Private Equity is ready for Vanguard type disruption

[hdas]

Source

The change can’t come soon enough...

Yin said Warren Buffett’s style of investing is a passive style that investors could use to hold private companies. Buffett famously invests for the long term and doesn’t always change a company’s management team. Yin argued that investing in private businesses doesn’t have to be any different from investing in public companies, which are often held for many years without investors pushing for changes to the business’s strategy. With a Buffett-style private equity model, asset managers could charge significantly lower fees and reduce the need to make disruptive changes at the corporate level to generate returns. In fact, some of the largest private equity firms have recently launched funds that use this approach.

According to Willis Towers Watson, part of the reason companies are staying private longer is because of short-term pressures in the public markets. But Yin points out that private equity investors can also exit investments after short periods of time. A new, longer-term private model could be appealing to a new segment of entrepreneurs and company founders.

Can’t find the “paper” referenced in the article.

Cheers

[mjb]

The original disruption for private equity was publically traded shares.

[alfaspider]

The biggest problem is that private company shares/units lack the liquidity of public shares, and probably always will. It would be difficult to have an "index fund" of private companies because funds would have difficulty buying and selling to track the "index" (or whatever reference point you use to track a broad basket of private companies) in a timely fashion.

[simplesimon]

The change can’t come soon enough...

A low-cost private equity fund would not be available to most people. Are you an institutional investor?

[hdas]

The change can’t come soon enough...

A low-cost private equity fund would not be available to most people. Are you an institutional investor?

Im an accredited investor, and that should be enough. Heck, You can get in now with 100-200k....obviously the wrappers required for this imply more fees, which is disgusting. So, yes change is needed, hopefully Vanguard capitalizes on this.

Cheers

[Valuethinker]

Source

The change can’t come soon enough...

Yin said Warren Buffett’s style of investing is a passive style that investors could use to hold private companies. Buffett famously invests for the long term and doesn’t always change a company’s management team. Yin argued that investing in private businesses doesn’t have to be any different from investing in public companies, which are often held for many years without investors pushing for changes to the business’s strategy. With a Buffett-style private equity model, asset managers could charge significantly lower fees and reduce the need to make disruptive changes at the corporate level to generate returns. In fact, some of the largest private equity firms have recently launched funds that use this approach.

According to Willis Towers Watson, part of the reason companies are staying private longer is because of short-term pressures in the public markets. But Yin points out that private equity investors can also exit investments after short periods of time. A new, longer-term private model could be appealing to a new segment of entrepreneurs and company founders.

Can’t find the “paper” referenced in the article.

Cheers

The industry standard of "2 and 20" = 2% pa on committed (not invested) capital plus 20% carried interest has been around so long that it's hard to imagine it will "bust". There will be pressure, to be sure - The Sovereign Wealth Funds have demanded, and sometimes received, lower fees. Big funds are sometimes only getting 1.5% I hear.

But persistence of performance is the key to the asset class. Swensen is very clear on that - you have to be in the top quartile funds, and in Venture Capital, anything outside the top 10% (actually, funds run by the top 10 or so VCs, and no others) is effectively a waste of money (read the depressing Kaufman Foundation report on same).

I don't see how you can build a low cost entry point that gets around that. You are going to wind up being the money that gets invited into the deal when the established players with their networks of contacts, advisers and their active portfolio management strategies have turned down. PE is *work* - you sort through hundreds of deals looking for that gem. Or fight your way through dozens of Investment Bank-led auctions, and hope that in overpaying for this last asset, that you have not paid "the Winner's Curse" and there is some angle that the vendor and its advisers did not think of, that lets you squeeze a double digit IRR out of the deal.

It's worth a thought, whenever you see somebody making an excessive margin, there "ought" to be a way to disrupt that.

But I don't see one, and this all smells of 2000 mania - which ended quite unhappily. Whereas the big money is made in Private Equity by doing deals when the world around you is imploding (but I saw plenty of deals in 2000 that looked fairly dumb in 2002 when they were being refinanced at 1/0th the valuation).

Somebody give me a structure which combines the advantages of Private Equity (leverage, close portfolio involvement by the investor, alignment of management and investor interests) with lower fees?

Advent International managed to raise EUR 17bn with no threshold on the carry? i.e. 20% of *all* upside?

And remember American PE funds pay carry deal by deal, which is even more a perverse incentive than European funds (where at least the manager has to return the original capital before they start getting carry - i.e. fund carry not deal carry).

[Valuethinker]

The biggest problem is that private company shares/units lack the liquidity of public shares, and probably always will. It would be difficult to have an "index fund" of private companies because funds would have difficulty buying and selling to track the "index" (or whatever reference point you use to track a broad basket of private companies) in a timely fashion.

That's the key. There is no index.

And each ownership transaction is hard work:

- for a VC round they have to prepare an Information Memorandum, market to potential investors, negotiate valuation and legals

- for a Private Equity/ LBO sale they have to appoint an Investment Bank or advisor to prepare a sale memorandum. Hold an auction and select at least 2 sets of bidders to go to round 2. Go to full and final offers at Round 2. Then there's a huge amount of due diligence, legal negotiation, negotiating with banks to provide leverage finance, etc.

This stuff takes time, and is expensive. And somebody has to be driving it both on the investor end and the company & existing owner end. It does not happen as if by magic.

Buffett, btw, is explicit. He does not compete in PE auctions. He finds companies whose managers and owners (quite often family or descendants of founder) want to continue to run the business but don't want a PE situation where in 3-5 years there will be an exit or a public company scenario where they have to spend huge amounts of time meeting investors. That Israeli metal-forming company, Iscor? Classic example of same.

Even Precision Castparts, there was not, AFAIK, a rival bidder - and that was a listed company.

[hdas]

Can’t find the “paper” referenced in the article.

Found it, not even a white paper, it's just a pamphlet. Some interesting tidbits nevertheless:

This might surprise many, but according to one study
the total value of unlisted companies in the world is well
over US$100tn, larger than the total value of all listed
companies. It dwarfs the current size of the private equity
industry (c US$3tn)1

Cheers

[Valuethinker]

Can’t find the “paper” referenced in the article.

Found it, not even a white paper, it's just a pamphlet. Some interesting tidbits nevertheless:

This might surprise many, but according to one study
the total value of unlisted companies in the world is well
over US$100tn, larger than the total value of all listed
companies. It dwarfs the current size of the private equity
industry (c US$3tn)1

Cheers

OK

If you look at Ontario Teachers Pension fund, for example, they have a significant direct investing operation. Deploying capital directly into LBOs. As a way of avoiding the "2 & 20" fee structure.

The challenge will be to source deals - I think they do that by only agreeing to invest in GP (fund managers) fund as an LP if it also gives them direct co-investment opportunities.

They have also built up a large team of private equity professionals. In effect taking the PE management firm, the GP, in house.

I don't see how this would help Vanguard? Unless their plan is indeed to build up a PE office - recruit experienced PE execs and remunerate them in a way that could attract talent - it takes a decade or more to build up a successful PE partnership. Remembering that PE execs are paid multiples of what fund managers are paid, let alone fund managers at a quant-index house with no equity participation (given VG's ownership structure).

Perhaps they can build direct relationships with PE managers like Blackstone, as a way of providing capital for deals but how then would the fees work?

There *are* fund-of-funds out there, which typically charge 75 -100 bps to act as LP in dozens of selected PE funds. Gives a smaller institutional investor a much broader exposure than they could themselves achieve (minimum for LPs is typically $10m per fund). However that fee would be on top of the 2& 20 so now we are at say 3 & 20 and there would be a performance fee for the managers of the Fund-of-Funds.

[hdas]

OK

If you look at Ontario Teachers Pension fund, for example, they have a significant direct investing operation. Deploying capital directly into LBOs. As a way of avoiding the "2 & 20" fee structure.

The challenge will be to source deals - I think they do that by only agreeing to invest in GP (fund managers) fund as an LP if it also gives them direct co-investment opportunities.

They have also built up a large team of private equity professionals. In effect taking the PE management firm, the GP, in house.

I don't see how this would help Vanguard? Unless their plan is indeed to build up a PE office - recruit experienced PE execs and remunerate them in a way that could attract talent - it takes a decade or more to build up a successful PE partnership. Remembering that PE execs are paid multiples of what fund managers are paid, let alone fund managers at a quant-index house with no equity participation (given VG's ownership structure).

Perhaps they can build direct relationships with PE managers like Blackstone, as a way of providing capital for deals but how then would the fees work?

There *are* fund-of-funds out there, which typically charge 75 -100 bps to act as LP in dozens of selected PE funds. Gives a smaller institutional investor a much broader exposure than they could themselves achieve (minimum for LPs is typically $10m per fund). However that fee would be on top of the 2& 20 so now we are at say 3 & 20 and there would be a performance fee for the managers of the Fund-of-Funds.

Thanks for your comments. Are you perhaps giving too much credit to the current crop of Managers?. Do you think technoglogy can help in the governance issues?

I think the current structure, practices, etc. of PE is shaped by the nature of the pool of capital available and the incentives of the intermediaries. So when you introduce a player like Vanguard, those two variables are going to be dramatically affected, how?. I don't know, I'm an ignoramus in this area, however, the the evolution of financial markets has a one way direction in favor of the creation of capital, transparency and lower cost.

The spirit of this needed evolution is neatly captured by Hernando de Soto in his book the Mystery of Capital (albeit applied to a different problem in a different context).

Cheers

[danieljquirk]

One could argue that there is already a liquid solution in double and triple levered ETFs like SSO or UPRO

There are a couple of reasons that PE returns have been so good, but the most most important is long-term leverage in a long-term bull market. Low interest rates and financing costs have also been a tailwind. The negatives of PE are 1) the extremely high fees and 2) the inability to efficiently reinvest cash flows due to lumpy payments, and 3) capital that often sits idle waiting to be called. The reported returns that are frequently mentioned in the press are somewhat cherry picked and often don't reflect the opportunity cost of the idle capital.

Levered ETFs have returned substantially more than most private equity funds. Obviously levered ETFs have high volatility and other flaws, but if one can be convinced to invest in private equity, the better long-term economic decision is probably just to buy levered ETFs, which are much less expensive and allow one to stay invested the whole time. But many investors, even sophisticated institutional investors, probably could not handle the volatility and would eventually sell at the wrong time.

[hdas]

One could argue that there is already a liquid solution in double and triple levered ETFs like SSO or UPRO

There are a couple of reasons that PE returns have been so good, but the most most important is long-term leverage in a long-term bull market. Low interest rates and financing costs have also been a tailwind. The negatives of PE are 1) the extremely high fees and 2) the inability to efficiently reinvest cash flows due to lumpy payments, and 3) capital that often sits idle waiting to be called. The reported returns that are frequently mentioned in the press are somewhat cherry picked and often don't reflect the opportunity cost of the idle capital.

Levered ETFs have returned substantially more than most private equity funds. Obviously levered ETFs have high volatility and other flaws, but if one can be convinced to invest in private equity, the better long-term economic decision is probably just to buy levered ETFs, which are much less expensive and allow one to stay invested the whole time. But many investors, even sophisticated institutional investors, probably could not handle the volatility and would eventually sell at the wrong time.

You bring a good point about leverage, however, what's interesting (to me at least) about private equity, is to be able to access a whole new pool of investment opportunities that might have different behavior than public equities. What we have now is a travesty of a scheme mostly working in function of the intermediaries. Cheers

[michaeljmroger]

I’d personally love that. I almost went to a multi-family office where I was going to pay obscene fees largely because I was interested in their private equity funds.

[Valuethinker]

the the evolution of financial markets has a one way direction in favor of the creation of capital, transparency and lower cost.

And history is cyclical. Don't ever think progress is only one way.

https://press.princeton.edu/titles/10921.html

worth thinking about the above as a description of the cycles of history.

Institutional arrangements exist because of particular circumstances, but also path dependence - how you got there.

We have seen various efforts to provide a "more direct" route into investing in private companies, before, most notably in the dot com era. It did not work, then.

It's clear many of the "Unicorn" valuations achieved in various funding rounds were completely unrealistic, as reflected in the subsequent IPO and after markets.

There was a lot of talk that direct to investors had bypassed the traditional Silicon Valley VC - that they were obsolete. Given the capacity of new ventures to burn investor cash, I am not sure that I understood that new model - it's the governance which is a key part of the VC proposition.

It may be that direct-to-investors is a good model, I just have not seen (so far) a proposal as to how it will work.

[hdas]

Two references, for people that want to learn more about this:

1. VC: An American History by Tom Nicholas
2. Patient Capital: The Challenges and Promises of Long-Term Investing 1st Edition by Victoria Ivashina, Josh Lerner

Cheers

[McGowan]

As a 35 year PE professional, it is my belief that Private Equity investing is a bad idea for most people no matter what. Good for fund managers but increasingly less good for investors (who are chasing better returns anywhere they can find it).

There is an old saying in Finance that basically says 'when an investment class starts inviting in Joe Public, the fund drivers believe that the best returns have already happened'. Buyer beware.

[hdas]

As a 35 year PE professional, it is my belief that Private Equity investing is a bad idea for most people no matter what. Good for fund managers but increasingly less good for investors (who are chasing better returns anywhere they can find it).

There is an old saying in Finance that basically says 'when an investment class starts inviting in Joe Public, the fund drivers believe that the best returns have already happened'. Buyer beware.

Who cares about an old saying that doesn't conform to reality.........case in point: world equities for the last 200 years. Cheers

[NoFred]

I would like to see a way to have more companies be public, including some option to be on the market with fewer and less frequent reporting requirements. Incentivize more organizations to go public instead of avoiding or delaying the move.

[NS_Bane]

It is regulation that prevents grandpa and grandma from investing in PE, not a lack of financial engineering. PE firms would love to have PE index investing available to ordinary investors, as it would increase liquidity and magnify returns.

[simplesimon]

Investments and funds do go south even pre-IPO, there just isn't much news about it (maybe Softbank/WeWork right now in the mega deal space).

The article is meant for people who already have access to PE. PE is not private if anybody can invest. The word "Vanguard" in the article is throwing things off.

[Valuethinker]

As a 35 year PE professional, it is my belief that Private Equity investing is a bad idea for most people no matter what. Good for fund managers but increasingly less good for investors (who are chasing better returns anywhere they can find it).

There is an old saying in Finance that basically says 'when an investment class starts inviting in Joe Public, the fund drivers believe that the best returns have already happened'. Buyer beware.

In the UK the industry has gotten around the Limited Partner illiquidity issue by raising closed end funds (Investment Trusts) which act as LPs in a number of funds - either by one manager (captive) or across the asset class (Fund of Funds).

Investors have liquidity in the shares of the Investment Trust, even if the underlying LP interests are illiquid.

That piles fees on fees -- say another 0.5% to 1.0%.

They have performed well for investors albeit with a huge dispersion of returns. And in the financial crash they really suffered badly (as you would expect).

They normally trade at a discount to NAV despite share buybacks. The old CEF problem.

My understanding re US tax is:

- because of PFIC rules US investors cannot invest in them (although the US ETFs seem to have holdings in 3i, the largest of the vehicles)

- an analogous structure in the USA might have tax issues?

[Valuethinker]

Thanks for your comments. Are you perhaps giving too much credit to the current crop of Managers?. Do you think technoglogy can help in the governance issues?

You still need people representing investors to do the due diligence & negotiate the terms & legals. Then you need people to sit on the Boards, representing the investors. Take charge of sale & fundraising processes.

Whether Board meetings are held virtually or not, you still have to have governance mechanisms in place that require representatives of major shareholders to participate in the decisions.

I think the current structure, practices, etc. of PE is shaped by the nature of the pool of capital available and the incentives of the intermediaries. So when you introduce a player like Vanguard, those two variables are going to be dramatically affected, how?. I don't know, I'm an ignoramus in this area, however, the the evolution of financial markets has a one way direction in favor of the creation of capital, transparency and lower cost.


Cheers

What is probably needed is a Closed End Fund of Funds approach, like the UK Private Equity investment trusts. That would give individual investors liquidity but also exposure to the asset class. The UK ones function like high beta stocks.

However I understand that US tax rules might make such a structure unworkable? Presumably around the flow thru of dividends, interest & capital gains - the underlying Limited Partnership interests (in the PE manager funds) will produce returns in that mix - analogies to a US MLP.

[Valuethinker]

As a 35 year PE professional, it is my belief that Private Equity investing is a bad idea for most people no matter what. Good for fund managers but increasingly less good for investors (who are chasing better returns anywhere they can find it).

There is an old saying in Finance that basically says 'when an investment class starts inviting in Joe Public, the fund drivers believe that the best returns have already happened'. Buyer beware.

Indeed re returns & attracting private investors. Top of cycle.

If you look at multiples paid EV/ EBITDA and the gains that have accrued from leverage in a falling interest rate environment, then you can see the easy money has been made for this cycle. Some companies are on their 4th or 5th round of different PE owners.*

Last time I checked fundraising was at near record highs and since the typical fund has 5 years to invest that money once fund raise is closed, that sets a fuse on doing deals at any price that you can possibly justify.

* the mattress industry, apparently. The infamous deal of "the burning bed" - that CS First Boston merchant banking deal which cost them ?450m? in the late 80s. You'd think PE would never touch the sector, again. Then I read an article in NYT about 10 years ago about how all the mattress makers were owned by PE firms, and some had traded hands 3,4,5 times.

[aristotelian]

Folks interested in this might check out this interview on Meb Faber's podcast. There is a new platform for private equity. You do need to be an Accredited Investor although I was able to get access to the website just by filling out their questionnaire.

https://mebfaber.com/2018/09/19/episode ... ch-shares/