Private Capital & Private Equity Trends: Post COVID-19 & Beyond
Introduction
As exit the COVID-19 post pandemic timeframe let’s take a brief look back at the role and outcomes of Private Equity in the development and support of the small business services sector. There are some significant findings and learnings that we, as “stewards” of small business, need to know, learn from, and respond to.
While most of the reports and articles on the Private Equity sector focus on the “mega” stats, “macro” numbers, and analytics for the last year, there are some trends and outcomes that have become somewhat “chronic and subliminal” that will affect our utilization and structures of Private Capital, in Post COVID-19 economy .
Private Equity has continued to perform reasonably well as an asset class over the past 3-5 years until Q2 2020, with returns averaging 12% - 15%. However of recent, Limited Partners (LPs) are beginning to question legacy issues and the model effectiveness of Private Equity. The long-held ideal of allocating capital from LPs to a fund for a 6-8-year investment period, at the accepted 2% management fee structure and 20% of the LP’s “carry” or investment return (commonly known as the 2/20 compensation model) is being questioned. However, more questions of what’s next for LPs in terms of commitments, greater transparency, and governance could be what will dominate conversations with Private Capital when the LPs flex their strength and influence, especially in the Post COVID-19 arena.
By way of background, not all funds are the same in size, have the same focus areas, and investment criteria, etc. A reasonable analysis of the entire Private Equity market can be divided into three segments:
Over $7B Assets Under Management (AUM)
$1B-7B Assets Under Management (AUM)
Under $1B Assets Under Management (AUM)
The looming question for LPs, GPs (General Partners of the Funds), and all Private Equity stakeholders is this: What will be the mega-trends that drive better return performance and more transformation to support the private capital needs of the economy, and specifically the small to middle market companies?
The Four Trends of Private Capital/Private Equity to keep close watch on are best summarized in these primary areas:
Legacy <10-Year Fund Trends + Funds
Evergreen Funds & More Permanent Capital Vehicles
LP’s Recent Trends: What Do They Want?
Family Offices: Roles and Trends
“The Look Back”
As a first step to see how these trends will impact the market, an important initiation point is to consider what the data and research tell us. No data set is perfect, but, directionally, we should consider how the big LP money is flowing in and out of the markets and to whom.
Pitchbook, a research and data provider, has provided us with a detailed analysis of the flow of capital from the LPs’ allocations to the end-user companies of equity capital, from 2016 through 2018. This information states that 2016 was a record fundraising year for Private Equity funds, with notable increases in “direct investment” activities by LPs and Family Offices. While the information for 2019 is still not complete, the preliminary data indicates that funded investments or the past 3 years of IRRs (net of fees to the LPs) remain in the same range of 12-15% average returns, irrespective of the improving economy in the USA and increasing public capital returns.
Therefore, this Private Capital performance has resulted in:
A reduction in commitments by LPs to Private Equity from 2017 to 2019, with the expectation that, in 2020, this trend will continue. This will be true in all 3 segments of Private Equity.
Significant increases in LPs and Family Office “direct investments” to end user companies in 2016 and 2017, with the expectation that this trend will increase when we see the final 2018 data and we realize the realities of 2019.
As the LPs and Family Offices, in 2020, clarify their direct investment policies and staff them with experienced deal professionals and proven operating executives and advisors, this will have an uplift effect on the net returns of the LPs and Family Offices over the next 3 to 5 years.
LP and Family Office deal volumes, in terms of dollars, approaching nearly 15-20% of all deals in the sub-$1B fund market segment, according to preliminary 2019 data.
The realization that dis-intermediation hits every industry eventually and Private Equity is no exception.
Therefore, for those of us in the small- to middle-market business market category, direct investments from LPs and Family Offices become a very viable option, especially if the debt resets or tightens even at the senior debt levels.
Post COVID-19 “A Look Forward”
This directional trend of more participants and competition for the investment in the best business models will make it difficult for Private Equity General Partners (GPs) to sustain even 12% IRR results within their current models and overhead loads.
This brings us to the trends to observe and consider in 2020 and beyond:
Evergreen Funds, better known as 15-year lock-up funds (versus 6- to 10-year funding cycles) will increase in their popularity and will be attractive to large LP capital. This should drive co-investing and will have a positive effect on the middle market of Private Capital activities.
LPs’ direct investments will increase at a faster rate than those of Family Offices, due to their access to resources. Look no further than the early January 2019 announcement of OMERS opening a Silicon Valley office for venture/late-stage investing.
How effective LPs pivot from deal access via co-investing with Private Equity, to more robust and economically efficient direct investing models will be a trend to watch.
Family Offices will continue to be active and build “in-house” deal expertise and migrate to more direct investing models as well. Their impact in “pirating” deals from the core middle market private equity firms is already established.
The $1B-$7B fund size will have to provide proper optics, increased reporting on the status of deal flow, including investment and operating results to LPs. Should the LPs flex their muscle and strength and put guidelines around minimum investment levels to the funds, the result will be more value for the management fee paid and an increased portfolio of investments.
Recent data-proven results have only shined the spotlight on the need for the much-needed transformation of the Private Equity business model and its role in the distribution of Private Capital to private companies.
For a mature asset class such as Private Equity to never have had a natural evolution or effective change to complex market conditions is, at best, curious.
Where structured debt supply and the resulting price effect goes will determine how much LP and Family Office success of their “direct investment” participation will drive the change in how Private Capital is deployed in 2019 and beyond.
Conclusion
Over our nearly two decades, Ephor has participated in nearly 2 dozen Private Capital situations as investors, operators, board members, and advisors to transformational services business models. We have learned a lot, done a lot, created significant wealth and have certainly learned from our mistakes.
One of our many learning lessons is that the procuring and the financial engineering of our capital needs, while weaving through all the complexities of dealing with Private Capital, is no minuscule task. It is complex and full of risk.
Many times, we have seen CEO/Entrepreneurs make inappropriate decisions regarding capital formation, which have resulted in negative long-term effects on the business model and its effectiveness.
Therefore, we urge you to get outside expertise, knowledge and experience as you go about satisfying the growth and capital needs of your business.