1. What do you think of the buyouts environment today?
From an LP’s perspective, extremely competitive, difficult and complex are the words that immediately spring to mind. In most sectors of the buyout market, whether you slice it by fund size, industry sector concentration or geographic focus, there are a number of competing fund products. The difficulty for most investors-no matter what their investment preference-is separating out the wheat from the chaff. There are very few “new things under the sun” in private equity, and a defensible structural competitive advantage is even rarer. Superior performance that is not driven by cyclical market factors is hard to find, and in a period where succession from the founders of name-brand funds to the next generation of investment management is a key issue, trying to determine which groups will continue to perform well in the future is even more difficult.
From simply looking at fundraising numbers one would think that all problems are solved, just invest in a mega buyout fund. Though mega buyout funds have certainly caught investor’s attention-and their checkbooks-a lot of LPs are still conflicted. They are worried as to whether the leverage and resultant financial engineering that has generated outstanding returns in the last few years can continue.
2. If that is what investors fear, why is so much money going into the mega buyout funds?
Two basic reasons. First of all, there are simply not a lot of opportunities around to invest significant amounts of money and generate significant returns, whether in alternative investments or in publicly traded securities. Forecasted returns on all major asset classes are down, and the view in the rearview mirror on mega buyouts over the past three years or so is quite positive. Secondly, the staff at most large institutional investors is risk averse. Their personal upside reward if they take a risk on an investment decision is minimal, while the downside risk for them can be large. For them, investing in a mega fund-all of whom are well known, established players-is a safe bet. As the saying goes, “no one was ever fired for buying IBM”.
3. What do you think about the astounding amount of capital raised last year by buyout firms? Do you think there is too much money allocated to buyout nows?
One thing to note: the bulk of the money raised for buyouts into 2005 went into the mega buyout sector with nowhere near as much of a surge into the lower end of the market. On the other hand, it is evident that peak years of fundraising in any private equity market sector end up being poor vintage years as far as returns are concerned. And since the amount raised for mega buyouts in 2005 was so large, the returns of the buyout asset class will be driven by mega buyout returns.
4. What would be a good alternative to putting money into buyout and venture funds?
One fundamental of private equity investing is worth restating here: Good GPs that can consistently perform well are hard to find, and you need to back them consistently in order to maintain access. Sector selection doesn’t drive returns in private equity the way it does in the much more efficient public markets; manager selection drives returns. Areas right now that might be of particular interest include:
* Small and middle market mezzanine funds (flying below the radar screen of hedge funds in the second lien loan business)
* Restructuring funds focused on dealing with companies in trouble
* Geographically, European middle market country focused funds and the developing middle market buyout funds in Japan.
5. Are you betting on the large market, mid market or small buyout market to generate the best returns going forward?
In the long run, I believe the value proposition of smaller funds is stronger. The best of them don’t rely on cheap debt and financial engineering to generate returns, but increase revenues and profitability to portfolio companies by focusing on professionalizing small companies that need that touch to continue to succeed and grow.
However, if you are a very large institutional investor, how do you invest in a sector where a 10% allocation to a fund is only $15 million to $25 million? How many such investments do I need to make to get diversified exposure in the sector and yet have a significant impact on my portfolio? This structural issue is one of the reasons that mega funds are attracting so much capital from large investors who are being driven by economies of scale.