In my opinion, we have a tendency to disrespect simple innovations, especially if the innovators are making a fortune on them. It seems like we are hard coded with an irrational equation to assess the fairness in the fortune amassed by others. The more groundbreaking the innovation, the more wealth may be accepted. I am just as guilty as everyone else, especially when I questioned the decision to have Daniel Ek, founder of Spotify, to host a radio program in Sweden. I argued disrespectfully that Spotify was not as innovative as they proclaimed when they announced the program. In my limited view, the concept and technology had been on the market for quite some time thanks to Steve Jobs and the company was not worth a market cap of $ 5.3 billion as implied when they raised money the last time. But I have changed my mind lately. I am starting to see the beauty in simplicity and stories like the parable where Christofer Columbus won the support for his voyage to America by balancing an egg on the pointy end at a table. Lotta Engzell-Larsson has told a similar but more recent story in her book on the Private Equity industry in Sweden. The book, Finansfurstarna (~”The Finance Czars”) is a balanced biography on the industry. She even succeeds in giving a balanced account on the Carema story and dares to challenge the cheap semantics that we hear from the left wing that private equity and profits in welfare is bad. Nevertheless, I get the feeling that she is biased by the innovation-to-wealth formula when she claim that “seldom has a group made as much money in such a short time as the PE pioneers without making a disruptive discovery”.
I will argue in this blog post that the Private Equity model was innovative when launched in Sweden during the late 80s. The pioneers created an investment vehicle that created substantial value to their customers, the limited partners, but that model is in my opinion outdated now and need to be re-invented for increased liquidity and transparency.
At the inception, the idea of private equity was a simple and brilliant idea that filled a void. They gave investment managers at Insurance Companies, Universities and other institutions access to the lucrative buy-out market were unlisted companies outperformed the listed peers that the manager were limited to previously. To put it short, they created a new asset class that defied previous assumptions on trade-offs in risk vs reward, at least during the heydays. The idea is simple but not the business model. The author did a splendid job in explaining it and I hope that it doesn’t get lost in my translation and brief summary below.
The general partners at the private equity firms get commitments from their customers, the limited partners (LP), that they will make payments to a fund so that the PE firm can acquire companies that they will develop for 4-6 years and then, hopefully, sell at four times the initial price. The LPs get their return on the investment when the fund is closed after 10 years. All the holdings have to be divested prior to the closure. The General Partners charge the limited partners a management fee of 1-2 % on the committed amount annually. The management fee may be refunded if the portfolio performance exceeds a threshold value, usually 8%, when the performance fee, the carried interest, kicks in. The carried interest is usually 20% of the outperformance.
Ernst Young was commissioned in 2012 by SVCA, the Swedish Venture Cap Association, to assess the value that the Private Equity industry creates. They proved that PE outperformed the public markets 3,6 times as depicted below. Contrary to common belief, the outperformance is not only due to the increased leverage in the PE holdings. The biggest value driver is the strategic and operational improvements, e.g. add-on investments and new management.
But there is another interesting chart in the report that illustrates one of the three drivers that I think will make the current PE model outdated. As you can see below, the most common exit is that the PE firm sell the company to another PE firm. The limited partners do not like this trend, especially not if they have invested in both the selling and buying fund, since they know that each transaction drives costs from corporate finance units, legal experts and management consultants.
The PE firms are sensitive to the opinion of the limited partners on these so called secondaries but they are forced to play by the rules that they have defined themselves. The selling PE firm has to divest prior to the closure of the fund and the buying fund is forced to invest according to the commitments from the LPs to charge the management fees.
The second reason that I think that the current PE model will need to be re-innovated is the illiquidity of the PE funds. As a limited partner, you make a ten year commitment to the fund and have to accept that you have checked in and cannot leave prior to the closure. True, the private equity firms have helped limited partners in financial distress but there is no secondary market or at least not until recently. The financial crises changed that. Then, many investment managers realized that they couldn’t stay true to their PE commitments when the stock market fell without becoming incompliant to their own risk policies that dictated the maximum allowed exposure to alternative investments. Recently, we have seen players that buy the PE commitments with a substantial discount to the net asset value of the fund share.
The third and main reason that PE industry will be forced to reinvent themselves is the increased competition on the market. The “low hanging fruit” has been harvested. Most companies have given up their diversification strategies and divested their non-core holdings and it is unlikely to expect any further advances in the privatization of public services. And the potential sellers are more professional now. They will probably engage a corporate finance unit to stage a controlled auction to ensure that they get the best price. Meanwhile, we see that the Nordics has increased from 4% to 12% of the entire venture cap fundraising in Europe so it is fair to assume that the PE industry finally will have to accept the economic laws of diminishing returns.
To summarize, the PE industry found an innovative way to give their customers access to the lucrative buyout market that they previously were locked out from. The PE pioneers have been handsomely rewarded for their innovation but they have to re-innovate their business model for increased liquidity and transparency to stay aligned with their buyers, especially now when the negotiation power of the PE’s decreases at the same rate as the outperformance to the public markets. Personally, I think that we will see more publicly traded Private Equity, either as funds or companies like Ratos and Bure. And, please, do not hesitate to read the book “Finansfurstarna” (Currently only available in Swedish) for a good primer on the Private Equity industry in Sweden