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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Wiley Finance Series
- Sprache: Englisch
“Private equity is more economically significant than ever, as institutions hunt for high returns in a risky world. Private Equity 4.0 examines the role, workings and contribution of this important industry in a straightforward yet revealing manner.”
Dr. Josh Lerner
Jacob H. Schiff Professor of Investment Banking
Chair, Entrepreneurial Management Unit
Harvard Business School
A multi-perspective look at private equity's inner workings
Private Equity 4.0 provides an insider perspective on the private equity industry, and analyzes the fundamental evolution of the private equity asset class over the past 30 years, from alternative to mainstream. The book provides insightful interviews of key industry figures, and case studies of some of the success stories in the industry. It also answers key questions related to strategy, fund manager selection, incentive mechanisms, performance comparison, red flags in prospectuses, and more.
Private Equity 4.0 offers guidance for the many stakeholders that could benefit from a more complete understanding of this special area of finance.
- Understand the industry's dominant business models
- Discover how value is created and performance measured
- Perform a deep dive into the ecosystem of professionals that make the industry hum, including the different incentive systems that support the industry's players
- Elaborate a clear set of guidelines to invest in the industry and deliver better performance
Written by a team of authors that combine academic and industry expertise to produce a well-rounded perspective, this book details the inner workings of private equity and gives readers the background they need to feel confident about committing to this asset class. Coverage includes a historical perspective on the business models of the three major waves of private equity leading to today's 4.0 model, a detailed analysis of the industry today, as well as reflections on the future of private equity and prospective futures. It also provides readers with the analytical and financial tools to analyze a fund's performance, with clear explanations of the mechanisms, organizations, and individuals that make the system work.
The authors demystify private equity by providing a balanced, but critical, review of its contributions and shortcomings and moving beyond the simplistic journalistic descriptions. Its ecosystem is complex and not recognizing that complexity leads to inappropriate judgments. Because of its assumed opacity and some historical deviant (and generally transient) practices, it has often been accused of evil intents, making it an ideal scapegoat in times of economic crisis, prodding leading politicians and regulators to intervene and demand changes in practices. Unfortunately, such actors were often responding to public calls for action rather than a thorough understanding of the factors at play in this complex interdependent system, doing often more harm than good in the process and depriving economies of one of their most dynamic and creative forces. Self-regulation has clearly shown its limits, but righteous political interventions even more so.
Private equity investment can be a valuable addition to many portfolios, but investors need a clear understanding of the forces at work before committing to this asset class. With detailed explanations and expert insights, Private Equity 4.0 is a comprehensive guide to the industry ways and means that enables the reader to capture its richness and sustainability.
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Private Equity 4.0
Reinventing Value Creation
Benoît Leleux, Hans van Swaay
This edition first published 2015 © 2015 Benoît Leleux, Hans van Swaay & Esmeralda Megally
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Library of Congress Cataloging-in-Publication Data is available
A catalogue record for this book is available from the British Library.
ISBN 978-1-118-93973-4 (hbk) ISBN 978-1-118-93983-3 (ebk) ISBN 978-1-118-93984-0 (ebk) ISBN 978-1-118-93982-6 (ebk)
Cover Design: Wiley Top Image: ©iStock.com/czardases; Bottom Image: ©iStock.com/DNY59
All cartoons reproduced with permission by IMD and Lyrique
Contents
List of case studies
About the authors
Hans van Swaay
Esmeralda Megally
Professional Acknowledgments
Personal acknowledgments
Benoit Leleux
Hans van Swaay
Esmeralda Megally
Foreword
The road to sustainability: from arbitrage to operational value creation
Gaining perspective: The road ahead
Introduction
Private equity at the crossroads
An historical perspective to gain insights for the future
Private equity: all about people
The best capitalism has to offer? The conceptual groundings
Believers, sceptics and cynics
Notes
1 Private equity: from “alternative” to “mainstream” asset class?
Executive summary
Moving into mainstream
A brief history
An increasingly global industry
An industry in the limelight
Notes
2 Private equity as a business system
Executive summary
Setting the stage
The (apparent) madness of private equity fees
Commitments versus investments
Distributions in cash, please!
Due diligence, leverage, focus and… incentives
Illiquidity… and new ways to cope with it
Notes
3 Value creation in private equity
Executive summary
The art of private equity
Sourcing deals
Creating value in private equity
Exiting investments
The economic impact of private equity
Notes
4 Private equity performance
Executive Summary
Performance metrics
Valuing realized and unrealized investments
Reporting fund performance
Membership and self-reporting biases
Performance by segments
Performance by fund size
The persistence effect
The timing effect
Comparison against benchmarks
Correlation to other asset classes
Notes
5 The main characters in private equity
Executive summary
Size matters: fund sizes, deal sizes and other dimension issues!
Global alternative asset managers
Regional, domestic and multi-country funds
Mid-market funds
Venture capital funds
Distressed private equity
Secondary funds
Funds-of-funds
Institutional limited partners
Notes
6 The supporting cast
Executive summary
London as European centre of gravity
The private equity ecosystem: follow the fees
Investment banks
Lending banks
Accountancy firms
Law firms
Due diligence specialist providers
Strategy consultants
Placement agents
Fund administrators
Recruitment consultants
Public relations agencies
Notes
7 Investing in a fund
Executive summary
The private equity game
The decision to invest
Choice of investment vehicle
Diversification in a rich marketplace
Timing
The pitch
Manager selection
Due diligence
Subscription to a fund
Capital calls
Monitoring
Distributions
Reporting
Fund liquidation
Notes
8 The future of private equity
Executive summary
Reports of private equity’s death were highly premature
Private equity in a changing world
Conclusion
Note
Index
End User License Agreement
List of Illustrations
Chapter 1
Exhibit 1.1
Annual private equity fundraising
Exhibit 1.2
Largest private equity deals to date (billions)
Exhibit 1.3
Private equity fundraising by region
Exhibit 1.4
Private equity fundraising by emerging markets
Chapter 2
Exhibit 2.1
Typical structure of a private equity partnership
Exhibit 2.2
Phases in the life of a private equity fund
Exhibit 2.3
Company life-cycle private equity investment strategies
Exhibit 2.4
Composition of LP universe by investor type as of December 31, 2013 (number of LPs)
Exhibit 2.5
Breakdown of aggregate capital currently invested in private equity by investor type as of December 31, 2013 (excluding funds-of-funds and asset managers)
Exhibit 2.6
Average private equity allocations by investor type as of December 31, 2013 (as a % of AUM)
Exhibit 2.7
Strategic allocations of leading European family offices
Exhibit 2.8
Distribution of management fees among private equity buyout funds (all funds Raising & Vintage 2012/2013 funds closed)
Exhibit 2.9
Distribution of hurdle rates among private equity funds (all funds Raising & Vintage 2012/2013 funds closed)
Exhibit 2.10
Management fees, carries and hurdles rates in US buyout and VC funds
Exhibit 2.11
When fund sizes wreak havoc in incentive structures: revenue estimates for a sample of 144 buyout funds
Exhibit 2.12
Average number of employees by firm assets under management as of December 31, 2013
Exhibit 2.13
Relative importance of value drivers
Exhibit 2.14
Private equity secondary market: pricings and global transaction volume
Chapter 3
Exhibit 3.1
Pre- and post-buyout key spending areas as percentage of revenues
Exhibit 3.2
Value creation drivers over the last cycle (N denotes number of transactions)
Exhibit 3.3
Estimates of value drivers in 2008 BCG study
Exhibit 3.4
Six active ownership principles that drive company outperformance
Exhibit 3.5
Buyout exit routes in Europe by amounts at cost in 2012
Exhibit 3.6
Private equity-backed buyout exits broken down by type and aggregate exit value
Exhibit 3.7
Net job creation rates: targets vs controls before and after LBOs
Chapter 4
Exhibit 4.1
Net IRR deviation from median benchmark for private equity buyout funds
Exhibit 4.2
Sample of a schedule of investments
Exhibit 4.3
Spread between first and third quartile managers at Yale Endowment ten years ending June 30, 2012
Exhibit 4.4
Impact of fund size on predicted relative IRRs
Exhibit 4.5
Relationship between predecessor and successor fund quartiles
Exhibit 4.6
Net IRRs by vintage year—all private equity
Exhibit 4.7
Cambridge associates LLC US PE index vs. benchmarks, as of September 30, 2011
Exhibit 4.8
Median public pension fund returns by asset classes (as of June 30, 2013)
Chapter 5
Exhibit 5.1
EVCA classification of buyout transactions by deal size
Exhibit 5.2
EVCA classification of buyout funds by fund size
Exhibit 5.3
Global private equity raised, by type of firm
Exhibit 5.4
Largest GPs by total funds raised in last 10 years
Exhibit 5.5
Largest GPs by total distressed private equity funds raised in last 10 years
Exhibit 5.6
Largest GP secondaries: GPs by total secondary funds raised in last 10 years
Exhibit 5.7
Largest GPs by total private equity fund of funds raised in last 10 years
Chapter 6
Exhibit 6.1
Financial sponsor revenue ranking—full year 2012
Exhibit 6.2
Bank revenue ranking, full year 2012—fees paid by financial sponsors
Exhibit 6.3
Annual private equity-backed M&A activity
Exhibit 6.4
Top 10 debt-financing providers to private equity firms in 2013 by deal value (aggregate value of deals for which financing was provided)
Chapter 7
Exhibit 7.1
Comparison of characteristics of various investment vehicles
Exhibit 7.2
Ratio of capital calls to distributions for global buyout funds
Guide
Cover
Table of Contents
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List of case studies
Case study 1
Carlyle consolidates the forged ring industry
Case study 2
Goldman Sachs’ investment in Shenzhen Hepalink Pharmaceutical
Case study 3
Warburg Pincus’ investment in Bharti Tele-Ventures
Case study 4
Barbarians at the Gate: KKR’s buyout of RJR Nabisco
Case study 5
The founding of Tribeca Capital Partners and the OndadeMar investment
Case study 6
Texas Pacific Group (TPG) and Ducati
Case study 7
Argos Soditic and the Kermel management buyout
Case study 8
Chrysalis Capital’s entry into India
Case study 9
Tumi and the Doughty Hanson Value Enhancement Group
Case study 10
Blackstone and the Celanese acquisition
Case study 11
Carlyle and the AZ-EM carve-out
Case study 12
Bain Capital and the turnaround of Samsonite
Case study 13
EQT’s investment in Tognum
Case study 14
HIG and Thermal Industries
Case study 15
TVM and the Jerini deal
Case study 16
Cerberus and the car rental industry
Case study 17
Coller and the Abbey Bank deal
Case study 18
The Pantheon deal
Case study 19
The Danish pension fund system
About the authors
Dr Benoît Leleux
Dr Leleux is the Stephan Schmidheiny Professor of Entrepreneurship and Finance at IMD in Lausanne (Switzerland), where he was director of the MBA programme and director of Research and Development. He was previously Visiting Professor of Entrepreneurship at INSEAD (France) and Associate Professor and Zubillaga Chair in Finance and Entrepreneurship at Babson College (MA, USA). He obtained his Ph.D. at INSEAD, specializing in Corporate Finance and Venture Capital. He is recognized as a leading specialist in entrepreneurship, venture capital, private equity and corporate venturing, in particular in emerging markets. He also has a strong interest in family businesses and has been the director of the IMD-Lombard Odier Global Family Business Award since 2008. His latest books include Investing Private Capital in Emerging and Frontier Market SMEs (IFC, 2009) and Nurturing Science-Based Start-ups: An International Case Perspective (Springer Verlag, 2008). Dr Leleux earned an M.Sc. in Agricultural Engineering and an M.Ed. in Natural Sciences from the Catholic University of Louvain (Belgium) and an MBA from Virginia Tech (USA). His teaching cases have earned 17 European case writing awards and he has been running executive education programmes and consulting assignments for more than 50 leading global corporations and investment organizations. He is also involved with a number of private equity and venture capital funds as well as numerous start-up companies in various capacities.
Hans van Swaay
Hans van Swaay has a long track record in private equity as Partner of Lyrique, Head of Private Equity at Pictet & Cie, Managing Director of UBS Capital, Managing Director of Merifin and partner of Lowe Finance. His career has taken him through many cycles of the private equity industry. Today with Lyrique he is actively involved in private equity investments for private wealth, like family offices and private banks.
Hans has made direct investments in Switzerland, Germany, France, the United Kingdom and in the Netherlands. As an investor in funds he has been active in the United States, Europe and Asia. As a direct investor he has on occasion assumed operational responsibilities in industrial situations as CEO in Germany and in Switzerland and he regularly publishes articles on private equity.
Prior to his private equity career Hans van Swaay worked with Shell in the United Kingdom in general and financial positions. He started his career in the construction industry with one of the Netherlands’ major construction companies, HBG in the Middle East.
Hans van Swaay holds an MBA with honours from IMD (Switzerland), an M.Sc. in engineering geology from Leeds University (UK) and a B.Sc. in geology from Leiden University (the Netherlands).
Esmeralda Megally
Esmeralda Megally started working in the venture capital industry in 2007, when she joined Boston-based venture capital firm Commons Capital as manager to explore—with the Bill and Melinda Gates Foundation—a new business model in venture capital. At Commons Capital, she worked closely with venture-backed portfolio companies to develop and implement growth strategies and was in charge of identifying new investment opportunities globally.
She holds a B.S. and M.S. in Economics from the Université Libre de Bruxelles, Belgium, a Masters degree in Management of Technology from EPFL, Switzerland, and an MBA from the Massachusetts Institute of Technology’s Sloan School of Management (MIT Sloan), US. She served as venture advisor to the NextLab at the MIT Next Billion Network and was part of the biotech committee of the MIT Technology Licensing Office, working alongside entrepreneurs, investors and large corporations to devise licensing strategies.
Esmeralda is a co-founder of Xsensio, a spinoff of the EPFL Nanolab in Switzerland which develops nanotechnology-based intelligent stamps. She is also a co-founder and board member of GCS, a Tanzania-based spinoff of the MIT D-Lab that was selected by Forbes’ 30 under 30 and Bloomberg Businessweek America’s Most Promising Social Entrepreneurs. Her innovations have been awarded the Harvard Catalyst Grant, the EPFL Innogrant, the MIT IDEAS International Technology Award, and the MIT IDEAS Graduate Student Award. Esmeralda is the co-author with Benoit Leleux and Michel Galeazzi of an IMD case study on the IPO of Tumi (EFMD Case Writing 2013 Award, Finance and Banking category).
Professional Acknowledgments
The authors would like to acknowledge the contributions from Grant Murgatroyd and from Cyril Demaria. Grant contributed significantly and came up with the idea of the supporting cast which grew into a whole chapter of its own. He is now editor of Alt Assets’ Limited Partner Magazine. Cyril these days is Executive Director at the Chief Investment Office at UBS. His insights were most helpful in formalizing the content of the book. The authors also acknowledge the help and support from the private equity research department at Preqin.
Nothing would have been possible without the invaluable contributions from many industry luminaries. Most of them donated their time generously to discuss the industry and its inner workings, opening doors for further engagement of key industry players. Their deep insights and phenomenal intellect made essential contributions to the authors’ pursuit of the new paradigms of private equity. In particular, we would like to thank the following individuals, hoping not to have left too many contributors out:
Stephen Schwartzman - Blackstone, David Rubenstein - Carlyle Group, Conni Jonsson - EQT Partners AB, Dwight Poler - Bain Capital, Jon Moulton - Alchemy Partners, John Snow - Cerberus Capital Management, Peter Cornelius - AlpInvest, Rhoddy Swire - Pantheon Ventures, Martin Halusa - Apax Partners, Elly Livingstone - Pantheon Ventures, Stefan Fischer - TVM Capital, Angus Russell - Shire, Jeremy Coller - Coller Capital, John McFall - Labour MP, Tony Tamer - H.I.G., Chris Brown - Freshfields’ international private equity group, Volker Heuer - Tognum, David Blitzer - Blackstone, Kenneth Mehlman - KKR, Piers Hooper - Equus, Jonathan Russell - EVCA, Tim Jones - Coller Capital, Erwin Roex - Coller Capital, Peter Bertone - Booz Allen Hamilton.
Professor Leleux would also want to thank hundreds of participants from private equity programs he delivered in the past around the world, at institutions such as IMD, INSEAD, Babson College, the Amsterdam Institute of Finance, The China Europe International Business School (CEIBS), the Shanghai Financial Authority, the European School for Management and Technology (ESMT), the Vlerick School of Management, the Moscow School of Management Skolkovo and Skoltech Institute of Science and Technology, the Ecole Polytechnique Fédérale de Lausanne (EPFL) and many others. Those participants were instrumental in furthering the intellectual curiosity to push further the investigations of some of the lesser known corners of the industry. Dr Leleux would like to acknowledge the generous support received over the years from the IMD Research and Development department. This book is built on almost 8 years of research, including a large number of original clinical studies on various private equity stakeholders, all supported by IMD financially and through research assistants. The Case Administration department was also instrumental in bringing those cases to fruition, providing editorial and registration support flawlessly over the period. Finally, the Information Centre regularly provided access to unique library resources to complete this book project. The book project was regularly delayed because its authors considered it essential to let the dust settle after the upheavals generated by the financial crisis in 2007 and the economic crisis that ensued. The patience and resilient support of IMD in this period is most appreciated and made a huge contribution to ensuring a longer-term perspective to this book.
Hans van Swaay wants to acknowledge the fact that the idea for this book was born when at Pictet & Cie, building its private equity business. Being part of Pictet helped access some of the greatest names in private equity and it was a treat to work with such a prestigious institution that understood the relevance of private equity to its business. Having done what private equity is all about, i.e. co-founding Lyrique, he has been able to test many of the ideas for this book with his partners at Lyrique and with his friends and partners at Providence Capital in the Netherlands. Lyrique took up the idea of the cartoons that were originally created for the book. Its tongue-in-cheek cartoon calendars, addressing private equity issues, have become a regular feature and are used by many private equity practitioners today. They would have been impossible without the help of highly professional cartoonists, Robert Thompson, Tim Harries and Matt Percival.
Personal acknowledgments
Benoit Leleux
Dr Leleux wants to thank Dina for her unflinching support during what can only be described as a roller-coaster emotional process, and Egor and Sophie for reminding him that there are indeed priorities in life. It would not have happened without them: they provided new meaning to the term “values creation”.
Hans van Swaay
Hans van Swaay wants to acknowledge the patience and support of his wife Hazeline and their children, Harley and Quirine, as many evenings and weekends were spent on co-writing this book and not with them.
Esmeralda Megally
To my parents, with love and gratitude.
Foreword
Private Equity 4.0 is upon us, and with it hopefully enough experience to start drawing inferences about what works and what does not in private equity. Maturity is an expensive and time-consuming proposition sometimes; to paraphrase the infamous quote: good decisions are based mostly on experience, but experience is the cumulative result of many bad decisions... The financial and economic crises of 2007–2009 were very much the last nails in the long-rotting coffin of private equity “as it used to be”. There is also a wonderful opportunity to take stock of the developments of the last 70 years in the industry and, with the dust slowly settling, to envision the future of this most original and resourceful industry. There is no doubt in our mind that private equity is here to stay. Its contributions to society and the economies of the world are too large to ignore. But yes, it did stray at times, taking advantage of temporary opportunities created by mismanagement and misguided economic policies. These arbitrage opportunities were low-hanging fruits; it is preposterous to blame private equity investors ex-post for having taken advantage of such blatant economic insanities. But these low-hanging opportunities have, for the most part, been arbitraged away (don’t despair though on the creative ability of governments to create new ones…), forcing the private equity industry, against its better judgement, to start considering more sustainable business models, including the ultimate indignity of actually having to create value the hard way, i.e. earning it! Yes, this was said, of course, a bit “tongue in cheek”, but the reality we will endeavour to describe in this book is not far removed from this somewhat crude caricature. Private equity post-crisis has indeed been going through its own revolution, one that we believe can finally be taken to maturity as an invaluable component of the world’s economic system. New business models have emerged with fundamentally sounder groundings providing robust bases for sustainability.
The road to sustainability: from arbitrage to operational value creation
Private equity, in its original incarnation, was very much (ad)venture capital, born out of the industrial and technological advances brought about by World War II. Georges Doriot and his early fund, American Research and Development (ARD), wrote some of the fundamental rules of the game, most notably the fund and incentive structures. The model was picked up later on by buyout funds, which soon outgrew their venture capital brethren and came to dominate, size-wise, the industry. As such, private equity has often become synonymous with buyouts, even though technically buyouts are only a major segment of the private equity industry.
Since the creation of ARD in 1946, private equity adopted and capitalized on a series of business models, replacing them when new opportunities to create value emerged. Private Equity 1.0 capitalized on the organizational inefficiencies of large diversified conglomerates, splitting them apart with the financial helping hand of the junk bond markets of the 1980s. The cycle came to a screeching end with the indictments of the junk bond kings and their patrons. The 1990s were around the corner, and with them a glorious period of GDP growth, multiple expansion and ultimately a technology bubble of epic dimensions, in which Private Equity 2.0 bloomed under the guise of new technology and growth. The internet crash of April 2000 brought the club back to earth. As no good deed goes unpunished, central bankers came to the rescue of the faltering economies that followed the 2000–2001 correction, opening the floodgate of a liquidity surge private equity quickly took advantage of in its 3.0 iteration. As for all previous irrational exuberance episodes, the party had to come to an end when realities intruded on the collective hallucination, taking with it the cheap leverage dreams. The credit bubble was over: it was time to find a new model for value creation that would not be as dependent on financial engineering or the availability of cheap credit. Welcome to Private Equity 4.0, a model that spells the return to the sources of private equity: value creation through operational improvements and the enabling of growth, rather than on pure financial engineering. In other words, earning money the hard way...
In a sense, this is a most welcome development for the industry as the first real opportunity to make it sustainable. This is the age of maturity, the chance to capitalize on 50-odd years of deal making in a wide array of economic environments. Private equity has shown its mettle and its uncanny ability to re-create itself in the face of wildly changing circumstances. With some of the brightest minds involved, and backed by some of the smartest money available, private equity demonstrated the resilience expected of an industry whose impact goes far beyond the deals it actually engineers. Private equity for many has become the standard for corporate performance, the benchmark against which managers of all stripes are measured. Its simple existence and presence disciplines many economic actors to unleash upon themselves many of the measures private equity investors would have forced upon them. The total impact of private equity on economies is thus impossible to measure, but it is fair to assume that it is probably orders of magnitude larger than the deals it actually gets involved with or the value it generates in those transactions.
Instead of being thanked for the impact they had on whole economies, private equity players have been portrayed as barbarians, locusts, asset strippers and worse. How could such a small group of individuals reap such humongous profits if not by devious means? Were the convoluted tax structures used by the funds and their general partners not the proof of some malfeasance at play? Were the millions earned not unfairly taken away from employees and managers left in the cold? Private equity was the all-too-visible hand that proved markets were not anywhere close to efficient. Its very existence and survival proved that corporate governance systems were inappropriate at best, deeply flawed at worst. Unsurprisingly, this flew in the face of common wisdom. Private equity exposed the limitations of the system, and as such was a convenient scapegoat for its ills. And the privacy it likes to shroud itself in was further proof, if needed, of its Machiavellian intents.
Gaining perspective: The road ahead
With the perspective offered by three full cycles at least, it seemed appropriate to try to draw some pragmatic lessons for would-be investors and practitioners alike: What are the best strategies to invest in private equity? How best to select fund managers? What is the best time to commit money to funds? What are red flags in fund prospectuses? How is value really created in private equity transactions?
This book is anything but a blind endorsement of the industry. It is always incisive, and at times critical if not cynical. Some practices in the industry deserve to be criticized and attacked to the extent they hide or even harm the true contributions made. Like all industries it has its black sheep, and exposing those dubious practices only reinforces the credibility of the industry as a whole. The authors can best be described as “critical believers”: they are convinced that private equity embodies and leverages some of the most effective tools of capitalism. But because of this, it also “packs a wallop”, and as such its potential for misuse is great. Nobody ever said making money was easy... In this book, we offer insights into the industry deals and rules of engagement with a view to discovering the most effective ways to reap benefits from them. The recipes are not simple; but, like a good cooking book, the rewards can be most satisfying...
Introduction
Private equity at the crossroads
The economic crisis of 2008–2009 will stay in the annals of private equity as Anni Horribili, the years in which the bill was passed for all the prior misdeeds of an industry that had come to believe it could “walk on water”. The downgrade to “villain” status was at the same time painful and immensely illuminating. This time, the very fundamental modus operandi of the industry was put under the limelight and seriously questioned. Was private equity really contributing to the strength of an economy? Were the various actors of the industry properly rewarded for their actions? Were the incentive structures properly aligning the various interests at play? Was it appropriate to let this important component of economic activity continue to operate with minimal levels of disclosure and regulation? Did it truly deserve the favourable tax treatment it had been able to engineer? And finally, was private equity truly delivering returns over the long term?
With private equity at a crossroads, the timing could not have been better to investigate its inner workings and provide some much needed direction for investors and industry watchers. The recent financial and economic crises have stopped private equity investments in their tracks, and forced a critical re-examination of the various business models and governance structures. Out of this extraordinary boom-to-bust cycle emerges a new understanding of the drivers of performance in the industry, laying the ground for stronger governance and incentive structures.
An historical perspective to gain insights for the future
If the attention focused on private equity is new, the principles behind it are not. For most of history, there has been a need to link capital from wealthy families or institutions with worthy enterprises or endeavours. Academic studies have traced adventurous relationships between investors and entrepreneurs as far back as King Hammurabi, who reigned over the Babylonian Empire from 1792 BC until 1750 BC.1 A closer example of private equity activity is the financing of Christopher Columbus’ adventures, who had, by the 1480s, developed a plan to travel to the Indies by sailing west across the Atlantic Ocean. He tried to secure financing from King John II of Portugal and King Henry VII of England but it was Ferdinand II of Aragon and Isabella I of Castile who finally agreed to put resources into the venture, together with private investors. The agreement stipulated that Columbus would be made “Admiral of the Seas”, and be given 10% of all revenues from the new lands.2 Upon his return, Columbus never received what he was promised, Spain citing a breach in the contract.
The entrepreneurial nature of the adventure, Columbus’ persistence to achieve his goal, the financing and reward structures and the sheer magnitude of profits (Spain’s imperial power can largely be attributed to the venture), lie behind what many see as a beguiling comparison with today’s private equity industry. In private equity speak, this first-time fund was raised with as much difficulty as new groups encounter today.
This book has been conceived as a timeless, unbiased investigation of the ways and means of the private equity industry. As authors, we clearly believe the private equity industry has a good story to tell; for many reasons, internal and external, it has not made the case powerfully so far. To a large extent, we see private equity as potentially the ultimate embodiment of effective capitalism, or what we sometimes colloquially refer to as “capitalism on steroids”. The basic premises, i.e. detailed due diligence, efficient financial structuring, close and active support of management, alignment of interests throughout the entire value chain, and a rigorous focus on creating and realizing value are difficult to argue with. But the lack of transparency and the complexity of some business models have created suspicion and mistrust. Underneath the surface lie a number of myths and half-truths that in the end discredit the industry as a whole. To understand private equity as an asset class, it is thus essential to dive into its inner workings and hopefully make sense of those finer realities.
Keeping a perspective is always difficult when the storm has just passed and left few players unharmed. It is at this critical juncture of the industry’s existence that this balanced perspective is most important, giving it a chance to re-establish itself for the future.
This book is grounded in interviews with some of the world’s leading investors, case studies of successful and less successful deals, extensive research and the more than 50 years’ combined experience of its authors, as academics, investors and practitioners. It seeks to explain how private equity actually functions, who the key players are, and examine the different segments of this rapidly maturing market. The objective is to develop a “How To” guide for potential investors and industry observers, providing a realistic “deep dive” into the inner workings of this most intriguing, often opaque and definitely deeply misunderstood industry, with guidelines about ways to invest and errors to avoid.
To discover the inner workings of private equity, we offer to take you down its most interesting alleyways, in search of its true modus operandi and value creation potential. Chapter 1 provides an assessment of where the industry stands today. Chapter 2 investigates the industry’s dominant business models. Chapter 3 analyzes how financial and economic value are created in the industry. Chapter 4 details how value creation comes to be measured in the industry and examines the return characteristics and fund performances by industry segments. Chapter 5 gives an overview of the main characters in the industry, i.e. the successful firms in each of the industry segments and their “representative” deals, while Chapter 6 provides insights into what we refer to as the “supporting cast”, i.e. the ecosystem of advisors, gatekeepers and professionals gravitating around private equity funds. Chapter 7 takes a fund investment perspective, trying to provide guidelines for the selection of funds to invest in. We conclude with Chapter 8, where we attempt to provide a map to the future of the industry, highlighting the issues at stake in an increasingly challenging environment and suggesting ways to improve the contribution of the industry. Throughout the chapters, case studies of successful deals are used as illustration.
Private equity: all about people
As often, headlines in the popular press tend to paint a rather biased picture of a situation or individual, and the more so the more secretive the target. Why bother with actual data when one can simply create them? Private equity in that sense has all the attributes to become the ultimate scapegoat for politicians and journalists alike: it caters to high net worth investors only (i.e. the privileged ones), involves a small number of professionals only (hence attacks on them do not disturb the voting base much…), keeps its practices suspiciously discreet, uses a colourful array of tax-optimized vehicles, enjoys a way-too-cozy relationship with the powers-that-be (from bankers to politicians), seems to lack all form of social or environmental responsibility credentials and, to make matters worse, seems to earn oversized salaries and bonuses not in line with the performance they generate. In other words, the ultimate form of leech: private equity lives off society’s weaker elements without a trace of ethics or concerns for the very society that harbours it. In short, the ultimate abuse of capitalism...
But could this all be misplaced? Could this be the result of undue focus on some deviant behaviours within an otherwise perfectly healthy industry, or simply the upheavals of natural selection in a maturing industry? Are we throwing the baby out with the bath water? In this book, we make both a passionate plea for the contributions the industry makes to society and investors’ portfolios, and mercilessly point out the weaknesses in its business models. In other words, while we can be described as “true believers” in private equity, we are certainly the most critical (and at times cynical…) observers of that very same industry. This critical sense is essential in analyzing the facts and developing a cohesive set of principles to make private equity work for you as an asset class. In other words, we have not sold our soul to private equity: as investors in our own right, we are attempting in this book to share some of the hard learned lessons about how to “do it right”. As we will show you later, this is both one of the most exciting, creative and ultimately value generating segments of the world of finance and one of the most difficult to make sense of, or even to accommodate in a portfolio. Ultimately, it is one that relies more heavily than any other on people, managers at funds and at portfolio companies. People are the most difficult elements to assess and at times to motivate. But when properly supported and incentivized, they can be the most incredibly resourceful asset… Private equity is about people: incredibly sophisticated, passionate and focused people. And human nature remains one of the most elusive characters to capture…
The best capitalism has to offer? The conceptual groundings
In theory, private equity uniquely combines elements that could create one of the most sophisticated “economic animals” on earth, the ultimate embodiment of the powers of competitive markets, unfettered creativity and rapid adaptation. Of course, as Einstein once put it, “in theory there is no difference between theory and practice, but in practice there is”. And the translation of these concepts and theories into practices has been a convoluted process at times polluted by raw opportunism. But what are the conceptual groundings of private equity? Why would we assume they would ever lead to superior performance?
Empowering and incentivizing: partnering for mutual success
What private equity masters more than any other investment form is the power of incentives to get the best out of people. Private equity deals are mostly about people: therefore, strong incentives have to be put in place to attract, retain and reward the best of them for performance. Not the incremental or marginal type of incentives found in many corporate environments, bonuses tied to vague corporate targets. Private equity builds into its relationships with key personnel the strongest forms of incentives, i.e. oversized and painstakingly handcrafted to match targets individuals have control over. This is probably the single most important driver of private equity deal performance, and one the industry rarely gets praise for. Granted, it tends to benefit a relatively small number of key executives (even though quite often a generous bonus pool is often created for other employees in the acquired firms). But private equity understood before any other industry the kind of ferocious talent war that was going on in the corporate world, and did something about it.
Competent people with the skills to really make a difference at a company level are rare, very rare, and they have multiple career opportunities. Why would they elect to get into the high pressure world of corporate value creation? Because you offer them what they aspire most to: freedom of action and oversized financial rewards. To be “in charge” and directly benefit handsomely from one’s actions is the most emotionally rewarding situation, one in which most individuals would go to incredible lengths to ensure success. In a way, private equity investors understood before anybody else that you can only succeed with management teams, not against them. Hence their model is really one of “partnering for mutual success”. This strong empowering and incentivization of managers is the foundation on which every other element of the private equity recipe is built. And this base is rock solid and will survive the taming of the wild leverage markets. Debt just comes in to leverage and complement the impact of the incentives: it was never the key driver of performance. Let there be no doubt that the horse that draws the cart is empowerment and strong performance incentives, and those are sustainable drivers of performance.
Focus, focus, focus
The second key building block in the private equity recipe is the obsessive focus on single transactions. Private equity is not about diversification within a portfolio: it is about building a collection of positions, each of which standing on its own and actively managed to create value. Asset managers for their part are mostly punting on assets, trying to assess them the best they can and then counting on the power of diversification to generate interesting results. For a private equity manager, diversification is a non-starter: they bet the house on each and every deal, and will dedicate the resources to make them shine. Yes, there will be losses, and when a deal has clearly reached a point of no return, private equity managers will turn into merciless cullers. They will not lose another dollar or another hour of their precious time trying to salvage what is clearly a “goner”. This discipline of the deal is fundamental to the success of the recipe. By bringing to bear the full power of incentives and empowerment onto a single deal, they demonstrate that “dilution” (of incentives, perspective, focus, etc.) is the curse of the corporate world. Private equity portfolios are not portfolios by any stretch of the mind: they are collections of individual assets that are managed as such. And there lies another key to their success.
Strategy is cheap; operationalizing is key
The third key building block is the realization that value is created not out of some grand strategy but instead in the meticulous implementation of an internally consistent operational plan. Private equity managers often have backgrounds in strategy consulting, because being able to identify a strategy to leverage assets is a good starting point. But that’s all it is: a starting point. To a large extent, a strategy is about as good as any other, or put in other words, having a strategy is definitely better than not having one. What matters in a strategy is not the strategy itself, i.e. the macro plan, but the internal consistency of its operational components. The strategy consultants that managed a successful move to private equity (many did not succeed…) are those who believed and enjoyed putting the plans into action. Consulting can be the most frustrating professional experience since you rarely get to implement, i.e. you do not really get to live the impact of the recommendations. Private equity puts its money where its strategy mouth is. For some of consulting brightest minds, the attraction of operationalizing the plans is just too much to resist, in particular when the incentive plan allows them to capture a big chunk of the value they have hatched.
Alignment brings cohesion
The fourth key building block is the alignment of incentives along the complete value chain. By alignment of incentives, we refer to a strong performance discipline that percolates through the system at all levels. General Partners are strongly incentivized to deliver performance to their Limited Partners, and the management teams in the deals are strongly incentivized to deliver performance to the GPs. Alignment is a tricky balance to achieve, one that is inherently unstable. For example, GPs typically collect income through two major channels: management fees and carried interest. The traditional fixed fee structure tends to create an incentive for GPs to raise ever larger funds and invest them, usually at the expense of their ability to find quality deals. The potential benefits of the carry quickly end up overwhelmed by the size and certainty of the management fee which, although never conceived of as an incentive per se, often turns into the dominant form of compensation for fund managers. Recalibrating these two constituents is a must to keep the LP and GP interests aligned.
Flexibility as strategic value
The fifth building block to be considered is the flexibility built into the private equity system. This is one of the most interesting areas to investigate because it is also one of the most misconstrued by the popular press, in an era more concerned with governance than with performance. The private equity industry has always been characterized by its extreme flexibility and creativity. Fund mandates are always loosely defined and give a lot of latitude to GPs to capture emerging opportunities. New funds are launched on a dime to capitalize on new markets and strategies. The speed at which this industry matures is a reflection of that flexibility as well, i.e. its ability to discover and capture the value in emerging niches. In a world where globalization has brought, not a standardization and reduction in volatility but very much the opposite, i.e. more risk and more rapid changes, the value of flexibility has increased dramatically, and private equity is perfectly positioned to respond to those changes.
Carrots and sticks: the value of discipline
So far we have focused on the “positive” externalities, i.e. arrangements that reward or incentivize superior performance and results. But a comprehensive and dynamic system should also include solid negative feedback loops, i.e. penalties for non-performance. These “disciplining devices” are as important as the incentives, but they would never deliver performance on their own. A number of tools are used to establish strong discipline. First, there is the use of limited lifetime vehicles for the funds. This forces GPs to periodically “return to cash” and show the real value of their hands, to use a poker analogy. Similarly, this show of hands gives them the ability, or not, to earn the right to manage the LPs’ money for another round. In a world where investments don’t have a natural horizon, forcing a shorter one is a way to indicate that value needs to be created on a shorter calendar. Second, the use of debt and leverage on deals is also a way to impose fixed costs and deadlines on the management teams. But let us not lose sight of the prize: leverage by and of itself does not create value.
Leverage… at all levels
It is not completely accidental that we mention financial leverage only at this point in the private equity recipe. Debt has been both a boon and a curse to the industry. In an early era, back in the early 1980s, the availability of high yield debt to support management buyouts created the ability to create value out of financial engineering, i.e. debt pyrotechnics. Since access to debt was relatively difficult, control over those markets created position rents for a limited number of clever financial institutions and their whiz kids to extract tremendous fee income. But the markets for private equity and sophisticated debt have matured, and with maturity money has become more of a commodity, available to most at competitive rates.
The value of leverage as differentiator and value creator has vastly diminished to the point of being essentially immaterial. Yes, debt still brings leverage and discipline, but both are useless if applied to bad deals. The real estate, banking and public debt crises of 2007–2009, and the subsequent full blown economic crisis, brought to the forefront an interesting philosophical question. The use of debt is effectively incentivized by governments in most countries by the tax deductibility of the associated interest expenses, sometimes with some cap. The very same governments realized during the crisis that individuals and companies indeed made use of that feature to lower their cost of capital, sometimes to the point of putting themselves in financial insolvency. The question is then the following: why did governments in the first place decide to favour the use of debt over that of equity?
Realistically, in a world where safety and sustainability are considered important, governments should be incentivizing the use of equity to finance companies, not debt. In other words, it is equity that should be tax-privileged, not debt. Again, as is unfortunately too often the case, it is the governments and their regulations that have brought upon themselves the very disaster they now want to disclaim… Debt’s role in the private equity value creation formula is limited and a regulatory aberration. The deleveraging of private equity we are witnessing today is probably the best thing that ever happened to the industry, focusing people’s minds on what it always was about, i.e. operational value creation through bottom line improvements.
The cash flow paradox
Another negative externality that cannot be escaped is the inherently difficult pattern of cash flows in the typical fund. For investors used to making “investments”, the principal of commitment and progressive drawdowns in parallel to distributions is but an absurdity. It would seem to make so much more sense to just commit and allocate all capital upfront and collect at the end. But that would create a number of issues. First, because of the unpredictable timing of all key events (investments, recapitalizations, exits…), the capital allocated would likely remain unused in the fund for long periods of time. Second, and a direct consequence of the first, the reported internal rates of return (IRRs) on the investors’ capital would necessarily be affected by this pattern. Third, it would eliminate the discipline of the periodic drawdowns.
Most funds include covenants that allow limited partners to stop contributions (also known as no-fault divorce clauses) if a majority of them lose faith in the investment abilities (or simply approaches and strategies) of the fund’s GPs. This “option to stop contributions” in itself is valuable as an inter-fund intervention mechanism, allowing investors to potentially cut their losses. Finally, the inherent illiquidity of the positions makes it illusory to ever expect to smooth out the pattern. Even listed private equity vehicles have shown the limit of trading the claims, with often massive variations shown in their prices above and below the calculated net asset values. Private equity is illiquid and will remain so. As such, it can only be incorporated in an investment portfolio by investors who have the capacity to handle the complex cash flow pattern.
The buy-and-sell approach: capitalism on speed
Finally, it is important to stress the value of the buy-and-sell approach that is said to characterize private equity as investors. It is fundamentally different from the traditional buy-and-hold approach a-la-Warren Buffett. Buffett was once quoted as saying that his favourite holding period for an investment was “forever”, and that is very much the way many investors still operate. And there is nothing wrong with that business model, except maybe its disconnection from a pressing deadline to meet. Private equity to a large extent is capitalism on speed: by providing tight investment horizons, it forces a quick realization of the value potential. Is this better than what could be achieved through a buy-and-hold approach? Probably not, but it achieves results faster. And in a world where uncertainties are increasing, not decreasing, having a tighter timeframe for value creation is probably ever more important.
Believers, sceptics and cynics
As will become obvious in the following chapters of this book, we can best be described as fundamental believers in the potential of private equity as value creator. At the same time, experience has taught us that every sophisticated system operates on the basis of a finally tuned arrangement, wherein minute changes can lead to catastrophic consequences. In other words, the difference between performance and failure is often linked to apparent details, especially when dealing with people skills. Private equity is no different: it is an asset class that requires extreme sophistication and dedication (not to mention, of course, caution) to extract its essence. It is both exciting and elusive, as demanding as it is rewarding. But equipped with a fair dose of scepticism and a realistic sense of criticism, it is possible to turn private equity into an indispensable asset class for many investors.
Notes
1
Gompers, P. A. and Lerner, J., “The Venture Capital Cycle”, MIT Press; Cambridge, Mass, 1999.
2
Demaria, C., “An Introduction to Private Equity”, Wiley, 2010.
1Private equity: from “alternative” to “mainstream” asset class?
Executive summary
Every day one reads about the latest private equity threat to a corporate icon. Some lament these threats, while others rejoice that at last an independent force has come in to shake up some lazy corporate assets. Private equity has been around for decades. However, in the years before the 2008 financial crisis, private equity funds gained the power to take on virtually any corporate target they chose. Some became household names—Kohlberg Kravis Roberts & Co. (KKR), Carlyle, and Blackstone from the US, Apax, Permira and CVC in Europe—just the most glamorous among the thousands of private equity funds in operation around the world. The trillion-dollar industry was bound to make some waves when it jumped into the corporate pool…
Whilst the basic principles of private equity have been around for a long time, the explosive growth of the industry is a relatively recent phenomenon. And with size comes a comprehensive “coming of age”, including a broader geographic coverage. While the US remains by far the largest market, some Asian markets are gaining in popularity, with their share in global fundraising expected to reach 20% soon.
As deal size increased, the very large transactions caught the attention of the media, politicians and regulators. Inconsiderate compensations started to generate popular resentment and attempts at regulation in many countries. The tax treatment of the general partners’ carries received a lot of attention, with their capital gains status questioned in face of the limited capital exposure by fund GPs. The use of tax-advantaged jurisdictions for the funds and special purpose vehicles for the deals fuelled the suspicion that private equity managers considered themselves somewhat exempt from greater social responsibilities, at a time when everyone was being asked to tighten their belt. A general move towards more transparency in all aspects of the financial world also put pressure on private equity to provide more disclosure.
All these signs in effect indicate an asset class that is slowly graduating to the mainstream and can no longer pretend to be “different”.
Like many of man’s greatest inventions, such as dynamite, private equity can make a great contribution to an investor’s portfolio when the basic investment rules are properly applied, and can turn into a rather explosive nightmare if put to uncontrolled use. In other words, private equity can be at the same time the best and the worst the world of assets can offer…
“Private equity” earned part of its alternative credentials because of its cherished confidentiality and privacy. As one of the most exclusive clubs, where price of admission into the best partnerships runs easily in excess of $25 million, with few if any regulatory authorities to report to until very recently, the industry was keen to maintain an aura of secrecy that helped its cause and reputation. Data on performance, strategies and mechanisms of value creation were hard to find and equally hard to assess since most stemmed from self-reporting to industry trade groups. Academic studies abound but suffer from the same shortcomings, mainly the inability to access comprehensive, unbiased data about funds and investments, especially on their performance.
The press in general also had its gripes about the industry. It shunned institutionalized private equity, preferring to spotlight VC-backed entrepreneurs and their more visible value creation and life-changing innovations. But the sheer magnitude of the industry and its deep penetration in the economic activity of countries makes it impossible for private equity to be ignored.
Moving into mainstream
Private equity has always been classified as an “alternative” asset class, i.e. a loosely defined class of asset which includes all assets beyond the three primary classes—stocks, bonds and cash. In the world of finance, alternative assets may include special physical assets, such as natural resources or real estate; special methods of investing, such as hedge funds or private equity; and even in some cases geographic regions, such as emerging markets. Private equity usually covers investments in companies not quoted on a stock market, i.e. private companies, or sometimes divisions of larger groups, or even investments in listed companies with private capital using a creative combination of equity and debt. Freed from financial and corporate constraints, properly refinanced and equipped with a strongly incentivized and focused management team, these businesses would possibly shine and deliver strong performances. The private equity owners would then sell the company to a corporate rival or take it public, hopefully with great riches for all at the end.
Until a few decades ago, private equity was a small, dark corner of the financial markets that few people had heard of and even fewer cared about. But the recent growth of the industry—before the debt crisis hit in 2008—has been extraordinary, whether measured by the capital raised or the number of funds on the market, as seen below in Exhibit 1.1.
Exhibit 1.1 Annual private equity fundraising
Source: Preqin
This extraordinary growth, according to many observers, makes the label “alternative” not appropriate anymore. In its introduction to the 2007–08 Survey on Alternative Investments, Russell Investments illustrated the new status:
“As interest in alternative investments has grown, and as such investments have become more mainstream, the phrase ‘alternative investments’ itself is beginning to sound like a contradiction in terms. What were once considered fringe investments are now deemed essential components of many institutional investors’ portfolios.”1
Large institutional investors—such as insurance companies, university endowments, pension funds and sovereign funds—have for the most part adopted private equity as a significant component of their portfolio, playing a leading role in the almost $3.2 trillion current assets under management of the entire private equity industry as of June 2012.2 For many, the move has been extremely beneficial: California Public Employees’ Retirement System (CalPERS), one of the largest public pension funds, recently reported that, since its inception in 1990 to December 31, 2011, its private equity programme has generated $20.2 billion in profits.3 Private equity is also a significant driver of returns for endowments, the most documented of which is probably the Yale Endowment Fund. In its 2013 report, the Yale Endowment Fund claimed its private equity investment programme has earned a 29.9% annualized return since inception in 1973.4 The University’s target allocation to private equity, at 31% of assets (June 2013 target), far exceeds the 9.5% actual allocation of the average educational institution, and is expected by the school to generate real returns of 10.5% with a risk of 26.8%.5
