Cultivating Alpha

Editor’s Note: As a consequence of a kind invitation from George Barker, CAIA, I recently had the opportunity to meet several chief information officers within some of the largest PE shoppes. While our event sponsor Salesforce is primarily in the CRM business there was nothing salesy about this discussion, although it became very clear just how important it is to know your client. That axiom should never fall out of favor, but it is particularly acute at the current state of the union within the private capital space. The following piece is a compilation of thoughts centered around why KYC is not only a law, but a cultural imperative for the successful GP.

It was over two years ago when CAIA Association published Portfolio For the Future. The authors’ pens were down well before we knew all that 2022 would bring, making many of the observations particularly prescient. Of evergreen note, was the contributed piece entitled Dependent on Operational Alpha written by Ashby Monk. While that essay focused on the investor (LP) finding an edge, a similar analogy applies to the GP as well.

There are “structural advantages” that come with the large and global PE organizations. They have longevity of track record, a relationship advantage with the most sophisticated LPs, and the ability to attract the very best talent to source the highest-potential deal pipeline. Perhaps most of that comes down to stating the obvious, but it is the “cultivated advantages that emerge over time” that can truly define a high-quality firm particularly at this turn in the market.

Before we get into the essence of the latter point, it is instructive to take stock of where we are in the current PE cycle and why an organization may want to cultivate and present a more transparent edge to their client.

The Bain Private Equity Midyear Report 2024 did not disappoint and was replete with some compelling facts about the current state of the union. Some simple math on Figure 8 on page 9 therein shows that $6.8T of global private capital was raised from 2017-2021, as we approached the 2022 reckoning. That cumulative total was just shy of two times what was raised in the previous five years, and that level of expansion requires an even bigger exit window. When said window shrinks (or closes!) it begins to resemble the woes of a Cape Cod homeowner who added three additional bedrooms and forgot to expand the septic system (been there, done that!).

The capital raised has a certain velocity until it finds resistance. $3.9T (one quarter of which is in buyout funds) has come to rest in the dry powder bucket, and another $3T sits invested in 28,000 portfolio companies (half of which have been held for 4 years or more). Forecast consensus for a reopening of the deal (exit) market seems to lean toward late 2024 but more likely 2025 or beyond. As an expected consequence, annualized fresh global capital to be raised in 2024 is forecasted to be a much skinnier $1T which brings the beginning part of this pipe back to 2016 norms. Most would agree that is a good thing, as we look to restore proper throughputs for all of the industry plumbing.

Bain makes the point that the quality assets have already traded and what is left will require some work. Margin improvements will need to supplant the typical playbook of multiple expansion at a time when the average buyout fund is now carrying double the amount of portfolio companies versus a decade ago (see Figure 5).

The client has questions and now is the time to burnish your cultivated edge. The average LP has been cash flow negative since 2019 with a turnaround prior to the end of 2025 unlikely. They have boards to whom they report and beneficiaries that have (contractual) expectations that cannot be met with negative cash flow. The end of the Bain report is a bit of a suggested playbook about ‘adjusting to a new normal.’ The ability to proactively speak to your clients with real-time, data driven facts, while understanding their pain points, will be today’s cultivated edge, and perhaps an ongoing structural advantage for your brand and your firm.

On a final note, our friends at ILPA just came out with some guidance on NAV-Based Facilities but a recent article on that same topic shows us why transparency can be so elusive… be like Ernie and curate like nobody’s watching; it will mean a lot to your client and your brand, and THAT is a structural advantage!

Seek education, diversity of both your portfolio and people, and know your risk tolerance. Investing is for the long term.