RSM: Passive competition puts pressure on private equity

Hands-off investment offerings wouldn’t seem to be competing with the private equity funds, but RSM’s Anthony DeCandido suggests they pose a real challenge for the industry.

This article is sponsored by RSM

No buyout firm touts their ‘hands-off’ approach to investing. On the contrary, ‘hands-on value creation’ has become an industry cliché that appears in virtually every private placement memorandum on an LP’s desk. And GPs do plenty to substantiate their claims that they pay attention to every line in every balance sheet of a given portfolio company – and do something about them. After all, what are all those generous management fees paying for?

Anthony DeCandido

Given the record fundraising tallies of late, the pitch is still resonating. But elsewhere, passive investment strategies have been enjoying an more dramatic boom. According to Bloomberg, passive overtook active investors in AUM last year, with actively managed assets at $4.7 trillion and passive AUM at $4.8 trillion. As recently as 2004, passive investing represented only $725 billion of AUM, while active investing AUM was $3.2 trillion.

RSM’s Anthony DeCandido suggests that private equity firms shouldn’t ignore the surging popularity of these passive offerings. On the contrary, they might put pressure on management fees and force GPs to further substantiate the value they bring to their portfolios, especially as politicians and journalists become more vocal about the industry’s size and influence.

Why should GPs pay attention to trends in passive investing vehicles?

For investors of all types, whether it’s they’re on Main Street investor or Wall Street, there are various options, and the cost point for passive investing has the attention of many within the marketplace. As retail investors and institutions get greater access to all kinds of strategies, this will inevitably be another source of competition for private equity as an asset class.

For now, private equity’s popularity is high, mainly because the return profiles have been so rich. Furthermore, when we look at the period from 2000 until today, the asset class has outperformed the S&P index by a compound annual rate of around five percent. So for sophisticated investors, I think it’s crystal clear that private equity is a preferred asset class.

But it’ll be fascinating to watch as we near the end of this business cycle, what happens when those return profiles aren’t achievable anymore. Because as we all know any organization, regardless of industry, will become much more cost conscious. And then there are broader societal trends.

Are we talking about the criticism of private equity in the press and on the campaign trail?

We are in the midst of a US presidential election season and there’s still this stigma around private equity managers. Elizabeth Warren has put forth the Wall Street Looting Act that puts private equity groups in the regulatory spotlight when a portfolio company goes through bankruptcy. Democrats are hoping to achieve better protections for some of the stakeholders, whether it’s health benefits, or reducing major windfalls to management and investors at the expense of employees, or communities.

But the conversation around this can easily unnerve the public and lead to criticism that causes large public pension plans like CalPERS to review their allocations. That might further accelerate the commitment to passive strategies. However, this isn’t just about politics. People expect new levels of transparency today regardless of who they elect. Look back to 2012, and the conversation around the Dodd-Frank legislation, where there was a real desire for investors and all stakeholders to understand the mechanics of what these managers do.

“For sophisticated investors, I think it’s crystal clear that private equity is a preferred asset class”

This led to a focus on managers adequately reporting their investment thesis, their strategies and their tactics. And people have only grown more interested in these kinds of details as they learn more about how managers work. They want to understand the mission and values of their managers and ensure they align with their own, especially in terms of social responsibility and ESG.

The Vanguard ESG ETF has proven quite popular with Main Street investors, as a passive strategy that delivers returns that investors can feel comfortable earning. However, such vehicles really need to stay true to these higher standards. One Vanguard ESG offering mistakenly included the gun manufacturer Ruger this past June, and under investor pressure, had to sell the shares in August and promise to put greater controls in place.

And I think this growing trend of individuals wanting to allocate their money to places that they believe are aligned to their mission and values is only going to continue. This might benefit these kinds of passive strategies at the expense of private equity.

Some GPs might argue that they work with sophisticated investors who may have their own ESG concerns, but these LPs will find the right solution within the asset class, and not venture into some passive strategy instead.

It’s not merely public criticism. This is about the business cycle, coupled with those transparency issues. We’re monitoring the middle market, which is the DNA of the client base we serve. And while we’ve enjoyed a robust M&A and private equity climate of late, there’s some telling signs that the business cycle is coming to an end, with some kind of slowdown on the way.

And then what? We’re all guilty of being a bit more cost conscious when the market retreats, particularly when there’s not enough delta between the private equity and passive strategies. That preference for the cheaper option is just human nature.

So if a GP were take these passive strategies as a factor, how should they respond? How do they argue that they’re still worth those fees?

Their value proposition will always include some element of helping to drive a company’s operating agenda. When that GP shows up to invest in that industrial business in Iowa, there are relationship synergies that are going to improve that enterprise and make it more valuable during that three- to seven-year period of ownership, a period that can allow them to weather a tough economic climate.

“Passive management strategies have benefited namely because of the technologies they’ve implemented that deliver value creation with near-zero marginal fees”

And GPs are already willing to reduce fees, though this is clearly isn’t ideal. The traditional 2 and 20 percent model has now become something closer to 1.6 and 16 percent. Though it should be noted that it’s debut funds where firms are looking to offer more favorable terms. I don’t think top quartile firms are looking to compete on fees anytime soon.

But I do think private equity groups will need to up their game on technology. Let’s face it, passive management strategies have benefited namely because of the technologies they’ve implemented that deliver value creation with near zero marginal fees.

So private equity groups are also going to have to look for ways that they can continue to drive their return profiles by leveraging technology. So we see it in ways they’re using satellite imagery or geolocation, or other mechanisms to get an edge in evaluating the markets that they operate in.

A classic example would be if a GP were investing in a financial institution or a credit union, and they pull the data on credit card usage for that institution. They could then scale that for thousands, even millions of people, and use that particular data point to improve the operating agenda for that credit union.

Today’s sophisticated technologies may allow these passive strategies to thrive without that active manager. But they can also empower GPs to make even better decisions around value creation and maintain their status as an asset class worthy of those fees, and their investors’ goodwill.