced asset through more than one underlying fund in their portfolio.

But even where the perceived downside of deal syndication is not a particular concern, LPs may still take the view that their capital is being looked after by too many managers. “People are now seeing that 30 relationships in Europe for example perhaps isn't the right number”, says Loren Boston at Merrill Lynch, who as a fund placement specialist spends much of his time talking to institutions. He argues LPs have recognised that beyond a certain point, the return of any additional diversification is likely to diminish. “The danger is that you end up buying most of the market, in which case it becomes difficult to see where the outperformance is going to come from”, declares Boston.

To avoid such regression through excess diversification to an undesired mean, a growing number of investors are aggressively cutting back on the number of managers they want to commit money to. “While some LPs are simply looking to call out the losers who didn't deliver last time”, comments Boston, “others have thought about it more systematically and are doing this from the top down”.

The task of eliminating specific managers from the roster of groups that can expect allocations from an institution in the future will be awkward. Given the crowded forward schedule for fundraising, most – if not all – GP groups planning new funds are banking on the fact that the majority of their current LPs are going to re-up. And in an industry where personal relationships still count for a great deal, telling current managers they are up for the chop is not going to be easy.

For the largest investors active in the asset class, working with fewer managers will also raise, and probably not for the first time, questions about how much capital they can effectively put to work. At a time when, in the venture market especially, many managers' funds are already smaller than their predecessors, institutions with deep pockets are bound to struggle to hit their deployment targets if fewer funds are going to be in the running in the first place.

The dilemma facing investors whose sheer size has become a potential burden is a key aspect of the fundamental question of whether or not it is possible to asset allocate in private equity. Large investors often subscribe to a school of thought that says fixed portions of their private equity allocations should be invested in specific areas of the market: Xpercent in large LBOs, Y percent in emerging markets, Z percent in secondaries and so on.

The problem with this approach to private equity, according to its critics, is that it encourages investors to slavishly follow the prescriptions of their allocation models – to the point where the practical constraints of doing so will have to be ignored.

Practitioners say that the asset allocation debate is currently splitting the market even more widely than it has done in the past. “It's a very topical issue, and it's causing friction in the asset class, with people moving in different directions”, says Remy Kawkabani, a London-based managing director of CSFB's Private Fund Group. “Asset allocation does have its merits particularly for the very big programmes, as long as people are aware of the dangers of overallocation. But it does run counter to another profound realisation that many investors have now had: that what really matters in this business is the selection of good managers”.

THE LIMITED PARTNER PERFORMANCE PUZZLEMean fund characteristics by class of LP and by fund type

N Fund size ($m) Fund sequence Fund IRR (%) Weighted fund
number IRR (%)
Public pension funds 2,317 983.8 4.77 7.61 2.63
Corporate pension funds 759 826.2 4.55 5.07 3.07
Endowments 1,433 587.7 4.69 20.47 16.87
Advisors 1,667 781.8 4.59 -1.79 -2.96
Insurance companies 594 542.2 3.98 5.47 2.13
Banks and finance companies 573 721.0 3.48 -3.17 -4.06
Other investors 244 429.1 3.72 5.87 5.87
Overall 7,587 776.6 4.50 6.88 3.76

This confirms that picking the next generation of winning private equity partnerships is easier said than done. Hence there is no guarantee that the current flight to (perceived) quality will necessarily produce a great many new fund portfolios that, ceteris paribus, will perform better than their predecessors.

The work done by Lerner, Schoar and Wong unequivocally confirms what most practitioners have long held to be true: that private equity is a difficult asset class to invest in. Says Lerner: “Private equity performance is no nicely bell-shaped curve. There is a very long tail at the end, which the majority of investors are failing to get into”.

What is less certain is which conclusions the inquisitive investor is to draw from this. Can they raise their game sufficiently to operate successfully in private equity? More experience, expertise and time, combined with better quantitative instrumentation at their disposal, may indeed help them pick the winners and stay away from backing the wrong teams.

But it also seems conceivable that some investors will give up altogether. Says Lerner: “It is very unclear at the moment whether some disillusioned LPs might conclude that this is a game that is just too hard to play”.

Precisely how this dynamic is going to play itself out over the coming years will be a fascinating spectacle to watch. Perhaps the future of private equity is a market place where a smaller number of elite GPs is investing on behalf of a similarly rationalised group of LPs – with both sides sharing in the asset class' raison d'^tre: exceptional returns.