INVESTMENT ACTIONS

Private equity perspectives

When investors look at public markets today, many see high valuations, low expected returns and a likelihood of increased volatility. So it’s little surprise that more than a few are increasing their focus on private equity. But private equity faces its own challenges, including intense competition for deal flow and higher-than-average valuations in some parts of the market. We examine the opportunities and risks in three distinct PE strategies.

Capital at risk. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.

 


Creating persistent alpha

With more companies going private or staying private for longer, the opportunity set in private equity is growing, and there are several ways for institutional investors to access the asset class: the traditional route of GP/LP structures; co-investments alongside those structures; secondary markets; and direct, flexible-hold strategies. Each offers the potential to deliver alpha across the full economic cycle, but each also comes with unique challenges, particularly in a late-cycle environment. We’ve asked three of our leading PE investors to provide some perspective on the current market climate and to share their views on what it takes to create persistent alpha.

Our Q&A participants are:

  • Colm Lanigan, Co-Founder and Senior Investor, Long Term Private Capital
  • Konnin Tam, Co-head of Secondaries and Liquidity Solutions, BlackRock Private Equity Partners
  • Lynn Baranski, Global Head of Investments, BlackRock Private Equity Partners
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Value creation in direct private equity

Q: You are a founding partner of a flexible-hold private equity strategy. There’s a perception among some people that such a strategy is a form of hands-off, passive private equity ownership. Do you see it that way?

A: Not at all. There’s almost nothing passive about private equity. In the private markets there is much greater disparity across both scale and quality, so the whole screening process is, itself, active. In addition, fees are not the differentiator between alpha and beta in private equity. They’re part of it, but a much bigger part of alpha generation is the active management of the business, active governance, and value creation – regardless of the time frame, shorter or longer. 

There have been approaches to longer-term investing in private equity that focused on asset selection as the number one indicator of earnings over a longer period, and then used the long holding periods to achieve something resembling private equity multiples, though not alpha. But those approaches have focused on assets that are infrastructure-like or on asset-intensive businesses with stable earnings, as opposed to businesses that can drive private equity IRR and multiples over long periods of time. There’s a big difference between the two, and the key to the latter is still active management of the business and active governance to drive return on invested capital (ROIC) and growth.

Q: You’re an advocate of the importance of persistent private equity returns. What are the keys to achieving them?

A: I think what we’ve learned is that good companies often remain good companies as long as they are effectively managed. The business model matters –Do they have a slightly better mouse trap? – as do other things, such as having better gross margins than their competitors. But it really comes down to superb management teams who think and act like company founders, and who unfailingly and unwaveringly focus on execution of the plan and the strategy that they know makes their companies successful. And part of that founder mindset is rigor around capital allocation. Favorable market positioning from differentiated business models, durable economics, and seasoned management teams with disciplined strategy execution are what drive ROIC, and those companies succeed for longer periods of time. Sponsors covet those types of companies because they know they have the potential to make them even more successful.

Q: What do you see as the most important aspects of a value-creation plan?

A: Developing a value-creation plan begins with identifying the fundamental variables that drive the business’ success. You’re looking for no more than five such points that allow you to focus management practices and create continuing value. For example, operational excellence is one, and it’s a must-have for every successful business. Drivers of scale are another.  Which elements of the business are on the right side of pervasive disruption is another, so you can focus your efforts on the greatest opportunities for growth. A final one should be your digital strategy – it’s imperative that it supports your day-to-day analytics so you can make the right decisions in an environment that’s moving faster, and is tougher to navigate, than ever.

When you focus on those few things that matter the most, you don’t overstretch your organization, and you can match capabilities with goals and incentives. People’s behaviors are shaped by incentives and associated performance metrics. If employees know that you are focused on—and measuring—the right things, and that’s how they’re going to be compensated from top to bottom in the organization, you have all the ingredients of success.

Q: Are there any special considerations that come into play in a late-cycle climate?

A: Having managed through a couple of cycles, I would mention several.

You need to be careful about leverage, which instead of adding to your returns can very easily subtract from them when the cycle turns. And you have to be wary of deals that have a lot of execution risk—for example, from moving plants or expanding margins. If you haven’t built in a recession scenario, you’re probably playing with a little bit more risk than you anticipated. Looking left on the return curve—thinking about what could go wrong, and factoring that into your due diligence and underwriting—is probably even more important right now than looking to the right.

In good times, extra volume through a business can hide a lot of inefficiencies and problems. It has been a little easier to take lower-confidence bets when you’ve had margin expansion due to 12 years of economic prosperity and growth that’s higher than trend. Multiple expansion has been a major driver of returns in the deals done since 2010. You’d be on shaky ground if you relied on that continuing.  It may, but it’s less likely than before.

If it looks like the business will be tested by an economic trough, it is key to focus on the fundamental business variables that generate lasting value and to position for growth. That can help generate a couple of quick wins to build confidence throughout the organization and put you in a slightly better position going into what could be a tougher period.

A robust capital structure is a big plus. Private equity is a long option, and if you have a capital structure that can withstand some of the hiccups, you’ll come through the other side. I would focus a little more on the balance sheet in this environment, too. If you have enough capital available, you’re in position to be the consolidator of your weaker competitors over time.

Of course, human capital is perhaps the most important element of all. To achieve long-lasting success, there is no substitute for having the right people and forging the right partnerships.

 

Colm Lanigan
Co-Founder and Senior Investor, Long Term Private Capital
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Private equity secondaries: Assessing opportunities in a growing market

Q: A lot of people are concerned that we're late in the economic cycle. How does this affect the market for secondaries, which we’re defining here as the sale and purchase of investors’ existing interests in PE funds and portfolios?

A: I think you need to consider the effects on both the supply and the demand side. On the supply side, we think the belief that we’re late in the cycle is prompting PE investors to consider repositioning their portfolios in advance of the next downturn. So we’re seeing an increasing number of sellers that are motivated by either a desire to lock in what they view as attractive underlying fund valuations or by a desire to generate some liquidity to reinvest into other opportunities in PE or in different asset classes.

On the demand side, we think that buyers are more consciously factoring late-cycle dynamics into their asset selection, underwriting and structuring. So we’re seeing greater interest in less-levered and higher-growth assets, as well as in assets that have more flexible debt packages or that offer greater secondary-market discounts. 

When you consider the environment from the perspective of both buyers and sellers, it makes sense that this is shaping up to be a record year in terms of secondary-market volume.  If you believe that we’re late in the cycle, then it may be prudent to pare back or reposition your portfolio. At the same time, if you are an informed buyer and can properly navigate the environment, there are opportunities to take advantage of the supply that is coming to market to acquire assets with counter-cyclical properties.

Q: We’ve seen tremendous growth in sponsor-led secondaries in recent years. What are the biggest challenges and opportunities in investing in these deals?

A: In a sponsor-led secondary—which can be defined as one in which the PE manager is partnering with a secondary buyer to offer liquidity for some part of an existing PE portfolio—there are several unique challenges. I think the biggest ones revolve around transparency and alignment of interests among stakeholders. The rationale for the manager doing a sponsor-led deal needs to stand up for their investors to be supportive of the deal. There also needs to be a true status-quo option for existing investors, meaning that they're not forced to sell if they don't want to. Ultimately, successful sponsor-led secondaries need to benefit the sellers, the buyers and the PE manager, and that makes these transactions quite complex, but it can also create interesting opportunities for buyers and for PE firms that can craft an aligned solution.

Because of that increased transactional complexity, we believe the market is underwriting such sponsor-led secondaries at a higher level than traditional secondaries. In addition to that “complexity premium,” sponsor-led secondaries often carry a unique opportunity from a portfolio-construction perspective.  Sponsor-led deals, by their nature, tend to be more concentrated than highly diversified portfolio deals, so buyers may be able to fill in gaps in certain areas of a PE portfolio, such as strategy, industry, or geography.

Q: What is the role of secondaries in investors’ portfolios and how has that changed in recent years?

A: It used to be that secondaries were primarily used by investors that were new to private equity, as a means to get invested quickly in a risk-mitigated and diversified way. By purchasing a shorter-duration, highly diversified portfolio in the secondary market, it’s possible to get immediate vintage-year diversification, with exposure to a number of managers across different strategies, geographies and industries.

While these new entrants to private equity continue to play a role in driving capital into the market, we now also see seasoned PE investors maintaining, or in some cases increasing, their allocations to secondaries. I've talked about secondaries as a counter-cyclical and opportunistic strategy. I think seasoned investors are maintaining an allocation partly because of those characteristics. We also think that an allocation to secondaries adds resilience to private equity and private markets portfolios, due to the benefits of additional diversification and the ability to price in more factors in a partly funded portfolio, among other factors.  

Because of these potential benefits, we do think more and more private equity investors consider secondaries to be an integral and consistent part of their PE portfolios. The way the secondary market has evolved over the years is analogous to the way the broad PE market has evolved. Private equity used to be seen as an alternative investment, now it’s a core one for many institutional investors. And secondaries used to be considered a niche part of the PE market, but now they are a core holding for many PE investors as the sheer size of the market expands and secondaries become a regularly accepted portfolio management tool on both the buyside and the sellside.

Q: How do you see the secondaries market evolving in the future?

A: In a little over a decade, we’ve seen the market evolve from just single- or multi-fund portfolio transfers to encompass dozens of different kinds of transactions, including sponsor-led deals, team and portfolio spinouts and carveouts, real asset secondaries,  private credit portfolios, preferred equity, and synthetic secondaries, which replicate the economic outcome of a secondary transaction without actually transferring the underlying fund portfolios. So there’s been a great deal of innovation in the market in a relatively short amount of time, really in response to the dynamic and complex asset class that is global private equity. We expect that to continue, and we believe that market participants will continue to develop new transaction types to address new needs and opportunities.

We also think market transparency and the speed of execution will continue to evolve and improve, but inefficiencies will persist as well. I think one area where we’ll see a good deal of innovation is in the quality of the analytics. We think of the secondaries market as data-rich, but analytics-poor, so we believe it’s ripe for future advancements in analytics that will allow investors to leverage more of that data.

Konnin Tam
Co-head of Secondaries and Liquidity Solutions, BlackRock Private Equity Partners
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Co-investing in a dynamic private equity market

Q: Where are you finding value in private equity co-investments right now?

A: What we really focus on is the general partner’s angle on the transaction – how are they going to add value and what’s their value-creation plan? We then spend a lot of time in our due diligence focused on how best to stress test the assumptions that underlie the value-creation plan. In today’s market, this would certainly include understanding how the company or industry performed in different market cycles.

On a forward-looking basis, understanding how a company may perform in a potential recession and what levers management can use to weather a downturn is critical as we stress test business models. With these questions in mind, where we see value right now is very asset-specific, but there are some common themes that catch our eye. 

Q: What’s an example of such a theme?

A: Corporate carve-outs are interesting—there’s always a steady supply of these transactions as companies sharpen their focus on core businesses and adjust long-term strategies to drive value. We really like orphaned subsidiaries. Typically, the best management teams or executives don’t want to work in a non-core subsidiary of a larger company. Without that leadership, orphaned subsidiaries tend to lack the strategic vision and investment they need to grow – they’re often capital-deprived. So in a corporate carve-out, while there may be cost-cutting in some areas, there can also be investment in growth-drivers. GPs often add best-in-class management, with an incentive structure that motivates them to align with the value-creation plan. Often their investment back into the company drives value creation in the form of new product development or expansion into additional geographies.

Q: Any other themes you like?

A: We will spend time on buy-and-build strategies, which can be effective at creating value even when purchase prices are relatively high. We’ll look at a company that we think is really best-in-class in a fragmented industry. We’re willing to pay market price and maybe even above for a healthy core platform asset. Then we can execute a roll-up or tuck-in acquisition strategy to accelerate top-line growth and drive operational synergies. A recent example of this that investors might find surprising is a traditional travel agency that we acquired. It’s focused on highly curated packages for affluent travelers—think African safaris—that no one is going to book on a discount travel website. We acquired that company at about $70 million in EBITDA and made some highly accretive follow-on acquisitions that have increased EBITDA to $125 million.

It’s also worth noting that in today’s highly priced market we look across the capital stack to find the best risk-adjusted returns. In that context, going back to 2018 we started seeing opportunities in preferred securities, where a company needs an additional layer of junior debt or preferred equity. These deals allow us to target high-teens return profiles, with multiple layers of equity buffers. Finally, we are always looking for any business that is disrupting a traditional industry.

Q: What are the supply and demand dynamics in co-investments today?

A: We’re hearing from GPs that every limited partner that comes through the door is asking to see their co-investments. LPs have to be careful on resourcing and due diligence in order to effectively build and manage the risk of a co-investment portfolio. But if you can do it well or hire a team to do it well for you, you’re lowering your fee load while adding potential alpha into a portfolio through asset selection and diversification.

From a supply perspective, we are seeing healthy supply as GPs rarely will partner with other GPs like they used to do. Rather, they are turning to their LPs for additional capital when needed. As a result, we are being brought into transactions earlier and earlier, usually during the bidding stage, because we are willing to provide the resources and team to move alongside the general partners as they are doing their due diligence. Committing the resources and time in the early stages of a transaction gives us more time to complete our due diligence, and it often allows us to lock in allocations. We’re starting to see larger and larger transactions as well, which have provided additional co-investment opportunities for LPs.

Q: How do you manage risk in individual deals and in a portfolio of co-investments?

A: We view portfolio construction as a key component of risk management. Vintage year is very important to portfolio diversification. We’ve seen some investors make the mistake of suddenly deciding they want to be in private equity and then deploying way too much money in a single not-so-great vintage year. We believe in building a private equity portfolio over a four- to five-year period, and that pacing is super important in portfolio construction and risk management.

We also look to diversify the portfolio by geography, industry, and general partner, and within industries we break that down by the stage of investment. If it’s a global program, we methodically track geographic diversification.

As we think about individual companies, we try to size our co-investments based on their risk-adjusted returns. Generally, our position sizing would range anywhere between 3% and 7% of a portfolio, with the 3% allocations being companies we perceive to have higher risk, but also maybe higher return potential.

A 7% company would tend to have an asymmetric risk-return profile. Typically, these companies are market leaders, and we can effectively diligence their competitive framework. They often have high cash flow conversion, and they may have high recurring revenues. As important, we like deals that have multiple drivers of value creation, so it’s possible to realize private equity returns even if companies don’t fully achieve any one component of their value-creation plan. 

For the last several years we’ve also focused more on the qualitative aspects of risk management –all the environmental, social and governance (ESG) factors and their impact on a company and its reputation, for example.

Q: How do you see the co-investing market evolving in the future?

A: We’ll continue to see the market evolving because LPs can provide unique solutions to the private markets. Fifteen years ago, LPs were not as critical to getting a deal closed. Today, when my team writes equity commitment letters to help provide certainty of financing for a take- private, we are comfortable working alongside the GPs--often with incomplete information. We have a dynamic investment approval process that can handle tight timelines.  And we will take board or observer seats and, at times, have voting rights.

We also see more fundless-sponsor transactions. If we know general partners that have a solid track record over time, and a network that allows them to find unique deals – maybe they’re trying to raise a fund, maybe they’ve left their organization and don’t have capital yet – we have found ways to provide them with capital to execute transactions. We’re willing to do the work because typically those deals are very proprietary, often have a unique angle, and we are able to buy them at a discount to where most of the market is trading.

Lynn Baranski
Global Head of Investments, BlackRock Private Equity Partners
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