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.

On to New Heights: A Review of Bain’s 2018 Global Private Equity Report

The best view to take in from the summit of a mountain is that of the next, taller mountain that you hope to climb in the future. 2017 provided quite a summit for private equity—awash with record amounts of dry powder and many lucrative deals—but taking stock of the successes and challenges of the past year will offer an ideal roadmap for how the industry can continue to prosper in 2018. Bain & Company evaluates the state of private equity in 2017 and discusses potential opportunities, obstacles, and strategies for the coming year in its 2018 Global Private Equity Report, available here.

A major theme of the report is the tremendous success of fundraising in private equity. The industry enjoyed a widely-reported windfall over $1 trillion in dry powder and posted a new record for fundraising driven largely by buyout funds. The final tally for 2017 indicates that, globally, firms raised $701 billion during the year, and in this timeframe, both the number of funds and their capital targets grew based on previous years’ levels. Furthermore, as Bain points out, of funds that closed in 2017, more than two-thirds met or exceeded fundraising targets and 39% closed in less than a year.

While Bain is careful to note that investors “are watchful for signs that the global market is overheating,” the report also shows that there’s little evidence to suggest interest in private equity is cooling. According to data from Preqin, 92% of investors with private equity allocations plan to devote at least the same level of capital, if not more, in the next year. Much of this investor confidence is rooted in results as private equity continues to outperform other asset classes.

However, the prosperity of 2017 and the optimism it’s carried into the beginning of 2018 don’t suggest private equity firms should become complacent. As competition over a limited pool of quality assets intensifies between firms with enormous reserves of capital, returns may flatten, so private equity’s recent string of historic successes means that the industry needs to develop new strategies and techniques for adding value.

Bain’s report suggests three potential paths for firms to establish new capabilities that will enable them to thrive. First, firms can improve their skills when it comes to assessing leaders and deploying talent into tailor-made roles that create value at all levels of the operation. Firms can also prioritize actively managing companies to achieve profitable organic growth instead of simply cutting costs or acquiring additional high-priced assets. Additionally, technology provides new opportunities for firms to conduct due diligence and analytics at lightning speeds, and they can take advantage of this in order to obtain insights, develop strategies, and take action faster than ever before.

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 Rise of Single-Family Offices

For the past several years, the rise of single-family offices has been one of the fastest-growing trends in asset management for the wealthy. According to Forbes, single-family offices are both growing in number and also in terms of how much wealth individual offices manage on behalf of their clients. There are several reasons behind this development: First, the ranks of the wealthy are expanding, which means there is simply more capital to manage, and these wealthy families enjoy the discretion, direct relationships, and personalized services that are possible through a single-family office.

“Single-family offices are very appealing because they can provide tight oversight of the professionals employed, and they often provide expanded access to business opportunities and economies of scale,” Richard Flynn, managing principal of the family office practice at Rothstein Kass PC, explained to Forbes. “Single-family offices can also be instrumental in ensuring confidentiality for the family.”

While there are some common characteristics to single-family offices, one of the advantages is that its organization and structure can be customized to meet the needs and interests of the family that it serves. This means that there are a wide range of options available at single-family offices, but at the same time, this makes it hard to define what constitutes a single-family office and how to count how many exist.

For professionals in the private equity sphere, Forbes also traces how single-family offices have been increasingly turning to private equity as well as hedge funds for recruitment in order to hire successful proven investors. Private equity professionals are often excited to join these offices, Forbes notes, because families are often more inclined to look at the long-term than other funds and because many single-family offices adopt participatory compensation models. Under such a compensation plan, wealth managers have a stake in the family’s overall portfolio or particular investments, which means they also get to enjoy in the success of the family’s investments.

“In our compensation studies, what we’ve found very interesting about the participatory compensation model is that while some investment professionals can earn many millions of dollars in a year others can earn nothing at all,” Usha Bhate, executive director of Institutional Investor, told Forbes. “The participatory compensation model usually has a number of failsafe mechanisms built in. For example, payouts, while guaranteed, tend to be stretched over a number of years, ensuring the investment professionals are not taking undue risks.”

The Importance of Strategic Edge in Private Equity

The private equity (PE) asset class has prospered in recent years, but as Bain & Company notes in its 2016 Global Private Equity Report, this may not be the case for long. In light of decreasing GDP growth around the world as well as other factors, investors anticipate that the double-digit gains that have become familiar over the course of the last four years may become a thing of the past. In fact, Bain predicts that the industry will settle at a “new normal” marked by positive cash flows but returns that are less stellar than those of the recent past.

If these claims are true and the industry is about to return to a resting point, then PE firms need to devote renewed attention to strategy. Fund managers should develop ways that their firm can remain successful and competitive in the changing PE landscape, Bain argues, by emphasizing their ambitions and strengths to create a “repeatable model” for strong investment. And since it takes time to implement a successful strategy, PE firms need to start now.

According to Bain, PE strategy should begin with a firm’s stated ambitions or visions of future successes. The next layer of strategy is to develop concrete goals and action items that allow firms to realize their ambitions. Lastly, a firm should look to hire a talented team of professionals to put this strategy in motion. In the report, Bain suggests three areas where a firm can hone its strategic investments: taking advantage of its “investment sweet spot,” identifying thematic insights, and mobilizing talent and resources.

Bain also asserts that PE firms’ strategies should emphasize repeatable results. As the PE environment continues to change in response to new trends, such as a preference for larger firms by investors, strategies need to be able to adapt and ensure steady, consistent returns even as the market evolves. Firms will need to be able to communicate the repeatable nature of their strategy to potential investors, so in addition to being ambition-oriented and repeatable, PE firms’ strategies should also be easy to articulate to clients.

To read Bain’s full report, click here.

Should Private Equity Firms Integrate ESG?

A recent Forbes article explored the opportunities that private equity (PE) firms could take advantage of by integrating environmental, social, and governance issues (ESG integration).

Considering the ideal position of PE firms to improve the world around us, it’s certainly an interesting suggestion that the writer makes about the role PE firms can take in developing ESG initiatives within the firm’s portfolio.

To explain how ESG integration could benefit PE firms, Forbes presents a compelling outline of the many social and financial boosts that could potentially happen. And there’s other research that suggests a similar positive influence.

According to this report, the PE industry possesses huge assets, somewhere around $2.4 trillion. Because of the size of the industry, it indicates the stage is set for PE firms to take a huge leadership role in ESG integration. Another reason PE firms are in such a good position to improve ESG integration is the most recent holding period for those companies in a PE firm’s portfolio. The holding period of a company’s stocks for a PE firm in 2015 was 5.5 years, while on Wall Street, it’s a mere 8.3 months. That short time period is not nearly long enough for a company to properly conduct ESG integration because it’s necessary to have a longer period of time to see concrete results.

Another possible benefit for PE firms? These entities are not held to many of the same regulations as listed companies, so PE firms can more freely check up on a portfolio company to ensure it’s being properly managed. In the case of evaluating ESG integration, this could mean determining how much value the company is creating, which could in turn influence future investment decisions.

Notably, a recent survey cited that businesses say risk management is their largest reason to begin ESG integration. Some experts argue that integrating ESG values is a first step to mitigating risk and helping companies appeal to their shareholders and potential investors who need greater assurances.

European PE firms are also honing their focus on ESG investments. In the last month, Invest Europe–a trade association for European PE, venture capital, and investors–published a due diligence questionnaire for private equity firms interested in ESG so that the firms can better assess potential ESG investments. That questionnaire is available here.