Private Equity Unchained: Strategy Insights for the Institutional Investor

Private Equity Unchained

Also by Thomas Meyer

BEYOND THE J-CURVE (with Pierre-Yves Mathonet)

J-CURVE EXPOSURE: Managing a Portfolio of Venture Capital and Private Equity Funds (with Pierre-Yves Mathonet)

MASTERING ILLIQUIDITY: Risk Management for Portfolios of Limited Partnership Funds (with Peter Cornelius, Christian Diller and Didier Guennoc)

Private Equity Unchained

Strategy Insights for the Institutional Investor

Thomas Meyer

LDS Partners, Luxembourg

© Thomas Meyer 2014

All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission.

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First published 2014 by

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ISBN 978–1–137–28681–9

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Meyer, Thomas, 1959–

Private equity unchained : strategy insights for the institutional

investor / Thomas Meyer.

    pages cm

Summary: Until recently, strategy played little meaningful role in the management of illiquid investments, and what many investors call ‘strategy’ has been more akin to ‘tactics’ or ‘learned reflexes’. Even large institutions still appear to manage their private equity allocations on such a case-by-case basis. But the environment has changed and returns are no longer ‘assured’ as they once were. Private equity and other illiquid asset classes have matured, as more players seek to deploy ever larger amounts in a market where opportunities necessarily become difficult to identify and access. The few principles that institutional investors have relied on up to now have been anchored in a less competitive past. Private Equity Unchained deconstructs existing practices and provides insights into how to think strategically about illiquid asset allocations. In order to thrive in markets characterised by extreme uncertainty, investors must first accept the limitations of what is knowable. This begins by leaving behind many of those financial theories that institutions normally cling to as a safe harbour for managing risk. Once divested of such false comforts, investors will be in a position to identify their real options and take an active and strategic approach to alternative investing — Provided by publisher.

ISBN 978–1–137–28681–9 (hardback)

1. Private equity. 2. Corporate governance. 3. Portfolio

management. I. Title.

HG4751.M4 2014

332.63—dc23                 2014023172

Contents

List of Figures and Tables

Acknowledgements

1  Introduction

2  A Neo-Classical Asset Class

3  The ‘Repair Shop of Capitalism’

4  Strategy Challenges

5  Strategic Asset Allocation

6  The Sky is Not the Limit

7  The Limited Partnership as Part of Humanity’s DNA

8  Do-It-Yourself?

9  Economics of Private Equity Firms

10  Objectives

11  Performance Persistence

12  Nobody Knows Anything

13  Spreading Risks – Thinly and Thickly

14  Private Equity Risk

15  Performance Measurement

16  The Galapagos Islands of Finance

17  The Locust and the Deep Blue Sea

18  Don’t Confuse Transparency with Intelligence

19  Spreading Risks – Part II

20  Open-Ended Relationships

21  Hard and Soft Power

22  Real Options

23  No Plan Survives

24  The Heavy Hand of Regulation

25  Private Equity Unchained

Notes

Bibliography

Index

Figures and Tables

Figures

3.1  Private equity as arbitrage

6.1  Commitments to private equity by large institutional investors

8.1  Institutional investing in private equity

8.2  Concave relationship between fund size and performance

8.3  Concave relationship for portfolio of funds

8.4  Direct investments vs. investments through funds

9.1  Incentive trade-off

9.2  Subsequent funds drive private equity firm’s economics

13.1  Risk profile of private equity

13.2  How much diversification?

13.3  Diversification of capital calls (schematic)

14.1  Private equity risk model

14.2  Probability of fund closing depending on deviations from standard practices

15.1  Development of dedicated resources

17.1  Taking positions in the fitness landscape

17.2  Managing the balance between growth, survival / exploration, exploitation / time horizon and slack resources

17.3  Explore, observe, amplify and exploit

18.1  Cost of data for superior decision-making

19.1  Classification and exposure to risk factors (simplified examples)

20.1  GP/LP relationship lifecycle model

20.2  Managing portfolios of relationships

23.1  Private equity programme value chain

Tables

19.1  Diversification dimensions

Acknowledgements

Finishing a book is like returning home after having climbed a mountain. Looking at the completed script is an anti-climax and one wonders how one embarked on this journey in the first place. To a large degree this book builds on previous publications over the last ten years, so the thoughts expressed here are the result of the cooperation and discussions with the co-authors of these works: Peter Cornelius (AlpInvest Partners), Christian Diller (Montana Capital Partners), Didier Guennoc (LDS Partners) and Pierre-Yves Mathonet (ADIA). In this context I must also thank Yasuharu Hagi (MCP Group) and Kazushige Kobayashi (Capital Dynamics).

Many ideas stem from the advice and conversations with other industry practitioners. I could list many people with whom I discussed the concepts explained in this book, but I at least should mention Guy Fraser-Sampson, Elias Korosis (Hermes GPE), Hal Morimoto (Astoria Consulting) and John Renkema (APG).

I am extremely grateful for the support of my colleagues Philippe Defreyn (LDS Partners) and Jobst Neuss (European Investment Fund) and for the help of Tim Jenkinson (Professor of Finance, Director of the Oxford Private Equity Institute and head of the finance faculty at Saïd Business School, University of Oxford). I particularly thank Ross Butler (JRA Butler) for his critical review and his help in improving earlier versions of the manuscript.

I also thank my endorsers, Colin Mayer (Peter Moores Professor of Management Studies at Saïd Business School, University of Oxford), Georges Sudarskis (Sudarskis & Partners) and Robert van Zwieten (Emerging Markets Private Equity Association).

Acknowledgements would not be complete without expressing my gratitude to Peter Baker, Gemma d’Arcy Hughes and Jamie Forrest at Palgrave Macmillan, without whom this book would never have seen the light of the day. Julie Rowbotham has done an outstanding job as copy editor and Francesca White as leader of the production process.

I reserve the last acknowledgement to my most important supporter: once more, my heartfelt gratitude goes to Mika Kaneyuki, my wife and best friend, who is my strength and purpose in life.

Luxembourg, May 2014

Chapter 1

Introduction

The focus of this book is institutional investment into the private equity market. That is to say, it is concerned with the deployment of capital into the asset class, rather than its investment into specific companies. For our purposes, private equity refers to an institutionalised way of owning a share of a company that is not registered and not publicly traded on an exchange. The process for investing in such financial instruments is not standardised but rather takes place through a negotiated process.¹ It therefore requires a significant degree of sophistication on the part of the investor, let alone the fund manager who will deploy capital.

In practice, this deployment is a search for opportunities in uncertain, under-researched or overlooked niches, where information is proprietary and where there is little or no competition.² It is not for the faint-hearted. The challenge then is how to reconcile these extreme uncertainties inherent in private equity with the needs of institutional investors to define and encompass risks prior to setting out on such a venture. The industry’s structure and particularly the intermediation through funds is, at least in part, a response to these extreme uncertainties.³

It may seem clichéd to say that the lifecycle of such a fund resembles a trade journey into the unknown, but this is much more than a metaphor – the private equity industry’s investment vehicle of choice, the limited partnership, has ancient roots and much in common with traditional ways of financing trade voyages. For instance, medieval Italian merchant families financed trade voyages through ‘commendas’. In this asymmetric relationship the ‘sleeping partners’ (that is, today’s ‘limited partners’) were not liable for debt and stayed at home while the ‘travelling partners’ controlled the venture and set sail to search for profitable business. ‘Travelling partners’ (for which, read ‘general partner’ today) offered skills, experience and the willingness to take high personal risks. At the time of the commenda the high profits were based on venturing across a vast geographical space and there was a concomitant need for trust underpinned by strong alignments of interest.

Centuries later this limited partnership continues to be the structure of choice for skilled and risk-taking professionals to pool funding from wealthy and relatively risk-averse parties for investments in an environment of extreme uncertainty.

Purpose of this Book

This book is primarily written for investment professionals who are already familiar with the key concepts of private equity. However, this is not about the next level of technical detail, but rather how institutional investors can achieve organisational effectiveness in this dynamic and competitive environment. While there have been a number of books published on institutional investment in private equity in recent years, and there is certainly no shortage of books on corporate strategy, there is next to nothing written on strategies for investing in private equity. Meanwhile academia seems far more interested in the deployment of private equity funds and their approaches to value creation and realisation, rather than the initial commitment of capital. Anyone seeking detail on how to develop sophisticated strategies in this area will have been frustrated.

This is also a deliberately un-academic book, because private equity investment is a largely un-academic exercise. The development of an investment strategy involves anticipating and shaping the future, a perspective that is in contrast to that usually taken by academia. Academics seek to understand how and why things work, which is mainly by looking at existing and therefore backwardlooking data. Their financial models may give good explanations of the past but their priority is not necessarily a practical application in the future, particularly when dealing with a highly uncertain subject. Academic results reflect a certain setting, come with a number of caveats, and are thus often contradictory, which make them of limited use for practitioners. In the discussion between academics and practitioners, neither side really understands or even tries to understand the purpose or motivation of the other.⁴

Quick Glossary

When referring to ‘investors’ in this book we normally mean institutional investors and their organisational entity set up for managing private equity investments. These institutional investors either employ professionals as ‘investment managers’ to directly invest in private equity or invest through funds where professional management is provided by intermediaries.

‘Funds’ in a private equity context are usually set up in the form of a limited partnership and are unregistered investment vehicles for pooling capital. Here institutional investors are the fund’s ‘Limited Partners’ (LPs) who commit a certain amount to the fund and do not take an active role in its management. The term ‘General Partner’ (GP) refers to the firm as an entity that is legally responsible for managing the fund’s investments and who has unlimited personal liability for the debts and obligations.

The LPs’ ‘Commitments’ are drawn down as needed. There is little, if any, opportunity to redeem the investment before the end of the fund’s lifetime. A significant part of the capital remains as ‘Undrawn Commitments’ in the hands of the LPs.

‘Fund managers’ are the individuals involved in the fund’s day-to-day management. They form the fund’s management team that includes the carried interest holders, i.e., those employees or directors of the GP who are entitled to share in the ‘super profit’ made by the fund.

There’s No Such Thing as a ‘Good’ Private Equity Strategy

The above statement may seem odd for a book on private equity strategy, but it is important to grasp at the outset. Among private equity fund managers – our ‘travelling partners’ – the concept of ‘strategy’ is often considered abstract and bearing little relation to their business. Indeed most fund managers appear to go without a ‘real’ strategy or confuse strategy with tactics, but are successful nevertheless. It is a corner of the investment world that seems to resist ‘business school’ strategy formulation. One could put this seemingly cavalier approach down to market immaturity. In fact it signals something fundamental about the nature of private equity investment.

Private equity is at odds with most of the rest of financial markets, which depend upon rich datasets, high precision and frequently updated information. In private equity, investments are often made in conditions of extreme uncertainty and, due to the asset class’s illiquidity, decisions are often effectively irreversible.

As an asset class, private equity is competing for funds with other asset classes that appear easier to access, understand, research, monitor and manage. Initially there were few players in an underexplored market that offered rich pickings, now many players have become active with money chasing deals. A few years ago ‘access’ and due diligence were seen as ‘everything’, but now the landscape has become more competitive and these traditional tools often do not lead to the desired outcomes any longer. The institutional learning about private equity investments and improvements of skills in assessing such opportunities have to a large degree been neutralised by increased inflows of capital into the asset class.

Private equity is still under-researched: relative allocations are still immaterial, and regulation is frozen in financial technologies that go back to the middle of last century. While academics claim to have a broad understanding about performance determinants on the level of a fund, significantly less is known about factors affecting how an institutional investor in funds performs. The existing research about investor performance determinants has been described as scattered and contradictory; and studies on how institutional investors in private equity funds can strategically affect performance through defined investment strategies are virtually non-existent.⁵

The thesis of this book is that investors in private equity tend to experiment too little and put too much weight on track record and that they overestimate their skills in evaluating opportunities. Perhaps because of the rich-pickings of the past, LPs still tend to underestimate the value of flexibility and rarely actively look for it.

In addition, where flexibility exists, LPs often fail to exploit it because of operational deficiencies. To be successful in a more competitive but uncertain environment, investors in private equity need to build an investment process that seeks new opportunities and efficiently exploits them by moving as quickly as possible. Here institutions often fail to be sufficiently committed to a private equity programme, and fail to put the necessary organisation, processes and procedures in place to become sustainably successful.

Private Equity Is More Biology Than Physics

Clearly, a step-by-step guidebook with clearly identifiable tasks that can be executed and as a consequence lead to a highly profitable investment strategy is not possible. Rather than with hard facts, we are dealing with a social system and cannot assume that this system obeys physical laws or that there is mathematical logic linking its various parts. More than other areas in finance, private equity escapes the rules of science that could provide the authority with which engineering can proceed. In this respect, private equity investing is closer to a social activity than to science or art, and thus offers parallels to Clausewitz’s characterisation of war.⁶ However, military strategy is an analogy that only applies to some degree. It is rather biological systems that enable growth and survival in a changing and occasionally hostile environment, with a balance between predators and prey that holds useful lessons.

There may be good reasons why ‘strategy’, associated with ‘strategic planning’ and ‘planning’ is not embraced by private equity investment managers. As the key to coping with an uncertain environment is flexibility, any plan carries the danger to take away this hard-fought-for flexibility. Strategy defines the rules, constraints, methods and resources. It cannot be a plan, as this would be too rigid and would quickly become maladapted to an uncertain changing environment. Management theorists like Henry Mintzberg have long argued that emerging strategies are more realistic. On the other hand, investors cannot be too opportunistic, as this often results in herding, essentially having no strategy at all and leading to chaos. Putting day-by-day calculation ahead of mission means that all is tactics but that there is no strategy.

However, it is possible to design and plan portfolios in terms of primary commitments where we are occupying positions in a private equity landscape. Planning aims to minimise search costs, i.e., where to search and how to evaluate opportunities. But one must act opportunistically when managing such a portfolio of positions, i.e., relationships, as it generates options to co-invest or to make secondary deals, or for restructurings, dealing with tail-end situations and fee renegotiations.

Baffling the Boffins

Employees in today’s financial markets would struggle with Aristotle’s assertion that it is the mark of a trained mind not to expect more precision than a subject matter will allow. In institutions that are subject to oversight, and where regulation desires predictability and boards demand an ‘unshakable case’ for investing, it is easier to rely on ‘science’ than to admit to have resorted to judgment as this puts the decision-maker’s career at risk. Conventional business strategies place emphasis upon planning and control. For most managers it seems inconceivable that one can work in any other way. However, putting formalised strategies onto paper will sooner or later give away the fact that you do not know much and have little control about the future. Investment managers may have strong views regarding the future, but why take the risk of exposing yourself by disclosing your thinking? In many situations they are essentially relying on hunches and are unable to describe all the relevant factors. Institutions may trust their investment professionals, but depending on individuals who may or may not be excellent investment managers is an uncomfortable perspective.

As Guy Fraser-Sampson caustically concludes in Intelligent Investing (2013), it is perhaps for this reason that many investors choose not to have an investment strategy: ‘If nobody knows what your objectives are, then nobody can say that you failed to reach them.’⁷ This is not necessarily caused by a lack of decisiveness but it is rather reflecting realism about the future. Despite the assertiveness most investment professionals demonstrate, they may well be aware of the fact that the ability to predict is weaker than most of us would like to admit.⁸ In environments such as the private equity market, which are characterised by extreme uncertainty, actions chosen to achieve objectives cannot be guaranteed to lead to the intended results.

How You Will Benefit

A well framed investment strategy should enable us to identify and achieve an objective with more certainty, quicker or for less cost. These dimensions – predictability, time and costs – are interrelated and not all can be met simultaneously, which is one explanation why there cannot be an ‘optimal’ strategy.

This book is intended to help you define some rules of the game to be followed to ‘deserve’ success in the sense that this substantially improves your chances, but by no means guarantees success.⁹ It is like in chess, where an understanding of the rules, the notation and even memorising the big games of the past does not make you a grandmaster. Nevertheless, it is a start.

Chapter 2

A Neo-Classical Asset Class

Depending on your perspective, private equity investing is either very new or very old. There are repeated examples throughout human history of organisational structures that look remarkably like today’s private equity limited partnership structure and some of which we will analyse in detail later on. Few, if any, have a direct evolutionary link to today’s industry, but they are nevertheless revealing about the nature of private equity investment.

The story of ‘modern’ private equity is very much a post World War II phenomenon and commonly seen as post-1970s. However, even this story is more complex than it seems, and resists the neat evolutionary narrative that is sometimes attached to it – for instance, from junk bond raiders to mega buyout funds say. What follows, therefore, is not an industry chronology but a reassessment of the classic ‘story’ with the goal of enabling a clearer analysis of the fundamental nature of private equity and its long-term cycles.

The Modernist Narrative

David Rubenstein, the co-founder of the Carlyle Group, describes the development of the private equity industry between the mid-1970s and mid-2007 in four different stages.¹ The period from 1974 to 1984 is viewed as the infant industry’s ‘Stone Age’, with small ‘bootstrapped’ deals raised on a transaction-by-transaction basis, with a handful of lenders and largely irrelevant to the financial world.

The ‘Bronze Age’ from 1985 to 1990 saw opportunities arising from the restructuring of bloated US industry, a wider investor base, the junk bond revolution and outsized returns, culminating in KKR’s record breaking leveraged buyout of RJR Nabisco. For the first time the use of leverage drew major adverse publicity.

By the early 1990s, however, the economy slowed and the junk bond market collapsed. Several high-profile buyouts resulted in bankruptcy, and with the development of takeover defences and protections, the leveraged buyouts of public companies virtually disappeared. After reaching a peak in 1989 commitments to buyout funds fell back to the early 1980s level, before slowly increasing again thereafter.²

The ‘Silver Age’ dawned in the mid-1990s after the ‘LBO kings’ had used their relative hibernation for a professional makeover. The industry adopted ‘private equity’ as a new name in an effort at this, and a lower interest rate environment was followed by a dramatic increase in the number and size of deals. Instead of giving preference to incumbent managers in MBOs, corporate vendors preferred to sell large divisions through auctions, leading to an increasing number of investor-led buyouts in the late 1990s.³ Multibillion dollar funds emerged with global investors and lenders and a public pension funds dominated investor base supported many new funds, albeit in an increasingly competitive market.

Buyout activity accelerated after 2002 in both Europe and the US and until 2007 private equity really took off, a period which can indeed be described as its ‘Golden Age’. The private equity industry gained a dominant position in the world with its firms becoming, in the words of The Economist, the ‘New Kings of Capitalism’.⁴ Private equity researcher Steven Kaplan estimates that within a quarter century commitments to this asset class increased by a factor of thousands, i.e., from $0.2 billion in 1980 to over $200 billion in 2007.⁵ Firms became large, sometimes even listed, but with the glamour again came public criticism and political backlash.

Cornelius (2011) added as a fifth period the ‘Great Deleveraging’ since 2008, with less leverage and more equity in deals, smaller funds and smaller deals. Raising money from investors became more difficult and commitments to buyout funds reverted to the levels of ten years before. The ‘Golden Age’ of private equity appears to have given way, to stay with the analogy, to the ‘Age of Iron and Rust’ with increased demands of firms to focus on strategic and operational improvements, the need to operate globally, in emerged markets, and to deal with corporate social responsibility (CSR) as risk management. This period saw losers but also winners, such as private equity firms emerging as the new merchant banks.

The Elephant and the Shrew

Rubenstein’s observations are no doubt shaped by his experiences as a large US buyout investor, and they are commonly held. While this modernist narrative certainly has its fair share of upheaval and reinvention, it is far from the full story. In fact, there was private equity before what he saw as the ‘Stone Age’, and its history since has been more varied.

It was a handful of venture investments in the late 1950s that triggered the development towards what we know of today as private equity. The dawn of modern venture capital was a predominantly American phenomenon, taking place against a backdrop of great social and technological upheaval, the emergence of television, mass communication, massive military expenditures, the space age and computers. Venture capital could be seen as the brainchild of General George Doriot, the pre World War II Harvard Business School professor, who organised the first non-family VC firm, American Research and Development (ARD), as a publicly traded, closedend investment company, subject to the Investment Company Act of 1940.

ARD was a pioneering organisation but with a structure that was plagued by a number of problems and with an ultimately failing business model. It was mainly the intermediation through limited partnerships that fostered a widespread adoption of private equity in institutional portfolios. In the early twentieth century increasingly limited partnerships were used in the US to raise capital for prospecting new oil fields. In 1959, Draper, Gaither and Anderson (later renamed Draper Fisher Jurvetson) adopted this structure and raised what, in all likelihood, was the first limited partnership in the VC industry.

Initially buyouts and venture capital were barely differentiated and many firms now recognised as private equity specialists had their roots in venture capital. Building on his experience of co-running the corporate finance division of Bear Stearns, Jerome Kohlberg, together with Henry Kravis and George Roberts, set up KKR in 1976 and in 1978 raised the world’s first dedicated leveraged buyout fund as a limited partnership based on the venture capital model with a size of just $30 million.⁶ The limited partnership proved to have a better fit with the business environment and could be argued to be the ‘ideal’ vehicle for private equity investing.⁷

Today, the gap between venture capital and buyout investing is filled with every conceivable permeation of private equity – growth capital, mezzanine, and increasingly infrastructure (such as bridges and roads) and real estate funds are argued to be counted as private equity too. In many ways, the differences between these types of investment are great. The target of buyouts are established businesses – generally privately held or spin-outs from public companies – that need financial capital for restructuring and changing ownership. Whereas buyout investors tend to use high levels of debt for buying whole companies, for growth equity they provide financing in exchange for just a share in the company. Venture capital on the other hand provides high-risk, high-reward finance designed for young companies that have different asset structures, cash flows and growth rates than mature companies. The term ‘mezzanine’ generally refers to a layer of financing between a company’s senior debt and equity. Structurally, it is subordinate in priority of payment to senior debt, but senior in rank to common stock or equity. In acquisitions and buyouts, mezzanine can be used to prioritise new owners ahead of existing owners in the event that a bankruptcy occurs. However, it is typically used to finance the expansion of existing companies.

In practice the delineation between the various forms of private equity is not clear cut and there are even overlaps with hedge funds and the debt financing provided by more traditional financial institutions such as banks. Even the line between private equity and public markets can sometimes be difficult to draw. It is easy to see why simple narratives tend to prevail. A large buyout investor today has little in common with a venture capital investor, and trying to explain the link would confuse people. But, like the elephant and the shrew, fundamental characteristics are not necessarily the most obvious.

Another complexity is that while there is a literal evolutionary link between the buyout elephants and the venture capital shrews of today, there is not necessarily such a link from historical uses of the private equity or limited partnership structure. In fact, the limited partnership structure could be rightly called ‘time proven’ as very similar structures had emerged in Babylonian times. These structures are not necessarily the ancestors of the modern private equity industry, but they have been ‘rediscovered’ as what arguably is the ‘machine of innovation’. It is all the more puzzling, then, that limited partnerships have attracted so little attention in the fields of financial modelling and investment strategy.

Beast with a Thousand Faces

Rather than attempting to map a coherent narrative of private equity history, those that will draw effective lessons from the past would do better to identify the common themes that precipitate market change and reinvention. We tend to see the past either as more ‘primitive’ or ‘more pure’ and by contrast view our current state as either ‘evolved’ or ‘debauched’. More commonly, evolution (or devolution) is a response to external factors, and private equity has shown an amazing ability to adapt itself to changing environments. One clear theme that follows each adaptation is a move from rich pickings to saturation.

The modern private equity industry’s roots lie in the enormous US economic expansion following World War II where growth was often favoured over efficiency and assets were mainly acquired for the sake of growth. The resulting conglomerates proved most of the time financially disappointing and thus provided rich opportunities for the newly emerging market for corporate control.⁸

The approach pioneered by Jerome Kohlberg during his time with Bear Stearns was targeting manufacturing companies with stable and steady revenues in dependable but generally unglamorous niche markets. These companies were bought in partnership with their management teams but were essentially paying their own acquisition by themselves borrowing the major part of their purchase price. This technique exploited the US tax code that allowed the companies to treat their debt like capital expenditures, i.e., as an operating expense that is deducted from profits through the depreciation tax schedules. The resulting significant reduction in taxes allowed the companies to retire these massive loans at a fast rate. Finally, the buyout firms sold these investments as soon as possible, usually within four to six years.⁹

The early successes led to the remarkable level of takeover activity during the 1980s. The LBOs by firms that were viewed as ‘raiders’, as there were no obvious synergies between them and their targets, quickly resulted in adverse publicity and political scrutiny. What annoyed the public and politicians alike was the fact that the investee companies were supposed to sell off their own core assets for repaying the debt incurred in the acquisition. These allegations of asset stripping have never since left the worldwide political debate on private equity.

Law of diminishing returns

In the 1980s, while the industry was still small, it was comparatively easy to identify opportunities, and private equity firms could generate their returns through good deal judgment, essentially ‘buying low and selling high’.¹⁰ With an increasing number of new firms entering the market and much higher amounts invested in private equity, this became more challenging, requiring financial engineering combined with powerful incentives, which became the dominant strategy during the 1990s. Like in all entrepreneurial undertakings, profits attract competition and imitators and markets mature. Baker and Smith (1998) estimated that in 1997 there were about 800 ‘LBO equity’ partnerships. The proliferation of funds led to stronger competition for assets, to a degree that traditional sources of private equity value creation process are bid away in auctions. This forced investors to spend more time and effort on the search for opportunities that matched their profile. Private equity funds started to operate internationally, not only in Europe, but increasingly also in emerged and still emerging markets, holding regionally or even globally diversified portfolios of companies. Firms also targeted an internationally diversified investor base. According to Cornelius (2011), large US pension funds had committed around one third of their private equity allocations to non-US funds.

As GPs had to just invest about 2 per cent of a fund’s equity and not only received a 20 per cent carried interest but also were receiving various fees, they had a strong incentive to buy bigger businesses, raise larger funds and manage several funds in parallel. This, in combination with growing investor demand for high returns, led to an increasingly competitive environment. In 2006 and 2007, institutional investors, such as pension funds and university endowments, committed a record amount to private equity, both in nominal terms and as a fraction of the overall stock market.¹¹ The private equity business model so far has been highly lucrative for fund managers, even if their investors were not earning as much. It therefore seems that the industry attracts entrants up to a point where LPs are not sufficiently rewarded and the average performance of private equity is low.

Change as a way of life

While many forms of investment classes, including certain equity investment classes, thrive on stability, private equity’s oxygen is change. Facilitating and exploiting the need for change is the sector’s raison d’être. Once that change is established, private equity becomes redundant, and so private equity moves from niche to niche, identifying gaps and market failures. Once these opportunities have been spotted, private equity swarms, taking early gains and effectively rebalancing the system.

While such a process tends to keep the system