Remember the fundamentals

The fundamental principles in the private equity industry that existed 50 years ago, 25 years ago, still exist today.

I’ve been involved in private equity in one form or another going on 30 years, and believe the fundamentals necessary to make a private equity investment work are still worth the trouble and the additional risk. Success comes from understanding and executing the basics.  

On the venture capital side, there must be a willingness for entrepreneurs and capital providers, whom I call capital mentors, to take risks and move innovation from bench tops and laboratories out into the market, to commercialize technology into real products and solutions markets want and will pay for. 

On the buyout side, you’ve got to have certain levels of inefficiency and dislocation in the market. You’ve got to have general partners who can competitively source attractive deals, convince the owner of the attractive company that they (the GP) are the right partner and close the deals. The capital commitment is almost the last ingredient.

David Turner

Both venture capital and buyout managers have to know what to do with a company once they start or own it, everything from parachuting in their own teams, working with existing teams, and bringing in new talent, and always must have an eye on monetising the company with a timetable to make it happen.

These are all fundamental principles that haven’t changed in this business. As LPs, it’s our job to back these types of managers regardless of the market cycle you’re in. We need to be convinced we’re backing the right group regardless of how long it takes to see some realisations.

What has changed, since the last market downturn, is this: to a large extent, private equity has become a momentum investing business, and that’s unfortunate for everyone involved. More capital will continue to pile into the market when markets become robust and overheated.

Lots of willing, allocation-anxious investors attract second and third tier managers, who are able to raise capital just because it is out there. This class of managers won’t likely produce the best returns. As we continue to make this a larger asset class, we’ll continue to see a degradation of median returns – we’ve seen them decline from the high teens to single digits in the last 10 years.

The large amount of capital and the growing number of managers has resulted in a bifurcation of investment quality, and led to a bifurcation of returns.

What should we have learned? The problem with this business is not too much capital chasing too few deals.  It is too much capital in the wrong hands. Private equity does not naturally lend itself to scale and we are awaiting, perhaps unwittingly, the next bubble. I believe there will be future rewards in private equity for those who practice patience and dedication to the fundamentals and understand this has been and will continue to be a bottom up business, one deal at a time.

David Turner is head of private equity for the Guardian Life Insurance Company of America.