Today's investors in private equity are looking for firms, not funds.
A subtle distinction, but an important one. A fund is a pool of money to be deployed in the acquisition of securities. A firm is the network, culture, systems, talent and infrastructure built around the fund to make sure the money is deployed intelligently and in alignment with the interests of the limited partners.
A fund has a finite life. A firm is designed to persevere through a variety of contingencies, including the departure of the founders.
And yet, historically, many private equity teams have structured themselves as bare-bones, thirsty consumers of capital with one mission: doing deals. All other considerations, such as the building business systems, were secondary.
Arguably this was efficient, but there was also a troubling conflict to this efficiency. Most general partners would never consider investing in a company that had no succession plan, had no business systems, had poor communications with its customers. And yet, that is precisely what many general partners asked their LPs to do with each successive fund – invest in an asset management company that, while holding forth the prospect of massive capital distributions, didn’t seem particularly well run.
Make no mistake, returns are still the primary concern of investors. Limiteds will take a poorly run firm with top-quartile returns over a well run firm with a middling IRR any day.
But increasingly, LPs have come to believe that well run firms do, in fact, increase the likelihood of good returns. And why not? A firm that has instituted a fool-proof due diligence system is less likely to invest on the whim of a founder. A firm that communicates well with its LPs is more likely to have the same quality of interaction with its portfolio companies.
Finally, the need for a well managed firm speaks to one of the industry’s dirty little assumptions – returns in the coming decade are expected to remain below averages of the earlier decade. With so little room for error, LPs are looking not for superhero risk takers, but for organisational sticklers who consistently avoid disasters, manage risk, and squeeze as much upside out of their portfolio as possible. This takes discipline and, well, a system.
Texas Pacific Group learned this while on the road with its fourth fund, which last Friday closed on $5.3 billion (€4.23 billion) in committed capital. Jamie Gates, a partner at the Texas giant, recently told PrivateEquityOnline.com that he heard again and again from investors their desire to see evidence of a strong firm.
Texas Pacific was founded by three private equity pioneers: David Bonderman, James Coulter and William Price. All three can lay claim to the many investment successes of TPG, but going forward they are now being asked what kind of a culture and system they have built at Texas Pacific beyond the force of their collective personal brilliance.
The firm has gone out of its way to show that it is a firm – hiring new professionals, dividing labour by sector and portfolio company, encouraging a decentralised and team-based decision-making process. Texas Pacific welcomed LPs to visit its offices to see the “depth of our team,” Gates says.
The management of a private equity firm as science unto itself has no greater proponent than Jeff Walker, head of JP Morgan Partners. In an interview in this month’s issue of Private Equity International magazine, he says that firms with integrated networks “are attempting to become more professional. They are going though the succession questions and development questions, setting up business structures, as opposed to boutiques that are dominated by specific individuals and less reliant on a professional process.”
The true firms, Walker says, “will have an advantage over the [boutiques] all the time.”