The shifting nature of private equity
BY Yaelle Gang | November 6, 2019
While private equity’s original advantage was taking over a firm to revamp its governance and operations, private equity companies are now finding fewer underperforming firms to fix and the private equity model is changing, according to a new paper by Elisabeth de Fontenay, a professor of law at Duke University.
The paper, which is set to be published in the Boston University Law Review, notes the rise of institutional investors and shareholder activists interested in private equity has forced management to up their games because they can’t get away with merely gesturing towards shareholder interest.
“It’s just not the case that you have these big bloated companies sitting on a ton of cash with very bad management that used to be the prime targets for private equity acquisitions,” de Fontenay says. “You just don’t find those anymore because management practices have been really pretty dramatically reformed, at least in the U.S., for several reasons.”
The main reasons, she notes, are that institutional and activist investors are increasing and business schools are harping on shareholder value. “The combination of those factors means that you see very different management practices today than you did, say, 30 years ago and that is actually bad news for private equity because it means that there are fewer juicy targets for them to acquire and fix up their operations and their governance.”
As well, private equity firms are having trouble finding private firms to target because many of these are being acquired by bigger companies.“There are a lot of strategic acquisitions going on that are taking those targets away from the private equity funds,” says de Fontenay. “They’re getting beaten in a lot of these auctions for some of these companies by the strategic acquirers who can pay a bit more because they’re expecting synergies from the transactions and the private equity funds are, for the most part, just thinking about buying and holding the portfolio company on a stand-alone basis.”
Venture capital funds and other investors are also encroaching into the private equity space, she adds.
Private equity’s lower returns are evident in the data, notes de Fontenay, noting over a 30-year period, private equity outperforms but that outperformance has declined over time and data seems to suggest returns for private equity and the public markets have converged.
“Really, you’re not doing any better by investing in the private markets than in the public markets, and you’re not doing any worse if you’re the average big institutional investor. And that, frankly, shouldn’t be a surprise to people given the amount of money that has been directed at private equity, particularly recently.”
The way private equity is actually generating its returns is also changing, she says. “There just isn’t the low hanging fruit that there was before, so it’s really hard to find good companies that are undervalued and that have big room for operational improvements.”
In response, private equity is moving beyond purely focusing on governance reform and now simultaneously running leveraged buyout funds and credit funds, real estate funds, alternative investment funds and even hedge funds, the paper noted. As well, private equity firms have started underwriting major corporate loans.
“And their activities, even in the buyout space, have changed,” says de Fontenay. “Even with those classic funds, a lot of them are now taking minority investments in portfolio companies as opposed to acquiring control, which is what they always did and which is what you would assume they would do if they actually want to change management practices and to change the operations of the fund. As a minority investor, you’re really just not able to do that, so that in itself is kind of a sign of a change in the way they’re expecting to generate their returns.”
Some of the new strategies taken by private equity companies are less likely to increase value than traditional governance optimization approaches, the paper cautioned, noting the new strategies also introduce new conflict of interest and complexities.
“Holding both equity and debt positions creates conflicts of interest for the sponsor,” the paper said. “In highly leveraged businesses, which is where these funds invest, debt-holders’ interests may diverge significantly from those of the equity holders. This makes it all the more remarkable that private equity sponsors may manage funds that are simultaneously invested in the equity and the debt of the same portfolio company. In such cases, investors in both the equity fund and the credit fund will worry that the interests of the sponsor may cause it to favour the other. Moreover, even if the equity and debt funds operate independently and do not share information, the funds’ common affiliation imposes risks on both sets of investors (such as negative treatment in bankruptcy) that they may not have priced in.”
Now, managing conflicts takes up more time and fund disclosures and provisions about conflicted transactions are increasing in length, it added.
Investors should be paying extra attention to what their private equity managers are doing as they are under a lot of pressure, de Fontenay says. “They may be doing things that produce returns in ways that the investors like, but they also may be doing things that are slightly less satisfactory, or even kind of illusory, in terms of showing returns. And so I think investors are going to have to do more diligence and pay closer attention to their sponsors in light of the fact that these sponsors are under a lot of pressure.”