In the 2000s, private equity briefly was anointed the king of Wall Street before its giant bouncy-castle deflated down to the pavement.
What will the 2010s bring for private equity? If your first guess is “extinction”, you clearly haven’t been around the block enough with this asset class, and therefore underestimate the talent that its managing partners have to reinvent, renegotiate and resell.
Before I set forth my predictions for the important hinges to look for in the “teens”, an overview of the important developments for private equity in prior decades would be instructive.
The 1970s: A few venture capital firms populate Silicon Valley and many of the founders of what will become major buyout firms are elbowing their way through bank corporate finance departments. In 1978 US pensions are granted the ability to invest in buyout funds, thus setting in motion a new wave of firm creations.
The 1980s: Leveraged buyouts become front-page news, but these deals are largely viewed as one-off novelties rather than sustainable strategies. Advances in the high-yield bond market provide plenty of fuel for a wave of takeovers that reach their crescendo in 1989’s RJR Nabisco buyout, clinched by KKR.
The 1990s: From the doldrums of an early decade recession and debt crisis, buyouts gradually claw their way back and the firms that sponsor them begin to take on more institutional trappings. Major investors begin to identify “private equity” as something that belongs in the portfolio. Thanks to a tech craze, for a brief moment at the end of the decade venture capital firms are raising more capital than buyout firms, an absurd trend that assumes the start-up economy needs more capital than the established economy.
The 2000s: Debt becomes scarce beginning in 1998 and then the tech bubble implodes in 2001. Private equity again experiences an existential crisis. Venture capital never returns to its late-90s glory days. But many buyout firms with capital to spend begin gobbling up strong companies and by the middle of the decade, a new wave of cheap debt drives big exits, big dividends and bigger new deals. Institutional investors scramble to allocate huge dollars to private equity, and this pushes fund sizes into the stratosphere. By the end of 2008 it becomes clear that many firms paid too much at exactly the wrong time and with too much leverage. The investors who backed their giant funds suddenly wished they’d skipped a couple of vintage years.
The 2010s: What now? Below are a few important trends upon which I believe the development of this industry will hinge:
- Returns will come down: Even if deals struck in 2009 and 2010 prove to be big winners, the weight of big-dollar bad investments from 2006 to 2008 will cause private equity as an asset class to lose some luster. But private equity still will look pretty good, and if it can promise a return in the low teens it will remain in great demand.
- Costs of business will increase: Being a private equity firm will become more expensive. Firms will need to hire more people and pay for more services to stay on the right side of a new raft of rules and regulations around the world. Taxes on carried interest, capital gains and personal income will make private equity less lucrative, but for those who succeed, still highly enriching.
- Non-Western markets will blossom: The private equity model of corporate governance will continue to gain natural footholds in major emerging economies, and select private equity firms in these countries, both locals and internationals, will experience epic growth.
- Private equity will remain entrenched in the portfolio: Although certain Western limited partners may hold steady or decrease alternatives allocations, as new pockets of investment capital open up around the world, many will initiate substantial allocations to private equity, and this will further internationalise – and grow – the asset class.
- Fundraising 2.0 will emerge: The old model of touring 20 US cities with a flip-book will endure, but will become in most cases insufficient for sustained success. New professionals, new services and new modes of communication will rise to connect capital with opportunities in ways that will surprise old-timers. Specialists in certain niche markets will gain influence.
- US public pensions will fade as a source of capital: These institutions remain important, but strict new rules will make accessing their capital more difficult. Many will begin to convert to defined-contribution plans, which will further interferes with traditional modes of fundraising.
- The public private equity firm will win fans: A platform that at first seemed like a contradiction will further reveal its utility. Trading publicly gives firms a higher profile and a valuable currency for compensation and expansion. These firms will “crack the code” on sourcing public capital for private investment, a major breakthrough that will put a cluster of GPs even further ahead of the others.
- Spin-outs will spring eternal: Private equity will continue to attract talented, ambitious financial entrepreneurs who never cease to believe they can do much better running their own shop than working for the founder. For every private equity firm that sputters out, two new ones pop up (and a subset of these will actually succeed).
- The new “barbell”: On the one end are gigantic globe-spanning branded franchises, and at the other end are innumerable sector specialists that tend to outperform the big guys, but have to work twice as hard to raise capital nonetheless.