Four for Friday ~ More on Private Equity

The previous posting, “Revisiting Beliefs about Private Equity,” explored the broad range of expectations about private equity, the changed nature of the investments being made, and the need for asset owners to take a fresh look at their approach.  Here are some other readings to ponder.

Certainty and uncertainty

In 2020, DWS and MJ Hudson published a report, “Rational or Emotional? The Real World of Private Equity,” based upon research by David Cooper and Richard Taffler.

It is part of a thread of “emotional finance” work from Taffler, which includes a great monograph (“Fund Management: An Emotional Finance Perspective”) co-written with David Tuckett for the CFA Institute Research Foundation (reviewed here).

Among the conclusions in the 2020 piece was that there is “a contradiction at the heart of private equity”:

Although actual investment outcomes are by their nature inherently unpredictable, PE practitioners are required to present a sense of certainty to their stakeholders, and need to believe this themselves.

Of those practitioners surveyed, 96% agreed or strongly agreed with the statement, “Living with uncertainty is an unavoidable part of my work.”  Yet more than 80% answered in similar fashion to this one:  “For us to convince our stakeholders, we need to convey a sense of certainty.”

That dissonance is not exclusive to private equity, but rather is endemic in the investment industry.  The difference is that everyone can see the errors in real time in public markets, while the shroud over private equity allows certainty to be sold more easily.

Access and analysis

An Institutional Investor article, “Desperate for Access to Flagship Funds, Allocators Struggle to Say No to GPs,” by Alicia McElhaney has drawn a lot of attention.  It reported that private equity managers “are getting pushy in the fundraising process, and there’s no clear way out of it.”

A pension fund chief investment officer was quoted as saying, “When they’re launching new strategies, it’s not even a gentle suggestion.  It’s pretty much like you do it or you’re going to be cut off.”

Asset owners, with rare exceptions, are price-takers when it comes to alternatives.  For fear of losing out on future opportunities, it appears many are fund-takers too.

Questions of access cloud the due diligence process and lead to “re-ups” that might not otherwise have been done.  One quote references contacts who have said that private equity teams are becoming more “about managing relationships with the firms as opposed to doing diligence.”

With references to gaslighting and ghosting, it does all sound like relationship drama.  What happens to the analysis?

Public pension plans

Maryland Law Review has published a paper by William Clayton entitled “How Public Pension Plans Have Shaped Private Equity.”  It argues that “public pension plans have left a deep imprint on how the industry operates, and the industry’s operations have enormous consequences for the fiscal health of states and localities across the country.”  Reasons cited in the abstract:

First, public pension plans have complicated the orderliness and efficiency of private equity contracting by introducing several distinctive non-market incentives and requirements to the industry.

Second, large-scale investment in private equity by public plans has also increased the number of ordinary people who are impacted by private equity fund performance.

Third, the massive flow of public pension capital to private equity over the years has also had important implications for capital formation dynamics and the distribution of bargaining power in the private equity industry.

The RIA rush

The hottest areas of the business over the last two decades are private equity and investment advisory firms, especially independent RIAs.  They go together, in that the ever-increasing multiples paid for RIA firms are driven largely by private equity money.

A February article by Andrew Foerch for Citywire RIA is titled “Here’s what private equity funds see in RIAs.”  It includes a list of some of the more notable investments in those firms.

The piece covers the driving force of consolidation in a fragmented industry, as well as the organic growth trends (especially among “upmarket clients”) that provide a tailwind.  In terms of business models, one person was quoted as saying that the firms “are actually not as volatile as you would think.”

Today’s environment might provide a test for that assumption, with both stocks and bonds down this year (and yet still highly valued relative to history, in the face of troubling inflation and interest rate trends).

Those involved think that the growth of independent RIAs is still in the “early innings,” and that “even conservative PE investors generally agree on the RIA industry’s lofty growth prospects.”  But the prices that have been paid are lofty too, in line with those expectations.  Private equity buyers have a lot of dry powder on hand — will they keep pressing ahead or rest for a time?