Asset managers shift to private equity from stocks
Track records indicate that private equity broadly defined is one of the only investment styles capable of producing returns that significantly outperform stock index investing. And a recent report from Morgan Stanley and Oliver Wyman notes that with overall asset management fees under pressure faster than expected — due to a shift to low-margin passive stock index investment — traditional managers should rapidly build up in high-margin PE (Blackrock, the world’s largest money manager, has already started). The report predicts that private market assets under management will grow 10 percent annually through at least 2023, “as the mix of public-to-private capital raising shifts and investors address under-allocation.” Bulking up in private equity is all the more pressing given the report’s further prediction that the pool of high-margin actively managed capital for public markets will shrink by over a third in five years. Brace for rapid growth in private equity.
The rise of toehold funds will lead to take privates
With assets these days often more highly valued by private equity than by the stock market — explained in part by a growing consensus that superior corporate governance in PE leads to better returns than stocks (see our page three roundtable) — GPs are increasingly incorporating toehold strategies into existing funds or launching dedicated toehold funds. Toeholds focus on taking minority stakes in undervalued public companies, getting to know management and investors, and convincing them that their most lucrative option, and the best way to grow such firms, is to sell to the fund. It’s a logical progression from the symbiosis that’s developed between stock market activists and PE funds — it just cuts the activists out. If the trend continues, the number of take privates will grow, further shrinking stock markets.
GP stake funds and skin in the game align GP and LP interests
With the average size of funds closing in 2019 at a record $1.3 billion, a jump of 136 percent in four years, it’s become hard for many GPs to make meaningful investments in their own funds. Ensuring a GP has enough invested so that loss hurts is an essential counterpart to GPs sharing in profit. Not having enough skin in the game — the threshold is often 3 percent of total commitments — is a deal-breaker for many LPs.
Average private equity fund size hits a record $1.3 billion.
They also fret that GP stake fund investment weakens aligned interests by cashing GPs out. But more often the stakes, which typically provide rights to management fees but not capital gains, bind interests. They give GPs capital to invest in today’s larger funds and make the GP’s more dependent on profit sharing. Selling GP stakes to fund groups looking to expand their product line can achieve the same goal.
Recycling moves from the margin to the mainstream in secondaries
Based on a Triago study of two dozen secondary specialists and the way they’ve invested successive vehicles raised between 2008 and 2016, it’s evident that capital recycling is now mainstream when it comes to the buying of closed private equity funds. Vehicles raised from 2008 to 2012 used only 8 percent of capital for repeat purchases. For vehicles raised between 2013 and 2016, 19 percent was similarly recycled. It’s rare for recycled capital to be used for more than two deals. Managers can usually only recycle capital from investments that have been realized within two years. In a marketplace characterized by high prices (see page one table), recycling is another means to leverage returns, similar to loans, deferred payments and preferred equity.
Secondary market turnover shows plenty of room for growth
Global private equity broadly defined, encompassing strategies focused on real assets, credit and venture capital, as well as buyout and growth, has $5.8 trillion in assets under management. With secondaries likely to post peak annual volume of $90 billion this year (more context on page two), secondary turnover is also set for a record, measured as a percentage of private equity assets under management. Yet at the expected rhythm, turnover will still only amount to slightly less than 1.6 percent of AUM. Given the welcome liquidity the secondary market provides for an asset category that’s otherwise difficult to exit, we expect to see turnover rise for years, slowed somewhat by the rapid growth of primary PE investment.