The Private Equity for Families Blog

New Reason to be In Private Equity

When we started our private equity firm 20 years ago, high net worth individuals and institutions were interested in the asset class for three big reasons:

  • Outperformance versus the Stock Market
  • Lack of Correlation to Publicly Traded Asset Classes
  • Persistent Outperformance by Top Quartile Managers.

McKinsey & Company just released a report on Private Equity that suggests a fourth, equally compelling reason, to own PE. Growth opportunities in the public market are shrinking as the number of publicly held companies shrinks. According to Mr. Klempner, one of the authors of the McKinsey report, PE is the best way for institutional investors to be exposed to those growth opportunities. A recent article by Julie Segal writing for Institutional Investor explains the new attraction:

“The number of private equity-owned companies has doubled since 10 years ago, Klempner pointed out, and the number of publicly traded companies is half that of 20 years ago.  Institutions need to be in private equity if they want exposure to growth companies, regardless of whether they can pick the top managers.”

However, the institutional imperative comes at a price. As the institutional community seeks representation in this asset class, it drives up valuations based on a surplus of investable cash:

The disciplined managers still look for growth at a reasonable price and the value managers look for misunderstood stories but, more than ever, success in private equity investing will be about the quality of the managers.

Priced For Perfection and The Long Run

Given that leverage constitutes an ever-greater percentage of the capital structure, the margin for error in company selection is unusually high. If you make a mistake in the public markets you can usually get liquidity at a price. By design, the private equity model locks up your capital commitment for as long as 10 years. If you want to get out of the asset class you can try to sell to buyers in the so called “secondary market”, but the bids are usually at a steep discount to the stated annual valuation.

The McKinsey report shares my enthusiasm for the best managers, but laments how hard it is to know who they are. Many private equity firms have transitioned from founders and are known for their collective, not individual, reputations. It is virtually impossible to cherry pick only certain portfolio companies in your exposure unless you have a liberal co-investment option. Ms. Segal points out the dilemma:

“Although persistency of outperformance by PE firms has declined over time, making it harder to consistently predict winners, new academic research suggests that greater persistency may be found at the level of individual deal partners,” the report’s authors wrote. “In buyouts, the deal decision-maker is about four times as predictive as the PE firm in explaining differences in performance. However, the McKinsey report stressed that it is difficult for institutions to make funding decisions based on individuals.”

Good investors in any asset class are hard to find and even harder to discover when the industry has $ 2.0 trillion of money to invest and thousands of managers. Smaller firms with more transparency about which managers are creating the fund’s outperformance (alpha) may be a winning tactic. Unfortunately, institutional money is often concentrated in a few large funds at the top of the pyramid and only a few funds allow investors to “cherry pick” individual deals or managers.

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Rob McCreary

Rob McCreary has more than 40 years of transactional experience as an attorney, investment banker and private equity fund manager, and has spent his career in building entrepreneurial organizations with successful track records Founder and chairman of CapitalWorks, he is responsible for developing and maintaining senior relationships with investors and portfolio governance.

This blog represents the views of Rob McCreary and do not reflect those of CapitalWorks or its employees. This blog is not intended as investment advice. Any discussion of a specific security is for illustrative purposes only and should not be relied upon as indicative of such security’s current or future value. Readers should consult with their own financial advisors before making an investment decision.

Private Equity for Families Blog | CapitalWorks Private Equity Cleveland Ohio

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