Protecting Private Equity’s Best Investment: Talent

Private equity funds are prioritizing talent amid the pressure of increased investor expectations, coupled with tightening regulations and a highly competitive market. Over the past 20 years, the number of publicly traded firms had declined from 7,500 to only 3,800 today, according to data from the RBL Group as reported in the Harvard Business Review. In wake of that drop, private equity firms have gained new influence.

Firms are now embracing a non-traditional model of “portfolio transformation,” which requires a commitment to strategy and operational excellence. Fund members are allocating resources toward engaging and developing talent more effectively than ever. The reasons behind this are twofold: First, by broadening their bases of talent to include a wider spectrum of experts, from investment bankers to executives and beyond, firms can strengthen their decision-making, and they can also improve management of portfolio companies.

While exceptional talent has always been a feather in the cap of the private equity industry, the renewed emphasis on it is, in part, a reaction to today’s sky-high prices for assets. Now, instead of chasing returns through dealmaking, firms are focusing on increasing revenues from portfolio companies. However, firms often tap their champion dealmakers to serve as board members or leaders of acquired companies, and they may not have the appropriate skill set to turn around a company. With the enormous cost of acquisitions, therefore, the need to improve the talent pool that can manage existing companies is obvious.

One major challenge for CFOs and fund managers is employee retention, according to NES Financial. This stems from an overall shortage in talent caused by demand for employees versed in a wide variety of new capabilities. Expenses associated with training new talent are often substantial, as private equity companies are known to pour a large portion of time and resources into cultivating productive, highly skilled workers.

To guide private equity funds in the areas of talent and leadership development, according to the Harvard Business Review, RBL states that over half of firms have introduced a new position: leadership capital partner, or LPC. The LPC is responsible for establishing a common culture among portfolio companies and may take part in hiring those companies’ human resources leaders. LPCs often play a key role in the vetting process for HR officers.

Annual councils—in which ideas, tools, and best practices are shared among chief human resources officers—are often headed by LPCs, who may have the final say as to which tools and systems portfolio companies should use. In addition, LPCs are tasked with presenting any talent-related findings during divestiture negotiations; for example, they might use data from annual leadership and culture audits to show proof of improvement and win buyers’ confidence.

To Infinity and Beyond: The State of Private Equity

Private equity funds soared to new heights in 2017 and show few signs of slowing down in the new year.

According to a report by Preqin, 921 private equity funds reached a final close in the last year and secured $453 billion in investor commitments: a new fundraising record. In fact, as more data becomes available, Preqin acknowledged that the actual amount raised could increase by as much as 10%. A major catalyst of this fundraising were mega buyout funds of $4.5 billion or more—they secured an impressive $174 billion in investor commitments last year—as well as North American and European-focused funds.

Notably, the previous fundraising record was set in 2007 as 1,044 funds secured $414 billion in investor commitments. This context makes 2017’s fundraising that much more impressive since fewer funds were able to secure an even larger supply of capital, thus highlighting the strength of private equity as an asset class today.

Funds also flew past another milestone in 2017 as the amount of dry powder, or committed but undeployed capital, exceeded $1 trillion for the first time. Despite this tremendous reservoir of capital, a report from PitchBook found that 52% of private equity professionals plan to raise a new fund this year with the hope that any new funds will raise at least as much as previous funds. GPs and other private equity professionals must feel an incredible level of confidence in their products and potential in order to raise additional funds, and furthermore, this also signals confidence that investors will continue to commit to new funds despite mountains of existing dry powder.

Additionally, the PitchBook report also noted that 70% of GPs do not intend to offer “special incentives,” including fee breaks or co-investment opportunities, to investors who make early or large commitments, which indicates GPs and funds still hold most of the cards in fundraising negotiations.

Private equity’s recent successes appear to validate predictions by experts that the asset and wealth management (AWM) industry will grow spectacularly throughout the coming decade. In an earlier blog post, I discussed a report by PwC profiling the future of the AWM industry, which predicted that total assets under management will practically double from $84.9 trillion in 2016 to $145.5 trillion by 2025. With private equity setting new fundraising records and accumulating unprecedented amounts of dry powder, PwC’s vision for the future of AWM seems to ring true.

The Future of Finance: Purposeful Capitalism

Evolution and the capacity for innovation on a large scale are cornerstones of the CFA Institute’s Future of Finance report. Throughout the four possible scenarios that it envisions on the horizon for the worlds of finance and investment, the CFA predicts revolutionary developments in market forces, communication, social organization, and other areas. These themes of innovation and transformation reappear in the CFA’s fourth and final proposed outcome in which the rise of a new, purposeful capitalism reshapes finance along moral, ethical, and more client-centric lines.

As I discuss more thoroughly in a previous blog post, the CFA analyzes a series of megatrends and posits four scenarios to describe how the financial world would respond: fintech disruption, parallel worlds, “lower for longer,” and purposeful capitalism. In the latter, the CFA suggests that firms will become more conscious of all stakeholders and seek to redefine value propositions by placing more emphasis on trust and nonfinancial considerations.

The impetus for such soul-searching, according to the CFA, comes from a recognition of limits and changing forces. The report notes that as firms acknowledge the interconnected nature of finance—particularly when “viewed as an ecosystem”—they will stress the importance of trust in business and look for ways to demonstrate integrity. Additionally, concerns over systemic issues like resource scarcity and shifting demographics will prompt firms to operate via the principles of sustainable development.

Furthermore, as trust and sustainability come to play a larger role in the financial world, firms will need to find ways of aligning their investment strategies with these values. As a result, pursuing the greatest possible returns or profit maximization may no longer be the supreme goal for many firms who hope to make ethics a key element of their brand or strategy; the report points out the paradox of holding tobacco and health care stocks as an example of this. In fact, the CFA notes that these tradeoffs will represent a large part purposeful capitalism’s development.

Ultimately, firms that embrace purposeful capitalism will pay attention to the needs of broader constituencies that include clients as well as the public at large. Ethical business practices, like the adoption of corporate social responsibility (CSR) or ESG investing, will take center stage at financial institutions, which will also prioritize leadership and diversity initiatives.

To read the CFA’s full Future of Finance report, click here.

The Future of Finance: “Lower for Longer”

Although interest rates in the United States inched higher earlier this summer, around the world, rates remain low as countries try to spur economic growth. The strategy of keeping rates low in order to encourage growth is not new, but according to the CFA Institute, it may typify the future of the financial industry as continued low interest rates lead to low returns, anemic growth, and a climate of political and social instability.

In a previous blog post, I profile the CFA Institute’s Future of Finance report and it’s four prognoses of how the financial sector may evolve in the coming years: fintech disruption, parallel worlds, purposeful capitalism, and “lower for longer.” In the last scenario, the CFA predicts that perennially low interest rates and other factors—including excessive debt in both the public and private sector and aging populations—combine to prolong the period of weak growth that has followed the global financial crisis.

According to the CFA, low rates will bring about an abundance of global capital and low returns, which will prompt continued intervention by central banks even as those interventions begin to have diminishing impacts. Governments will be largely be unable to respond owing to crippling public debt.

Meanwhile, as average lifespans become longer, corporations and public entities alike will have a harder and harder time meeting their pension obligations, which will lead to pension crises and even pension poverty. This will simultaneously increase pension costs and damage corporate values, further complicating the process of economic recovery and growth.

Under such conditions, the world of finance will respond by deemphasizing innovation since the abundance of capital will mitigate the incentive to develop new products or practices. And while markets may become more efficient thanks to more advanced technology to assist in due diligence and price discovery, they will also become less liquid as capital migrates to fixed assets like real estate and infrastructure.

Financial service providers will also need to cope with a higher level of regulatory scrutiny. The CFA forecasts that lower returns will cause firms to increase their marketing efforts in order to attract new customers; consequently, this will attract a higher level of oversight from regulators and thus additional compliance costs, further shrinking firms’ margins.

To read the CFA’s full Future of Finance report, click here.