The Condition of the Private Equity Paradigm
By: James S. Still
As private equity reaches the golden age of 20 plus years as an important component of an investor’s alternative investment class, a combination of the recessionary economic climate, cash constrained limited partners, and a dormant capital market create a challenging set of conditions. The fundamental question is how the PE model operates under these set of historically unique conditions. At MainStream, we posit four major issues confronting the industry.
Unlike many capital sector markets, including the public markets, the availability of capital remains uniquely high. Experts believe that $400 - $500 bb of committed capital is at the disposal of the PE community. We believe this figure to be misleading, however, as cash constrained LPs struggle to meet the cash and return needs of their organizations. For PE firms, discretion in the use of precious LP capital will be critical.
The longevity of the PE community has provided the opportunity for concrete long-term performance analysis. According to McKinsey, less than 25% of PE firms have achieved a return greater than a traditional index fund performance over the past ten years. Our view is that discerning LPs will limit investment into new funds and concentrate capital in larger, well-established PE firms. Alternatively, we believe that investment into new technologies, such as environmentally oriented companies, will become an increasing concentration for LPs.
The relatively dormant public market climate for IPO and secondary offerings combined with the slowdown in the M&A markets creates a challenging time for PE firms to value their existing portfolios. Setting aside the inability to “mark to market” at reasonable current market valuation levels, the overall lack of liquidity in the markets renders portfolio valuation difficult. This should be viewed, however, as a temporary concern for PE firms as the M&A and public capital markets cycles turn over the next 18 months.
In our view, the principal challenge facing PE is the operating performance of portfolio companies in this recessionary climate. PE firms have historically been strong in providing operating expertise and strong management to portfolio investments, a differentiating factor that has distinguished the strong from the weak in terms of financial performance. In this particular cycle, those firms that are able to leverage their operating expertise and background will be able, over time, to preserve and create shareholder value at levels significantly higher than their counterparts. In doing so, they will distance their firms increasingly as compared to the weaker performing funds, creating industry consolidation and a significant reduction in the number of competitors in the PE community over time.