Q: There was widespread fear that 2005, 2006 and 2007 PE vintages would be severely strained by their costly portfolios once the recession hit. As we’re now seeing, even pre-crisis funds are distributing significant capital back to their investors, and many are turning in profits. In your view, what does this rebound say about the PE industry?
A: We are seeing that the PE model has survived and thrived in the years since the Global Financial Crisis. Investors who have stuck with their GPs are being rewarded when those GPs are able to fully monetize their portfolios. Of course, there were valid questions raised in the months and years following September 2008 about the underlying mechanics of PE funds, and valid issues have been raised about the right “balance of power” between GPs and LPs. However, the mission statement – and ultimate justification – for PE remains what it has been since the 1970s – namely, the ability to deliver superlative returns.
As an asset class, PE withstood the crisis and recession remarkably well, and in a way is being rewarded by LPs with big fund commitments. Do you think PE can handle the weight of all the money that’s coming in, and still post market-beating returns in a reasonable timeline?
The question of “too much, too soon” has vexed fund managers (including GPs of PE funds) since the very beginning. The question of how much money to take in a particular fund must be analyzed and answered based on the very specific facts relating to the GP team, the industry sectors and geographic regions they will focus on and their ability to secure unique deal flow. The temptation will always be there to simply accept every dollar on offer, but the better GPs will map out a very clear path from the current successful fund launch to the successful launch of their next fund. And that next fund launch will only be successful if the performance of this fund is strong.
Relatedly, can PE continue to post outsized returns if more firms and more attention come into the picture? Phrased another way, as PE becomes more institutionalized and more crowded as an asset class (compared to the Wild West days of the 80s and 90s), will returns be negatively impacted by a more structured, competitive marketplace?
Competition is good in financial markets, from the perspective of both particular investors and individual PE professionals. The strength of the industry in recent decades has been relatively low barriers to entry and a clear path that allows a start-up GP to get into the game and demonstrate the strength of its investment team. This dynamism is crucial to the future strength of the industry and should be encouraged. Of course, witnessing the institutionalization of the leading players is a perfectly understandable consequence of the track record of success, but individuals within all PE firms are motivated by their personal success and having the freedom to eventually set up on their own and see their name on the door is a powerful driver.
According to our KS PME Benchmark, PE handily outperformed the Russell 3000 Index for several years prior to the crisis. Beginning with the 2007 vintage, however, the public markets have provided better absolute returns for investors. Why do you think this is?
Aggregating the performance of fund managers is always a tricky business, regardless of asset class. I think the better perspective focuses on the top tiers of performers who have been able to demonstrate consistently high performance over time. These will be the GPs that deliver the high returns that investors require, as they have in their teams the individuals with the demonstrated talent to make the best investment decisions.
Related to the prior two questions: PE firms adopted more value-creation approaches (like ‘buy and build’) after the recession hit. Even as the economy has recovered, it’s hard not to notice that recent returns haven’t come close to matching pre-crisis returns. Is this a new normal for PE – a focus on less lucrative but more normalized investment strategies?
It is the promise of high returns that have driven the industry since “Day One.” Therefore it is very important for GPs to send a clear message to their investors about return expectations. Again, it may be more useful to look at the ability of consistent performers to deliver above-average returns then to aggregate together an industry in which individual talent plays such a crucial role. In the past, successful PE firms have been able to deliver lucrative returns in a variety of different market environment. Investors will continue to demand this going forward.