Industry observers eyeing the wider fallout from the decision by the California Public Employees’ Retirement System (CalPERS) to cut the number of external money managers it works with are concluding that small and mid-sized private equity players need not worry about this trend among LPs to allocate larger amounts of capital to fewer GPs.
As a bellwether for the investment behaviour of other US retirement systems, CalPERS’ June announcement that it would cut the number of external money managers it works with by about half to minimise costs would have sparked concerns for some smaller GPs.
At present, it is partnered with 212 GPs including The Carlyle Group and KKR. It wants to cut that number to about 100, while keeping the same allocation to alternative assets. The 98 private equity managers among those partners will soon become a group of 30 that will see bigger capital commitments from CalPERS’ $30 billion private equity pot.
Citing CalPERS’ negative cash flows and the “daunting task” of managing multiple partnerships with GPs, CalPERS’ chief investment officer Ted Eliopoulos said in a June conference call that it is important for the fund to “have very strategic, meaningful relationships that scale with the managers we need access to”.
Of course, some smaller funds that lack scale will lose out and will have to source capital from places other than LPs engaged in cost-cutting, but there is always room for smaller market firms in private equity, according to industry professionals.
“Industries go through a natural progression. Typically that means they start with a large number of small players that succeed greatly and some wash out,” Stewart Kohl, co-chief executive of New York-based private equity firm The Riverside Company, told Private Equity International. “That does not mean that the rest of the industry goes away.”
He referred to a general cycle any industry experiences with plenty of volatility in the early stages. Over time, leaders – in terms of size and performance – begin to emerge and ultimately occupy a significant position in the industry.
“I think that is what is happening in private equity,” he said. “[We are seeing the] emergence of dominant leaders like KKR, TPG and Blackstone, garnering more and more assets, diversifying beyond their core private equity roots into real estate and other asset classes.”
Despite these putative leaders’ growing shares in private equity, he said there are still, and always will be, boutique and smaller niche players. The middle stream for such firms, he said, is where Riverside, which manages $4.6 billion in assets, sits in the hierarchy.
The Pennsylvania State Employees’ Retirement System and the Washington State Investment Board have been among other LPs taking the investment initiative of concentrating their allocation to fewer partnerships.
Of course, the smaller number of GPs will mean they will carefully choose managers based on selective criteria, such as performance.
“Private equity is really a performance industry,” Deloitte & Touche’s M&A private equity leader Barry Curtis told Private Equity International. “If you are an investor – small or large – if you are having good returns, you will be able to raise money.”
Curtis admits there have been shakeouts in the industry, referring to the now-closed HM Capital Partners and Forstmann, Little & Co, among others. In addition to these downturns, Curtis said the private equity market is awash with dry powder. But as long as funds generate returns, they will find receptive LPs, he said.
Kohl has similar thoughts about the vitality of the private equity realm.
“It has delivered good returns that are more than adequate to make up for what some might perceive as the negatives in private equity, like illiquidity,” Kohl said. “Because it’s proven as an asset class, I think LPs will continue to want to invest in it.”
A spokesman for CalPERS confirmed to Private Equity International that it will be a five-year process to narrow down the manager ranks.