In 2010, pfm made a set of predictions about the future direction of the private equity industry in a year of exceptionally bearish sentiment.
At the time, Simmons & Simmons survey found that more than 70 percent of sector participants thought the impact of the credit crisis would reverberate for years, or that the private equity industry had been changed forever. A double-dip recession topped participants’ concerns, while 69 percent said tax and regulation would be a significant impediment to the industry.
Seven years on, pfm has another 75 editions under its belt, dry powder is at a record high, limited partners are flush and debt is expected to remain relatively cheap. We discuss how those recession-era predictions have played out with industry stalwarts, Riverside chief executives Béla Szigethy and Stewart Kohl.
One prediction was that returns would shrink and firms would be forced to add operating and other dashboard-style resources in order to compete. How much has this materialized?
Stewart Kohl: The prediction was spot on, and continues to be the case. Private equity has emerged as an industry and operates in a much more business-like manner. Changed expectations are everywhere. Pressure to generate high returns remains, but there are also other pressures such as meeting investor environmental, social and governance expectations and increased regulatory requirements. LPs have also become more demanding in terms of information required from their GPs, and the extent to which they manage their own investments. This has, of course, increased the level of reporting.
As a consequence, we expected more personnel would be brought in to manage these new resources. Has this happened?
Béla Szigethy: Most firms that are of a similar size to us have grown their operations teams. In 2010 we had 12 operations staff; now we’ve got around 40. Some are managed internally, others are independent contractors brought on to help. The metrics are different in smaller firms, though. Strong systems and operations become a differentiator, and that’s especially important now that there is more money in the private equity space that’s going to fewer firms.
SK: The change is evident in our recruitment stats – our newest hire is a vice-president of compliance. It was only five years ago that we hired our first compliance officer, and even then it wasn’t a full-time role.
Regulatory headwinds and potential tax changes were expected to result in higher business costs – has this been the case?
BS: Back-office spending has increased by around 25 percent, and compliance costs have increased by a factor of 10. These costs now account for between 1 and 2 percent of the management fee.
Another key issue was around transparency; it was forecast to move to new extremes as public firms set the pace.
SK: It’s almost trite to talk about transparency; there’s no question about this. LPs are using better technology, have more insight into portfolio companies, and access to secondaries market data.
BS: There’s not much left to do. Portfolio companies certainly don’t want their financials splayed out publically. There is room for more uniformity on this front, though – each firm has its own system, so there could be more consistency.
A fifth prediction pointed to changes in the way capital and opportunities are connected, due to new professionals, new services and new models of communication and increased influence of specialists in niche markets. What’s your take?
SK: The market has become more niche. With the exception of [the] Harvard University endowment, which said it was looking for more opportunities across asset classes, most others are reducing the number of managers they invest with.
LPs are using data to pick the best asset classes, and the best managers, but have a strong desire to invest in the asset class. LPs need private equity more than ever, but they can’t “spray and pray.”
Fund managers now need to understand how to access LPs. Investors don’t want to deal with the administration associated with giving money to many firms, either. This means there are fewer GPs getting higher capital commitments.
Keeping with the fundraising theme, pfm predicted fundraising and marketing professionals would become higher-profile rainmakers within their firms – what do you think of that one?
SK: There’s no question about this, and we’re keenly aware we work for the investor. Private equity firms aren’t masters of the universe – we have bosses too!
We’ve built out our IR function, and they’ve become more prevalent, important and highly paid. To the extent that the IR team acts as the voice of the investor within the firm, then the transactions side does, to some extent, have to follow their lead, but I wouldn’t overstate their importance. The transacting team are still driven by their own views, and there can be healthy tension between the two, but the balance of power has shifted more in the direction of the IR team.
The final prediction was that non-Western markets would blossom and the risks associated with their expansion would need careful management. Where are we with this?
BS: There has been local-level blossoming. There have been deals in China and India, with firms there being very active, but while there’s potential, it’s not quite there yet for us. The vast majority of the action for Riverside has been in developed countries.
SK: In general, the promise of emerging markets has disappointed, and currency depreciation has been a drag. It was a reasonable prediction, and it doesn’t mean that it won’t transpire in the future. The seeds have been planted.
We’ve talked about some serious changes in the fund management world. Is there anything else that you think is worth mentioning?
BS: The convergence of returns is one thing. Over the past seven years, the cut-off point between good and not good has drifted. It was a 1.5x-2.0x cash-on-cash return, but that range has tightened. That’s because of the impact of the global economic crisis on returns and increased competition making it more difficult to make outsized returns. It forces LPs to look at factors other than performance.
SK: We’re an industry now, and in a lot of ways have proved ourselves. The global financial crisis could have spelled the end for private equity. The wall of debt could have led to bankruptcies, and liquidity would have been valued more than ever. But it’s gone in the opposite direction. The debt was worked out over time, and while there were lots of financial market failures, very few could be traced back to private equity. It became clear private equity was not a systemic risk, and while returns have fallen, relative returns remain strong.