Private Equity is a classic clubby insider high margin business. If open data and networks always disrupt these types of business, then Private Equity is overdue for disruption.
This post offers:
- A brief history of Private Equity.
- Private Equity in context to other asset classes.
- Two big problems facing Private Equity.
- The disruptive power of open performance data and what Calpers is already doing to bring about this change
- One disruption scenario.
- One venture going after this space.
This post is specifically about investing in mature, profitable private businesses. This is in contrast to early stage investing which is already being disrupted by crowdfunding networks for both accredited and non-accredited investors. Private Equity deals are usually control deals (vs early stage that are normally minority equity), so we usually refer to this as Private Equity Buyout.
A brief history of Private Equity Buyout
Private Equity Buyouts has gone through three iterations:
- Version 1: Lean Conglomerate. This was pioneered by Hanson Trust in the 1970s. They bought underperforming old companies and put in financial discipline and a new CEO who got a piece of the action after the business was sold. Hanson Trust was an operating company with diverse businesses, so the right name is conglomerate, but they kept Head Office very small and they were always willing to sell a business if the price was right. Their mental set was closer to a Fund than an operating company, so the appropriate tag is Lean Conglomerate. Many other firms did well applying the Hanson Trust model in different markets (often learned while working at Hanson Trust). For example, Misys took the Hanson Trust model and applied it to software and now there are many such software conglomerates.
- Version 2: Leveraged Buyout Funds. This cut the HO function down even further so that Conglomerate morphs into Fund, but the practices and techniques were similar. KKR was the pioneer in the 1980s. These Funds use leverage to juice returns and force cost cuts. Using strong cash flows to pay down debt, a Fund could sell after 5 years without even changing the business and still get a good return.
- Version 3. Take Private. This requires more work than the Leveraged Buyout model. It is about fixing what is dysfunctional in public markets – an obsession with quarterly earnings. Transformational change requires more than one or two quarters. One example is the $11.3 billion 2005 Sungard deal. Sungard, like Misys, had grown through acquisitions and at a certain point the result was too messy and the business needed to be revamped out of the eye of public investors.
Private Equity in context to other asset classes.
Private Equity is small in total assets compared to asset classes such as Public Equities and Fixed Income. Private Equity is one part of Alternatives which was $7.2 trillion in 2013 vs $56.7 for Traditional Investments. But note the growth rates.
However, Private Equity is big in one area which is Fees. In this FT article it is revealed that one pension fund alone (Calpers, more on them later) paid $2.4 billion in fees to PE Funds.
High growth and high margins means that any entrepreneur listening to Jeff Bezos (“your fat margin is my opportunity”) should be paying attention.
Problem 1: Software is eating the world.
Private Equity Funds pitch themselves to Investors as being more conservative/less risky than their wild cousins doing early stage equity. They will do rigorous analysis of the past 10 years or longer to see how predictable the cash flows are. No dangerous projections based on new products for them, their models are rooted in real world actual results of proven products.
That sounds good, but is based on a fundamental error which is the assumption that the future will be like the past. The Digital Era overturns that assumption.
Consider the printed telephone books aka “Yellow Pages”. They were a license to print money for a long time and many Private Equity Funds bought into them for that reason. Now it is hard to find people who use printed telephone books for anything other than doorstops.
Or consider hotel chains after AirBnB or Private Banks after Robo Advisers. How do you model future cash flows in those scenarios?
Problem 2: capital oversupply
When everything else changes, you can count on the law of supply and demand as a constant. Private Equity has been such a good business for so long that investors have been pouring money into the best funds (who then get high fees on AUM and the ability to do the mega deals). The problem is that this results in a lot of capital chasing the best deals (what Private Equity guys call “dry powder”) which raises prices on entry and that depresses returns on exit.
Calpers – its the data stupid
Into this closed, clubby world (”if you have to ask the price you cannot afford it”) comes Calpers (California Public Employees Retirement System) with their Private Equity Program Fund Performance Review. This is data transparency in action. It is only one investor but that investor is so big that it is a significant data point. You can sort all the PE funds online by all these different criteria.
Our thesis is that this data will drive a lot of innovation. Entrepreneurs will be able to show what they offer vs the competiton by referring to this data. It is like an Index for the Private Equity business.
Disruption scenario
Our thesis is that disruption will come from Family Offices, managing money for the Ultra High Net Worth Individuals (UHNWI) and their families. In the US alone there are 3,000 single-family offices with assets under management between $1 trillion and $1.2 trillion.
Four key points about Family Offices:
- They like the high returns of Private Equity and don’t worry about the lack of liquidity with money “locked up” for years (because they are managing money for multiple generations).
- They are agile because they don’t have any “explanation risk” (if something goes wrong they can learn from it and move on, they don’t have to explain their actions to investors).
- They don’t compete with each other.
- Many are still run by entrepreneurial families (who are used to taking measured risks to get better returns).
This makes the Angel List model of following a proven investor applicable to Private Equity. This is already happening in a small way with small networks of like-minded Family Offices working together on deals (referred to as “club deals”). This is where the entrepreneurial genes of the Family Office counts. Let’s say Family Office A made their money in Pharma and Family Office B made their money in Software. Family Office A follows Family Office B’s lead in Software and vice versa.
Angel List obviously works at the early stage end, but the brilliance of their innovation is that they take of all the “boring plumbing admin” stuff like reporting. That can apply to any form of asset management, including Private Equity.
Axial
One company going after the Private Equity space is Axial. They recently raised a $14m Series C and are led by a proven entrepreneur called Peter Lehrman who was part of the founding team at Gerson Lehrman Group (technology platform for on-demand business expertise).
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