The Future of Private Equity

Profiles for Success in the New Private Equity World

We are living in unprecedented economic times. High yield default rates have soared, Federal Reserve System assets have ballooned, housing starts have plummeted and more banks undoubtedly will fail. While there have been some signs of improvement, it is clear the events of the past two years will have a lasting impact on the global financial landscape.

Similarly, the private equity industry will see both fundamental changes as well as a reinforcing of the constant principles of private equity investing. Importantly, the bedrock is solid, and the model is not broken. Private equity investors can still be appropriately compensated for the illiquidity and associated risks of investing in the private securities of established and early stage companies. However, strategies must be appropriate for the new times, tactics must be adapted and revised, resources need to match the new requirements and teams need to be responsive to new challenges.

What has changed?

Broad, deep resources are now essential. Private equity firms must be able to respond to new regulatory, fundraising and portfolio management demands, among others. Firms will need to develop larger, more costly back office infrastructures to manage increased regulation so that investment teams can stay focused on investing, creating value and exiting investments. This theme also holds true in managing the fundraising process, where the allocation of time and resources will increase significantly. Today, an international network and capability are essential to support the global ambitions of portfolio companies by helping them enter new markets, find acquisition targets and develop new supplier relationships. An international network also enables a private equity firm to spot emerging trends early, fend off competitive threats and use the financial markets most effectively. The best performing firms will be those with genuine global reach and scale.

Active investors, not asset managers, will drive outsized returns. Operational expertise will be critical to driving growth and shareholder value, yet only a small minority of PE firms today allocate more than a third of their time to operations issues. Private equity investing is all about EBITDA growth and the speed of execution does matter. Since the first 18 months of an investment determines the return trajectory, it is essential to be proactive and aggressive in providing management teams with the tools and resources to be successful in good times and bad.

Risk must be assessed and managed in new ways. Studies show that limited partners are dissatisfied with general partner transparency and risk management. In an uncertain world with an uncertain trajectory, buyers and sellers must share the risk. This doesn’t mean target returns need to go down, rather risk needs to be managed differently so that investor outcomes are protected. Also, firms need to re-emphasize the capital efficiency of their investments and the value created from each dollar invested. In addition, transaction legal frameworks and capital structures must be revised and need to reflect the new market realities.

The new norm: proactive, creative and insightful. In the new private equity environment, quality private equity deal flow will be harder to come by. That’s why today, more than ever, private equity firms need to know where they want to invest and why, and then need to create their own opportunities. Firms need to be proactive in creating a differentiated deal flow in the right sectors with the right management teams, drawing on deep sector expertise and relationships. Generalist private equity firms will have a tough time competing for opportunities other than with price and will eventually fade away.

What Hasn’t Changed?

While there are some fundamental changes in store, some things, like integrity, ethics and teamwork, will remain constant as drivers of success in the private equity industry.

The blind pool, long term nature of the private equity asset class demands appropriate behavior and investor confidence. The reality is some private equity firms will not survive this downturn, and those that do endure will need to be better aligned with their investors. Investors now understand that when private equity partners have their own capital at risk, the alignment of interests creates the incentive to generate long term wealth creation, not short term fees. Further, transparency has to be a given, and there is a role for appropriate oversight and regulation. The adoption and implementation of meaningful Codes of Conduct will indicate which funds take these issues seriously, setting and upholding high standards for behavior in the funds’ business dealings and throughout their portfolios.

At the end of the day, private equity investing still comes down to judgment and the benefits of a well functioning partnership. Private equity is a team sport – firms need to define specific criteria for success, and then hold all team members accountable. This includes ensuring the appropriate tools, such as coaching, training and regular feedback, are available to PE firm personnel and portfolio company management teams to achieve success. Investments in people pay real dividends.

Paul Carbone is Director of Chicago-based Baird Private Equity, the global private equity group affiliated with Robert W. Baird & Co. (Baird). Baird Private Equity, which makes venture capital, growth equity and buyout investments in the United States, Europe and Asia, has raised and managed over $2.6 billion in capital and invested in over 235 companies since the 1980s.