Private equity dry powder hit an all-time high at $840 billion as of October 2016. Is this a worrying amount?
The fact there’s so much capital available in private equity doesn’t really reflect the potential, the deployment or the opportunity that’s there. The private equity market has always been trying to understand whether it has too much capital or too little capital. It’s a growing part of our economies but in most countries, it’s very miniscule. If you look at Japan, private equity investment is under one percent, compared with the US which is well over 15 percent. When you look at the marketplace, you have to take a step back and look at economic development, economic transition and activity, and then M&A activity.
How are limited partners responding to this?
You also have to realise that the investor community is changing and developing. Historically when a performing general partner had a significant loss in a portfolio, the private equity community would be tolerant and would support them in two following funds.
In today’s environment, they don’t. The investors will walk away from the relationship and try to put money with the general partner who has a similar mind set in terms of what it is they are looking for: regularity of deployment, protection of principal and consistent performance. And within that, it’s key to understand what’s driving investors to come to this conclusion – their focus is on net returns.
How have limited partners adjusted their expectations in the current low return environment?
In private equity one needs to be managing and generating a dynamic portfolio, buying and selling companies regularly. When you look at the substantial capital of the largest investors in the world, they want to hold assets for long periods of time. They may not want to necessarily experience the reinvestment risk every three to five years in a new fund with a general partner.
The world today is not an easy place to generate returns, how is this playing out in the LP-GP relationship?
One of the things that is difficult to place nowadays is a private equity firm that has 50 percent loss and the other 50 percent making five times money. Investors are just not interested in this kind of volatility because they have a real concern and focus on understanding what’s happening with their capital on an investment company basis.
It’s not a question of headline numbers but from the investor’s point of view the question really is: ‘What is in my pocket at the end of a fund life?’ This leads to a dramatic change compared with the past five years. Before they were more tolerant of the learning curve of a private equity firm. Nowadays there are a lot of firms to choose from and the investors have decided they are going to have fewer relationships putting more money to work with those selected.
Family groups are doing private equity directly; corporates are also getting more involved. There’s a lot of activity going on and these are not in partnerships – these are in direct investments and platform structures.
In what ways are general partners rethinking their strategies?
Many general partners are having to rethink old structures and becoming more creative solution providers. Private equity professionals are making a real effort to work with best practices, bringing in major consulting firms to review the essence of their businesses. They are looking inward and asking themselves: ‘Are we executing? Are we resourcing? Are we developing?’ They are looking at best governance, and the ability to modernise the business in today’s environment – and that to me is a very positive sign.
With the investor community becoming more involved directly in investments and market dynamics changing, private equity firms are making an effort to meet the highest standards, to run very good businesses – when you put this together you really have quite an impressive market.
What are your thoughts on the Asia market dynamic?
While the industry has matured in Asia, the talent pool is still quite limited with a scarcity of companies circulating in the system. From the general partner’s point of view, the question then is: should we develop and use the type of model that we are seeing in the US and Europe or should we do something different?
And that nuanced differential comes from the family groups and the mega investors who can hold and develop these companies longer. The question for investors then is: ‘Do I go into partnership structure where every three to five years I have to reinvest risks? Or do I find a pool of exceptional assets with a GP and hold them longer term?’
What’s next for private equity investors?
I think that large investors will become 50 percent third party and 50 percent direct investing. GPs always say the investor community lacks the resources, that they do not have the infrastructure and experience. But they have to remember that just like raising children, they grow into teenagers, and become adults.
And when the investor becomes an adult – which they do and a lot of them are today – they can source a deal and drive them, and they also know when to bring in a GP that has expertise. I think that we will see more and more of the market as the investor community gets more sophisticated.
What’s ahead for the coming year?
2017 will have a new US president and new policies, Brexit may or may not happen, elections are taking place in France and Germany, as well as in other governments. We should ask ourselves: ‘What does this all mean? Are the policies going to be pro-business or pro-development?’
The finance sector is suffering quite significantly with very low interest rates. Any slight rise in interest rates will be a healthy boost to the financial community. Additionally, if global governments become more focused on business development and best practices, that would become a nice environment to operate in.
This article is sponsored by MVision. It appeared in the Perspectives 2017 supplement published with Private Equity International in December 2016.