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Curatia Analysis for Wed, Sep 11

As Markets Totter, Sustained Private Equity Boom Expands Funds’ Power

Despite growing concerns that equity and fixed-income markets may have peaked, private equity appears primed to continue its extended run of good fortune for years to come.

That optimistic outlook has given private equity firms leverage, so to speak, in negotiating investing and deal terms — a trend that is redrawing the contours of the industry.

Fees

Along with electronification and, increasingly, AI, fee compression has been one of the tectonic forces reshaping the financial landscape over the last decade. The rise of passive investing has halved asset management fees. Hedge fund struggles have eroded the 2-and-20 model.

But years of sustained success have largely exempted private equity from that trend. Fee margins remained flat in H1 2019. And a 5% contraction in recent years is attributable mainly to “a bigger focus on credit funds” and fund manager concessions in exchange for larger capital commitments.

In spite of the industry’s trend-bucking fee stability, appetite for private equity investing remains robust. A recent Preqin survey revealed 40% of investors plan to increase private equity allocations over the next twelve months — a sizable jump from last year’s 29% figure.

As a result, funds are exploring new ways to exert pricing power to boost margins. A recent Financial News piece argued the days of free co-investments, in which PE firms choose limited partners to invest alongside them in a deal, “are numbered, or already over.”

With the value of co-investment deals having more than doubled to $104B from 2012 to 2017, raising fees from the current 0.5-1% range to 1.5-2% could yield significant revenue for PE firms.

Deals

Changing co-investing norms are just one of the ways in which the contours of private equity dealmaking are changing. Despite continued growth in dry powder, which ballooned from $400B in 2012 to $732B as of June, fund managers have remained selective in choosing buyout targets.

Deal volume declined 13% in 2018. At the same time, total buyout value jumped 10%, significantly boosting average deal size. That metric continued to grow in Q2 2019, with deal value falling 4% YoY while volume fell 11%.

Funds have also grown gunshy about exiting investments of late, with Q2 exits falling 34% YoY. In particular, they’ve “‘shift[ed] away from IPOs as an exit strategy,’” EY associate director of private equity Peter Witte said. IPOs fell 29% YoY in Q2.

The combination of private equity prosperity and dwindling IPO activity more generally has also prompted funds to expand their reach by targeting growth investments in the technology firms that are staying private longer.

Carlyle, for example, recently took a majority stake in HireVue, which uses AI to help firms make hiring decisions — part of a $30B push into global tech, media and communications by the PE giant. Blackstone is reportedly building a growth-focused platform as well.

By leveraging its success to secure more favorable terms with limited partners, boost average deal sizes, and expand into growth capital and the tech sector, the private equity industry has thus positioned itself more favorably, creating what it hopes will be a virtuous cycle.

Pushback

Growing industry clout has garnered pushback in various forms, however. In a recent Preqin survey, 64% of limited partners said management fees were “a key area of misalignment of interest in the private equity industry.”

In addition, volatility and recession fears have prompted leveraged loan investors to seek stronger covenants on the loans PE funds use to finance buyouts — a sharp reversal from earlier in the year.

But the biggest threat to expanding private equity clout arguably comes in the form of indexing.

Firms like DSC Quantitative Group are forging index funds to replicate the performance of private equity as a whole, giving investors access to the industry’s beta at lower cost and without PE funds’ “illiquid and opaque portfolios.” DSC calculates its PE Buyout index returned an eye-popping 17% annually between 1996 and Q3 2018.

Should they grow in popularity, such funds could one day pose an existential threat to private equity’s fee model — and even to the industry as a whole. That outcome would be ironic, since it could in turn wipe out PE index funds themselves by giving them nothing to track.