Barbarians at the exit?
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Thirty-five years ago, Kohlberg Kravis Roberts acquired RJR Nabisco, thrusting the private equity industry into the spotlight. The $25bn Nabisco deal, immortalised in the bestseller Barbarians at the Gate, remains iconic, however, over fifteen years, mounting tobacco risks and escalating debt costs had ultimately lost KKR $730m.
Despite this loss, almost every major institutional investor in the world is now investing extensively in private equity. Every CEO of Norges Bank Investment Management (NBIM) has at some point asked if they can invest in private equity, but been turned down every time. In its annual white paper, the $1.6tn Norwegian sovereign wealth fund cited the concentration of listed companies dominating the equity market and the potential for higher returns in private equity over the long term compared to listed equities. With fewer IPOs in developed markets, the companies coming to market are larger than before, which suggests that NBIM is missing out on part of companies’ growth by not investing until after they have been floated.?
Ludovic Phalippou, currently a Professor of Financial Economics at Oxford, first began publishing his findings on IRR methodology in 2008. The deconstruction of the flaws in the calculation of IRR, which is commonly used to measure the performance of private investments, would eventually become one of Phalippou’s major contributions to academic research. Either way, he exploded on the scene in 2020 with an incendiary and blockbuster paper titled “An Inconvenient Fact: Private Equity Returns & the Billionaire Factory,” which laid out how the private equity industry has created massive fortunes for the owners of private equity firms. Phalippou calculated that the $230 billion these owners earned in performance fees on funds raised between 2006 and 2015 alone had created 22 multi-billionaires by 2020 – up from three in 2005. Private equity’s beneficiaries are primarily the industry insiders, he argued. Christopher Ailman, the current investment head of CALSTRS, similarly recently concurred, arguing that executives in the private equity industry weren’t sharing the wealth they generate with the workers of acquired companies.?
According to Cliffwater research, private equity performance was very weak in 2023, returning only 0.8% compared with 17.5% for equities. This downturn has triggered concerns of an overallocation to private equity, posing a challenge for the industry.
Blackstone acknowledges that the process required for private equity firms to liquidate their record amounts of unsold assets and deliver on promised returns and distributions will be prolonged, despite the resurgence of mergers and acquisitions. “I think we’re still in the early stages of the recovery phase that will ultimately allow private equity investors to return capital. It doesn’t happen overnight” Jonathan Gray, president of Blackstone, told the Financial Times. Private equity firms anticipate that declining interest rates will stimulate deal activity, facilitating the disposal of $3tn worth of unsold private company investments, over 40% of which have been held for more than four years. This, in turn, will enable them to fulfil their commitments to large pension funds that are currently over-exposed to unlisted investments and are scaling back on new private market investments.
Private equity-owned businesses are now struggling, partly due to inadequate hedging against interest rate rises for the debt used to finance buyouts. With rates on the rise, companies are facing higher loan repayments and increased costs in servicing their debt. "There was relatively little interest rate hedging by private equity firms for their floating rate debt and now that rates have gone up, debt servicing costs have more than doubled over the past year and a half," explained Paul Goldschmid, partner at investment manager King Street.?
Private equity firms are adapting to market challenges by increasingly opting for a deal-by-deal fundraising model, aiming to mitigate the pressure of a downturn and address investor demands for reduced management fees. Data from advisory firm Triago reveals a staggering $31bn deployed by deal-by-deal investors last year, defying the industry's broader fundraising slump and marking a more than fivefold increase from 2019. This approach resulted in the acquisition of over 700 companies by private equity, more than double the figure from five years prior. The deal-by-deal approach offers investors an attractive alternative, often featuring lower, tailored management fees. However, dealmakers may negotiate for a larger share of profits upon exit. Despite this, investors appreciate the transparency of knowing precisely where their capital is allocated from the outset of the investment process.
In 2023, the industry raised a total of $803bn marking the lowest amount since 2017. Furthermore, dealmakers have encountered difficulties in identifying attractive new opportunities amidst a higher interest rate environment, resulting in a significant accumulation of 'dry powder', totalling $4tn of uninvested client funds.
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Another amendment to the traditional private equity approach is the semi-liquid buyout fund. This investment vehicle aims to make private equity available to smaller investors, with investment tickets as modest as $25,000. Three funds have been launched of late. Blackstone’s BXPE, managing $1.3bn as of January, joins the ranks of KKR’s K-Prime and Apollo’s AAA, both of which allocate a portion of their funds to buyout strategies. Collectively, these funds amassed approximately $5bn in 2023, as noted by Tim Clarke at PitchBook. Whilst this sum pales in comparison to the $73bn raised for retail-oriented funds in the previous year, according to investment bank Robert Stanger, it represents a significant step towards broadening participation.
A significant evolution in private equity is the transition towards a buy-and-hold strategy. Whilst acquiring distressed companies for rapid restructuring and resale was once a profitable approach in an era of cheap debt, the landscape has shifted. With fewer distressed opportunities available and escalating leverage costs, private equity firms have pivoted towards Warren Buffett's ethos of retaining exceptional businesses with strong management teams.
This shift in strategy has spurred the rise of evergreen funds, which diverge from the conventional closed-end fund model by not committing to capital returns within a specific timeframe. Over the past five years, the number of these funds has doubled, collectively representing $350bn in net asset value, as reported by Preqin. However, their focus remains largely on real estate, private credit, or buyout strategies that leverage existing traditional funds. Despite this concentration, there is optimism within the industry that evergreen funds will eventually mature into a distinct asset class.?
The dearth of M&A and IPOs keeping managers from returning cash to their limited partners, and LPs unwilling to commit new money to funds due to the denominator effect, may trigger a wave of consolidation in the industry. According to data from Preqin analysed by Bain & Company, the funds attempting to raise $3tn from investors will only raise $1tn.
More ominously, that crunch could affect the viability of some private capital managers. According to data from McKinsey, the 25 most successful fundraisers collected 41% of aggregate commitments to closed-end funds (with the top five managers accounting for nearly half that total). Closed-end fundraising totals may understate the extent of concentration in the industry overall, as the largest managers also tend to be more successful in raising non-institutional capital.
While the largest funds grew even larger, smaller and newer funds struggled. Fewer than 1,700 funds of less than $1bn were closed during the year, half as many as closed in 2022 and the fewest of any year since 2012. New manager formation also fell to the lowest level since 2012, with just 651 new firms launched in 2023.
One industry veteran, Partners Group, says that a broader shift is accelerating. According to Partners, the industry will contract to just 100 “next generation” firms. While industry consolidation is a natural progression for maturing sectors, the key question remains whether asset allocators will be content funnelling capital into a select few managers.
For real estate too, whilst managers faced one of the toughest fundraising environments in many years the largest managers fared best with the top five managers accounting for 37% of aggregate closed-end real estate fundraising. In April, the largest real estate fund ever raised closed on a record $30 billion. As McKinsey highlights, real estate underperformed historical averages in 2023. Closed-end funds generated a pooled net IRR of ?3.5% in the first nine months of 2023, losing money for the first time since the GFC. In aggregate, the average pooled lifetime net IRRs for closed-end real estate funds from 2011–20 vintages remained around historical levels (9.8%). And thought global deal volume declined 47% in 2023 to reach a ten-year low of $650 billion, the tide seems to be turning. According to data from Colliers shared with React News, private equity investment accounted for 11% of the office purchases in London year to date, as well as a quarter of deals that are currently under offer. The figures show that private equity has increased its market share year-on-year; accounting for 4% of purchases during 2022 and 6% last year.
John Kay in his book “Other People's Money: Masters of the Universe or Servants of the People” which was shortlisted for the 2016 Orwell Prize, writes that “when private equity funds are good they can be very, very good; but when they are bad, they are horrid.” He talks about his experience of ‘the private equity hotel,’ “whose overpriced breakfast and scuffed paintwork indicate the priorities of the management or with the current profits rather than future custom. This disappointing customer experience is the characteristic result of a transaction in which the private equity manager buys the asset, loads it with debt, pushes up earnings temporarily and places the asset back in a public market within a relatively short period of time.” This is an unfair characterisation of private equity. Identifying mismanaged and underperforming, or more colloquially in our sector, underpriced assets, and turning them around for a profit is precisely what makes returns so robust and keeps investors captivated. The moral of the story is not that the Government of Norway has rejected their SWFs foray into private equity, it's that NBIM have requested umpteen times. Besides, as we’ve demonstrated, the traditional private equity buy-to-sell model is outdated. The Barbarians are not heading for the exit; they've just been mastering new ways of unlocking the gate.?