Applying Darwin's theory to our industry, it might be said that private equity fund management companies are an extremely resilient species. Only the strong survive, yes. But the Darwinian death matches actually occur on the way to the final close of Fund I. Past that point, private equity firms appear to be extremely difficult to kill.
The brief history of private equity suggests that a fund manager can suffer poor returns, staff defections and limited partner disaffection and still raise that next fund.
The structure of the private equity partnership is one key to this longevity, of course – once committed, an LP is bound to the general partner team for a good 10 years or more, and a lot can happen in a decade. The ineffectiveness of interim performance calculation also fosters successive funds – five years after closing one fund, a GP can raise another one before anyone really knows the outlook of the current portfolio.
Institutional memory – or the lack thereof – is a factor. A state pension might go through two private equity portfolio managers and switch consultants in the period between fundraisings, better allowing an erstwhile dog-housed GP to engage in a bit of revisionist history.
And yet, one often hears reports of the demise of sundry private equity firms, typically in the form of: “They'll never raise another fund again”. But in many cases, they will raise another fund.
An oft-repeated macro theory of private equity industry “consolidation” has it that a handful of large, successful, global private equity franchises (take your pick – Blackstone, KKR, Permira) will control a greater share of institutional capital while an outer orbit of boutique firms will continue to thrive, but a great many middle-sized, so-so performers will gradually wither away.
Emphasis on “gradually”. The long-foretold shakeout isn't happening anytime soon. Even private equity firms that deserve to shuffle off this mortal coil post-haste can gain a new decade of life through a successful fundraising. Remember, GPs' first and most demonstrable talent is not investing, but raising funds. And while we'd like to think that LPs consistently award capital to managers with high IRRs and withhold capital from managers with low IRRs, they don't. In the hallucinogenic haze of interim IRRs, it's hard to sort out the genuinely bad performers from the long-term winners. In addition, many factors other than performance go into institutional decision making. Familiarity is a popular one.
And let's also not forget the current and anticipated clamour for private equity allocations among institutional investors. A-list firms like Providence Equity Partners are turning away billions of dollars in investor interest. Most of that rejected capital will end up in other, more accommodating vehicles, some managed by the very GPs who supposedly were to never again raise another fund.
Which brings us to last month's must-read New York Times article in which Ted Forstmann, co-founder and frontman of legendary New York private equity firm Forstmann Little & Co., promised to pull the plug on his fund-management franchise once the current fund runs its course.
Is this a voluntary move, or is Forstmann seeking to avoid an embarrassing follow-on fundraising flop? His firm's recent bumps in the road have been jarring – the loss of $1.5 billion through off-strategy telecom deals, a nasty legal battle with an LP (Denise Nappier's State of Connecticut), a near-total withdrawal from the deal market.
With these blemishes, could Forstmann Little have raised another fund? Absolutely. The born-again- GP campaign has worked for other faded franchises. What LP wouldn't be intrigued by a repentant, refocused, back-to-basics Forstmann Little? Nappier herself all but conceded this in an announcement following the buyout firm's $15 settlement with Connecticut. She said: “Notwithstanding the unfortunate conduct in this instance, the firm is among the giants in the industry, and well poised to provide the pension fund with a good return on those investments we are obligated to see through”.
This particular industry giant is choosing to fade away. His interview with the Times shows a man not particularly attuned to fund management as a desired line of business. To wit: “If I thought all I was good for was to invest money for pension funds, I think I would put a gun in my ear. I hope to Christ that's not why I was put on this earth. Man, I hope I have other interesting and fun things to do”.
In the near term, the private equity firms that disappear will likely do so for lack of will, not way. Long, grueling fundraisings are certainly not fun, but GPs intent on surviving institutionally have a pretty good track record of doing so.