The bottom line is that without a strategy for expanding organic, top-line growth at their portfolio companies, private equity firms will become less competitive at raising investor funds and making deals. “You’d better have a strategy,” says Misrahi of Apax, “or else you’re a me-too product. And if you’re a me-too product, in the next five years, you’re nowhere.” CCMP’s Murray offers an even more fundamental perspective: “Most of the industry doesn’t recognize the problem. The private equity business has always been about providing a solution for a company’s orphans or an entrepreneur’s needs; we make professional businesses more entrepreneurial and entrepreneurial businesses more professional. We need to go back to being in the solutions business and not just another asset class for investors.”
By embracing private equity’s third innovation of enhancing organic growth — adding new growth capabilities, changing the dialogue with portfolio companies, and making organic growth net free — the most innovative PE firms will enrich their “solutions business,” and gain market share and improve their overall profitability in the process. As they succeed, they will ensure that their core business continues to be a vital force in the capital markets, and at the same time will help promote a more productive, growth-oriented perspective throughout the corporate sector.
Might the Contract Change?
In a world where private equity returns will depend to a greater extent on portfolio companies’ ability to grow organically, there may be an argument for lengthening the life of certain funds. The typical seven- to 10-year cycle of fund raising, acquisition, and exit may not make sense with investments that are generating good returns. After all, engineering organic growth can take more time to show results than financial and operational engineering; it may be that after five years in the portfolio, the portfolio company is at the very beginning of what may be a decades-long rise in revenue and profits.
When that is the case, “Why rush to get out?” asks Paul Levy, managing director of JLL Partners, speaking of both the private equity firms and their limited partners. The power of compounding, Levy points out, really kicks in during the “out” years. Twelve percent for five years — no argument; that’s nice. Twelve percent for 30 years — that starts to be real money, Levy says.
Of course, most of the limited partners with whom Levy has broached the topic want to know what would happen, under these circumstances, to the fees they pay. A private equity firm may initially create a lot of value by identifying promising investments, improving company operations, and setting the company (per the philosophy of this article) on more successful organic growth trajectories. Eventually, though, the private equity firm’s contributions should be mostly complete. At that point, from the limited partners’ perspective, shouldn’t the fee structure change?
“Maybe you do something whereby instead of 80–20, after a certain point in time, it becomes I own 20, you own 80, and you can do what you want with your 80,” Levy says, describing the conversations he has had on the topic with limited partners.
Theoretically, lengthening private equity holding periods might also address some of the more contentious issues surrounding secondary buyouts, in which one private equity firm sells a portfolio company to another private equity firm, in order to close the fund and return money to its limited partners at the agreed-upon time.
With the IPO market largely closed off in 2009 and 2010, “secondaries” — an escape hatch for private equity firms looking to exit their investments — became common. Problems arise, however, when a limited partner ends up owning the same company as before, but through a different private equity firm — and having paid transaction fees coming and going. “That really creates tensions,” notes Eddie Misrahi, the managing partner of Apax Partners.
Yet changing the contract may be an idea whose time has not yet come. Private equity executives say most of their limited partners aren’t looking to rearrange things so that a portion of the capital they commit is “permanent.” On the contrary, says one private equity executive, limited partners “are always pushing to get out of investments, to get their money back.
“We’ve seen a couple of big investors that have been going through a broader bid process saying, ‘Is there a way to build a different partnership?’” adds the executive. But those inquiries, he says, have been less about changing the terms of private equity deals than about investing in other asset classes now under some equity firms’ roofs, like mezzanine funding and debt financing.
— K.F., J.N.