The worldwide financial crisis has produced many long-lasting and historic changes on Wall Street. One of the most significant changes for pension fund investors, however, took place off Wall Street. The financial crisis of 2008-2009, without much publicity but with deep impact, led to the end of the private equity industry — as we have come to know it. A new private equity industry will emerge, but how pension fund investors will participate in it is unclear. If the recent past is any indication of the future, pension funds will abandon many of their old standards and construct a new set of rules that will restore the private equity industry to its roots.
Reimagining, reengineering the private equity business
Pension funds seen key to PE industry going back to its roots
The private equity industry ended sometime between 2008 and 2009. With 2010 approaching, the practices of pension investing that contributed to the enormous growth of private equity in the past 20 years will be abandoned. Pension investors will critically review all of their traditional private equity assumptions, including percentage of assets allocated, industry sectors favored and type of manager selected. Many managers will be downgraded from the “A” list to the “B” list, while others will be dropped completely.
Contrary to the explanation most often cited by politicians, i.e., “greed,” I believe a number of factors conspired to produce the industry's downfall, the most important of which was competition. Competition for pension fund allocations drove managers to construct transactions that had one goal in mind: speed. The sooner money could be returned to limited partners, the better a general partner believed he or she would appear in the eyes of the pension fund trustees and executives as well as their advisers. A new league table emerged in the last dozen years. Instead of focusing on return on capital employed, private equity managers began touting their internal rate of return as the most important metric a pension fund should use in choosing a manager. How does one produce a higher IRR? By returning capital as soon as possible. This development was fueled by the lax lending practices employed by fee-hungry banks and brokers. And from the confluence of these two forces emerged the era of the leveraged recapitalization, or recap, in which various amounts of equity and debt originally invested in the business are replaced by a new tranche of debt at terms very favorable to the borrower, the private equity investor. This amounts to a dividend that allows these investors to take money off the table right away, typically well in advance of a larger liquidity event, such as a sale or IPO of the business.
But while almost everyone focused on the velocity of capital being returned to pension fund investors, almost no one criticized the means by which such capital was returned. Leveraging an already leveraged balance sheet interferes with strategic growth. Leveraging an already leveraged balance sheet compromises a company's competitive position in its industry and jeopardizes its future — especially in economically uncertain times. And just when nearly everyone thought the good times would continue without interruption, the music stopped and those companies and their equity shareholders had nowhere to go but down. In the slang of today's politics, those general partners mortgaged the future. As a result, billions of equity dollars were vaporized.
The new private equity industry will be defined by a reacceptance of what private equity is all about. It is about building not buying. It is about seeing operating rather than financial opportunities. It is about developing strategic insights produced by extensive industry expertise. It is about taking good companies with decent management teams and helping transform them into great companies with industry leaders as managers. Private equity is the turtle, not the hare, in the race to riches. Private equity investing will be practiced differently in the future — by returning to its roots. It was always about finding a mismatch between an outside investor's impression of value — as expressed in a company's stock price — and a company's intrinsic value. Recognizing that misperception, a private equity manager will see a path to value creation based on fundamental operating improvements. Better products, better marketing, better sourcing, better solution selling, leading to industry leadership. The result of this transformation is a company that has gone from a “might be” to a “must have.” A business with leadership qualities married to market potential.
But these qualities come about slowly. That is why the traditional hold period of private equity — when it first gained institutional investor interest in the late 1970s and early 1980s, when I started — was five to seven years, not 18 to 24 months.
The new private equity industry will be a return to coherency, a return to fundamentals. In the long term, those private equity managers and pension fund investors who embrace the past will perform best in the future.
Robert F. Mancuso is managing partner and founder of The Dellacorte Group, a New York-based, middle-market focused merchant bank active in corporate advisory services and private equity. He has worked in the private equity and capital markets arenas for nearly 35 years.