It's a slow Thursday night and the Principals on my team are working on a co-invest memo that will land on my desk on Sunday morning for a Monday IC. I have some time, I have been doing a lot of deep thinking on private equity as an asset class and I have a newfound love for writing, so I figured I would put all that together and give some of my thoughts on private equity as an asset class. The hope is to have a healthy, respectful debate on the asset class while touching on some of the topics I have seen in the PE forum recently.
PE is in a funk: Ultimately, GPs do not exist with LPs funding their commingled funds. LPs only do so because they believe the GP's fund will help them beat their PE benchmark, which generally tends to be the MSCI World, MSCI ACWI, some small cap index or very rarely, the S&P 500. Over basically any 5- or 10- year period since at least the early 90s, LPs have been generally successful in funding GPs that help them do this. But the last two years have been different. As public equity markets have shot up, the MSCI ACWI is up nearly 30% over the last three years, PE portfolios have lagged benchmarks significantly. I believe most GPs are completely oblivious to this fact and keep saying things like "hey, our 2020 fund is at a 7% net IRR but that is really good given the conditions over the last half decade". Like, nobody cares, it just looks like you are failing in the one thing you are supposed to do, end of story.
Darling sectors: Healthcare and technology have been the two darling sectors of PE since the GFC. Multi-site retail healthcare is f*cked and will likely remain so for the foreseeable future. I think technology PE will still do fine and will likely continue to be the best performing sector going forward. I do worry about the proliferation of GPs and the complete lack of any differentiation that 95% of GPs bring to the space. I also think we are likely to see new sub-sectors of activity emerge - hard to say where these are going to be but I think we should watch out for climate technology, infrastructure services, industrials businesses with an ESG angle etc.
PE is a money-making machine unlike any other: There is probably no other industry in the history of mankind where a small group of investors have managed to garner such a substantial piece of economics and then keep that up with no real fee compression for nearly 50 years. That is insane! Sure, there have been concessions - no-fee co-investments are a significant portion of PE capital deployment, there are now offsets against management fee etc. Let’s talk about management fee offsets for a second: in what other industry do you get to charge fees to your customers to do a job (invest), then go ahead and charge more fees to your counterparty to do the thing you promised to your customers? Like, what even is a monitoring fee when LPs are literally paying you management fees to find deals, create value and exit them?
GP stakes low key ruined the asset class: In the early days of PE, the idea was very simple. We will capitalize a fund for you and pay you a reasonable amount of fees so you can build a team, hunt for companies, invest and hopefully exit the companies well. As time went on, people realized that the treasure trove was not in the carry, which although substantial, was far from guaranteed and very sporadic. No, the gold was in the management fees - guaranteed, infinitely scalable if you can raise assets and extremely profitable given the margins of a GP firm. So of course, management fees got securitized and traded, both in public markets (Hamilton Lane, Partners Group, EQT) and private funds (Dyal, Petershill, a whole host of smaller firms). Today, it's nearly impossible to find a GP that's thoughtful about fund size increases. I mean I get it, if I were a GP, I would do the same thing - raise the largest possible fund that I can and then adjust my investment strategy to suit the fund size than vice-versa.
Continuation funds are here to stay: I love CV funds as a potential buyer of these assets. I hate them when it happens in one of the funds I am invested in. The veneer in these transactions is that the GP needs to be fair to both buyers and sellers but let’s be real – the GP is extremely incentivized to artificially deflate the NAV of the portfolio company as much as possible. Why? Because any credible secondary investor will require the GP to roll all of their carry and GP commit to the CV, and maybe even ask them to invest incremental capital. I have seen situations where the GP will make more $ in carry from a single asset CV if the business hits its upside case than they will make from the entire fund that the company came from. Alignment with LPs also tends to be better in CVs in that you are paying half the management fees the fund is charging and you have a ratcheted carry system. No, I don’t work in GP secondaries although I wish I did.
PE’s move into retail is extremely questionable: I think the likes of Blackstone, KKR, Apollo etc see the writing on the wall in that the institutional LP world is probably tapped out and that most LPs have already committed the maximum that they can to the asset class. But these are firms so used to 20%+ AUM growth CAGR that they need to hunt for new avenues for growth – voila, retail! The marketing message is extremely crude and self-aggrandizing: hey, the largest and richest investors in the world have been investing in PE for decades. Why don’t we let the little guy invest in this amazing asset class? Let me tell you why: 1) Your pre-supposition that investing in any PE fund will be accretive to the average investor’s portfolio is just plain wrong. LPs have entire teams of people dedicated to picking funds and most still have a hard time beating benchmarks. 2) the average retail investor's time horizon is much shorter than any pension fund, endowment or foundation. 3) These firms will milk the retail channel dry with a whole wazoo of fees and costs that they would never be able to charge institutional LPs. 4) Retail investors have been able to invest in real estate private funds for a while. Just look at how BREIT and Starwood has done. Just mosey on over to WSO’s RE forum and look at all the comments under syndicators there.
Let's talk about subscription credit lines: Earlier, I said that PE has managed to beat benchmarks by outperforming on a public market equivalent basis over several decades. But has this been true over the last decade? Yes and No. Yes because on a net IRR basis, the median PE fund has outperformed most public market benchmarks, except for maybe the S&P 500. But sub lines yo, these bad boys are a more recent phenomenon. As with everything else in the PE, the initial intention was a good one. Let's reduce deal closing risk and making our LP's lives easier but just having 2-3 capital calls a year. But then slowly, putting a new investment on the sub line for 3 months became 6 months became 9 months and now, the market practice is to not call capital for deals for a full 12 months. The resulting increase in net IRR is material. The sad part is that even if a well-meaning GP does not want to use or abuse sub lines, they will move down in net IRR quartile rankings. So everyone is forced to abuse sub lines. Has PE performance outperformed public benchmarks when excluding the impact of sub lines? I am not so sure.
Infrastructure investing is weird: Ok, this one might be controversial but what even is the point of infra investing? You have core infra assets yield like 6% - 8%. Like, just buy some bonds and call it a day. These are just infra assets where in the auction process, you have a cost of capital shootout between the bidders. You are just bidding up the asset price so high that you are just extremely confident that the maximum return you are making is in the high single digits.......until regulation moves against you. Look at what happened in Spain with renewable assets, what happened in Oslo with the regulator reducing tariffs on a pipeline asset by 90%, what is now happening with Thames Water. And then on the other end of the spectrum, you have funds like Antin buying crematoriums, Tiger Infra buying some infra IT business, EQT buying a parks company. Let's just not pretend any of this is real infra. If you are going to do that, just invest in a proper PE fund and call it a day.
Private credit's "golden age" was a fever dream: Remember how the titans of the private credit world went on Bloomberg and CNBC and started talking about this golden age of private credit? Well, the only reason there were even was a golden age was because the Fed actions had the impact of pushing up base rates. Sure, credit funds started posting higher returns than they ever have in the past but god, it was the ultimate beta trade. I said "was" when referring to the golden age because it wasn't long before these suckers started bending over backwards for PE sponsors again by reducing margins. Ruh roh, of course that was bound to happen if LPs open the spigot and create a wall of capital in a space where it is extremely hard to differentiate yourselves.
But I digress, private credit will probably be fine going forward. Default rates might creep up but there is still structural alpha in the space compared to the broadly syndicated loan market. And hopefully, the "wins" lenders have had against sponsors in terms of tighter documentation over the last two years persist (although I am not waiting with bated breath).
The carnage in real estate: I am on dicey territory here since I have never invested in RE but I have friends in the space and I have been fascinated with everything happening in the asset class since COVID. And man, it's been a bloodbath. COVID knocked the air out of office and to a lesser extent, retail. The resulting decline in rates supercharged industrials and multi-family real estate and investors in the asset class started displaying true tulip mania syndrome. As rates shot up, the carnage was real. Something about thinking about valuations in terms of cap rates instead of cash flow multiples really opens up people's eyes towards the concept of risk premium - like, why would anyone buy your multi-family property for a 3.75 cap when operating cash sitting on an investor's balance sheet can yield 4.5%?
I'll give some credit to the asset class though to be the first one to acknowledge that when rates go up, valuations have to decline. Our brethren in PE have a hell of a hard time accepting this fact - like, nobody cares about the market leadership or higher margins of your darling SaaS business. Rates go up = values come down. Simple as that. There's blood on the streets in real estate. My gut sense is that vultures likely will make a killing as the industry works out of this mess.
Wow, long one, may add more thoughts later!
Based on the most helpful WSO content, here are some key insights and musings on private equity as an asset class:
PE in a Funk
Darling Sectors
PE as a Money-Making Machine
GP Stakes and Asset Class Impact
Continuation Funds
PE’s Move into Retail
These insights provide a comprehensive view of the current state and challenges in the private equity landscape.
Sources: Most academic style of investing that requires the most thought?, Q&A: Private Equity Investor at a Large Buyout Firm Focused on Growth and LBO Strategies, Thinking Like an Investor, https://www.wallstreetoasis.com/forum/private-equity/thinking-like-an-investor-the-key-financial-metrics?customgpt=1, Long term, concentrated, deep fundamental investing
Super helpful views especially an AN1 like myself. Aside from tech and HC, what other sectors do you think are going to have stable tailwinds and a growing market. I've seen all the news coming out for the plans to tighten up PE investing in the physical HC space, which I imagine will lead firms to investing more on the biotech or tech focused side of things no?
Well, the nature of this game is such that no one really knows what the next hot sector or sub-sector will be. Think about technology; before the GFC, tech PE really only existed in growth equity and venture capital. I am old enough to remember the dismissive tone that LBO professionals would use when talking about tech. Like, why are we buying code, what even is that?. And then Robert Smith started doing his thing with Vista, Carl Thoma & Orland Bravo left GTCR to start their own tech firm and people finally wisened up to what these guys were doing and the attractiveness of SaaS as a business model.
What's going to be the next big thing like that in PE? No idea. At a smaller scale, you could argue that infrastructure services as a sub-sector of industrials should do well, managed IT services should do well, at least in the short-term. But none of this is a revolutionary thought.
I will address your question on HC with the poster below.
Can you elaborate on why you believe "multi-site retail healthcare is f*cked"?
Absolutely - there's three main reasons.
1. Depending on the type of healthcare service, top-line growth rates for these businesses have slowed across the board. Many reasons for this: in some business, labour shortages have meant that de novo openings have dried up, in others, payors are more aggressive with rates, reimbursement etc.
2. More than top-line, margins are getting squeezed. Labor shortages have meant that wages have gone up significantly. But it becomes very hard to pass through those additional costs to payors.
3. Perhaps the most important piece of all is that there is a significant bid ask spread in the valuation multiples of these business to an extent that I have not seen in other sectors. Potential sellers are holding on to 2020 / 2021 valuation expectations oblivious to the fact that EBITDA margins may have permanently come down in these businesses. No buyer today will pay those multiples. Hence, stalemate. Hence, no transaction volume.
I will agree that this is not an entirely universe theme across all of retail HC but there are enough specialties where this has been the case like physical rehab, dental, dermatology, oncology etc.
This is all before even talking about the political spotlight on healthcare roll-ups.
I would also say that the HC buy & build strategy has been a super lazy albeit profitable strategy over the last 15 years. When you really peel back the layers behind a HC roll-up, you generally find a platform businesses and a bunch of tuck-ins aggregated without any proper integration. There is no benefit to true organic growth in roll-ups. Sure, you can lay off all the back office employees at the tuck-in and get cost synergies but who really benefits in these transactions? Only the PE sponsor. The patient almost always end up being worse off in consolidation plays. Can you blame the politicians for wanting to crack down?
In some specialties, the industrial logic behind a buyout is questionable. Take dental service organization for example. With a tuck-in, you generally have a dentist who is probably in his or her late 40s early 50s sell a majority of their practice for cash. What incentive does this person really have at that point to stick around and provide quality care? They are likely already checked out and thinking about transitioning into retirement. When that dynamic hit head on with a labour shortage post COVID, things got ugly.
Lastly, HC roll-ups are funded heavily with debt. With base rates around 5% and lower leverage availability, the roll-up math just isn't very attractive anymore.
Hence, f*cked.
Used to work at a multi-site retail healthcare portco before everything blew up (spoke with a former exec from my former company recently and he highly advised staying away from that space as of 2024).
Somewhat disagree on the political front. I do think some consolidation plays in healthcare increase patient access. May not be providing much better care but still giving underserved / sick Medicaid + Medicare insured populations more access. The big move in healthcare now is HCIT focused on RCM and care coordination tools to help increase revenue via value based care contracts. At least in my opinion.
I have no idea how pharma / biotech / medtech work in the healthcare PE environment.
Great post btw!
On a related note, there’s an article that came out that Apax is not doing healthcare deals anymore and disbanded that whole team…
pretty telling when a lot of reputable PE shops are moving away from healthcare services or healthcare entirely like Apax, AmSec
Wasn't aware of this, thanks for sharing.
Awesome post, thank you!
In short, I agree:
Alright, a few more thoughts:
Let's talk about subscription credit lines: Earlier, I said that PE has managed to beat benchmarks by outperforming on a public market equivalent basis over several decades. But has this been true over the last decade? Yes and No. Yes because on a net IRR basis, the median PE fund has outperformed most public market benchmarks, except for maybe the S&P 500. But sub lines yo, these bad boys are a more recent phenomenon. As with everything else in the PE, the initial intention was a good one. Let's reduce deal closing risk and making our LP's lives easier but just having 2-3 capital calls a year. But then slowly, putting a new investment on the sub line for 3 months became 6 months became 9 months and now, the market practice is to not call capital for deals for a full 12 months. The resulting increase in net IRR is material. The sad part is that even if a well-meaning GP does not want to use or abuse sub lines, they will move down in net IRR quartile rankings. So everyone is forced to abuse sub lines. Has PE performance outperformed public benchmarks when excluding the impact of sub lines? I am not so sure.
Infrastructure investing is weird: Ok, this one might be controversial but what even is the point of infra investing? You have core infra assets yield like 6% - 8%. Like, just buy some bonds and call it a day. These are just infra assets where in the auction process, you have a cost of capital shootout between the bidders. You are just bidding up the asset price so high that you are just extremely confident that the maximum return you are making is in the high single digits.......until regulation moves against you. Look at what happened in Spain with renewable assets, what happened in Oslo with the regulator reducing tariffs on a pipeline asset by 90%, what is now happening with Thames Water. And then on the other end of the spectrum, you have funds like Antin buying crematoriums, Tiger Infra buying some infra IT business, EQT buying a parks company. Let's just not pretend any of this is real infra. If you are going to do that, just invest in a proper PE fund and call it a day.
I disagree with the infrastructure take, while yes core infra does not typically yield a double digit IRR, core plus and opportunistic/value-add infra provide much higher returns at almost 14-16% or more in some cases. Infra is almost always inflation-linked meaning its a safer play during higher rates, and in the last year had a lot a of fundraising momentum (taking a look at Brookfield and Macquarie specifically). Especially with the AI boom and the move to investing in more digital infrastructure, I think infra will stay strong in the coming years because frankly there isn't enough public investment going into infra assets. I would say the main problem with core infra investing is that there isn't much growth you can produce as its kinda capped, meaning you can only improve a water utility to a certain extent, ex: implementing/replacing piping to reduce leakages, etc., maybe more with value-add.
Thank you for the comment, this is exactly the type of back and forth I was hoping for.
So, let's talk about core-plus and value-add infrastructure. Let me give you a few thoughts on this:
1. Is a 14%-16% return within core-plus an attractive risk-return proposition? I would say no. Why would a rational investor that can invest in a PE fund that targets 20% return invest in a core-plus fund that will yield a materially lower return?
2. Now for the question above, you might say, well, this is infrastructure. The return is lower because the risk is lower. But are risks lower in infrastructure than PE? I would say no. I would say the risks are different, not necessarily lower. You might be accepting lower commercial or cash flow risk but you are also accepting a different set of risks that most investors in PE will not; i.e. regulatory risks with utilities, commodity exposure with upstream or midstream assets, development risks with data centers, merchant exposure with renewable power deals etc.
3. Then you might say, ok Mr. Hotshot, if you think you know so much and infra isn't as attractive as PE, then how come Macquarie and Brookfield and EQT and Antin and GIP and KKR are all raising massive funds? The answer to this question might be something you have never considered if you work at an infra GP. The answer is many LPs are playing benchmarks. You see, in LP portfolios, there is no differentiation between core, core-plus, value-add and opportunistic infra. For them infrastructure is infrastructure. And for them, the benchmark for infrastructure is usually a premium , generally 3% - 5% added over CPI. They now have every incentive to do two things: i) cram as much core-plus and value-add funds into their portfolio as possible (helps them beat their infra benchmark) and ii) cram as much infrastructure into their portfolios as possible (helps them beat their total portfolio benchmark). So that explains the fundraising success of these firms.
4. Lastly, I would go so far as to say that core-plus infrastructure is one sector where value for money in terms of fees paid to GPs is the lowest. Most core-plus funds that I know of have focused on two sectors over the last decade: digital infra (data centers, fiber, towers) and renewable energy. If you don't believe my comment on value for fees, just take a look at the last data center or towers deal your fund did (or any of infra fund for that reason) and ask yourself a question: By investing in this deal with me instead of the closest public alternative stock like a Equinix or Digital Realty, how much better off is my LP before fees? After fees? And in that sense, did my fund really add any value? I suspect the answer to that question will make a lot of infra investors uncomfortable...
Neil88, I always appreciate your thoughtful comments on here. Thank you. Have you seen the Lietz and Chvanov paper from earlier this year? It paints an even grimmer picture on returns than the one you present. Worth checking out.
I have not but it does look like a good paper.
Although to be completely candid, I don't put much weight in these academic papers comparing PE to public markets. The thing with private markets is that, well, they are private. The implication of that is unlike public equities, there is no standard, commonly used dataset available to compare results. So people can and will use whatever dataset they want to tell the story they are incentivized to tell.
And so, you tell who writes the paper and I'll tell you without reading the paper what the outcome of the "study" is.
Paper written by Hamilton Lane or Blackstone = Data clearly shows private markets handily outperforms public markets, it's so obvious, how can people not see this? Everyone should invest more in PE.
Paper written by AQR or GMO = Data clearly shows private markets returns have not outperformed public markets over the long-term. Private markets just does volatility laundering. There is no possible reason for private markets to outperform public markets over the long-term.
Wasn't it Charlie Munger who said "show me the incentives and I'll show you the outcome"?
These are fair points, but Lietz was at Partners Group and now lectures at HBS, and the research she cites is some of the best available in what you point out is very opaque field.
Well eventually PE was going to be a leveraged Russell 2000 trade given the narrowing valuation spread or the underlying structural alpha
It's probably already occurred
Sub lines have been around a long time. To your point, what has changed is their explicit use to game IRR, which some firms started to utilize aggressively when interest rates got really low post-financial crisis. The new game in town is NAV loans and as you pointed out CVs. Every situation is different, but I can point to a lot of scenarios where these are used to enrich the GP. Without naming firms, I do think LPs will start pushing back at some of the more aggressive use cases.
Great point on NAV loans. Like most other things in PE, I think the initial use case of these loans wasn't inherently a bad one. If you have a heavy buy and build thesis as part of your investment strategy, it isn't entirely surprising that you could run out of capital in your commingled fund. If you then still have conviction in the go-forward return profile of your assets, taking a NAV loan with a low LTV at a reasonable cost to continue your add-on activity isn't the worst use case.
However, if you are adding a NAV loan to your entire fund for the sole purpose of enhancing your DPI, I think that strategy is about to blow up spectacularly on a lot of GP's faces. I can't even fathom the thought process of the people who thought this was a good idea. Dude, as a LP, if you give me capital back while increasing the risk of my fund investment only to drive DPI, that in no way leads to me giving you more commitments to your next fund. No, I am going to take that capital and re-allocate it to GPs that know how to do their jobs and drive real DPI.
Agree on pretty much all points. A couple thoughts to add (as an LP):
Because of the bloated size of the larger funds, do you think it would be a better career move to perhaps go more down market and work at something like a MM/LMM fund? What about UMM?
I see some variation of this question being asked a lot on WSO. But man, the only person that can answer that question is you.
I mean, if you get a job at Blackstone or KKR or Apollo, absolutely take it. There is no other career where a reasonably intelligent and personable individual can make life changing amounts of money than at these firms. Yes, it is going to be more structured. Yes, you run the risk of being pigeon-holed into a sector you may not be passionate about. Yes, the top levels at these firms are crowded and getting to Partner is harder than ever. But if you start as an Associate and do well, you have a ramp to creating a net worth amount approaching a hundred million dollars by the time you are in your mid-late 40s. Who cares what happens after that? That kind of money will give you very valuable optionality of what you want to do after while entirely de-risking your family's finances.
MM can also be a great place to start your career, especially if you can find a firm that specializes in a sector you are passionate about. Sure, the Managing Partners will try to hang around more than at a place like Blackstone but there will definitely come a time when succession planning will need to be implemented because LPs will push for it. There is more of a risk that a generic MM firm will not be around in 10 or 15 years but then again who cares? If you are work at any reputed PE firm for 5-10 years, there will always be some type of a high paying career path open for you - be it lateraling to another PE firm, joining an operating business at a very senior role etc.
So you pick your poison and you are more than likely to be just fine.
No other place? There are AI companies paying 290K bases with $1m in equity at a 10x cap.
Completely echo a number of your points. The expansion into retail is absolutely hilarious and very much a result of BX/KKR/Apollo blowing smoke up the public's ass rather than any retail investor actually wanting to up their PE exposure. GP stakes are also a hilarious remnant of fundraising's glory days when firms could easily triple AUM in 4-5 years. Those days are clearly long gone and I'm wondering how firms like Blue Owl/Petershill/HP will re-craft their msg to LPs as their business models become glaringly nonsensical in the years to come.
And totally agree on infra/private debt aren't asset classes with longevity. Returns crumbling and way too crowded (yes, same can be said for PE but we all know that's here to stay).
Nothing like a wee dram of Lag16 on a Saturday night to open up a few more thoughts on our fascinating industry:
Private credit's "golden age" was a fever dream: Remember how the titans of the private credit world went on Bloomberg and CNBC and started talking about this golden age of private credit? Well, the only reason there were even was a golden age was because the Fed actions had the impact of pushing up base rates. Sure, credit funds started posting higher returns than they ever have in the past but god, it was the ultimate beta trade. I said "was" when referring to the golden age because it wasn't long before these suckers started bending over backwards for PE sponsors again by reducing margins. Ruh roh, of course that was bound to happen if LPs open the spigot and create a wall of capital in a space where it is extremely hard to differentiate yourselves.
But I digress, private credit will probably be fine going forward. Default rates might creep up but there is still structural alpha in the space compared to the broadly syndicated loan market. And hopefully, the "wins" lenders have had against sponsors in terms of tighter documentation over the last two years persist (although I am not waiting with bated breath).
The carnage in real estate: I am on dicey territory here since I have never invested in RE but I have friends in the space and I have been fascinated with everything happening in the asset class since COVID. And man, it's been a bloodbath. COVID knocked the air out of office and to a lesser extent, retail. The resulting decline in rates supercharged industrials and multi-family real estate and investors in the asset class started displaying true tulip mania syndrome. As rates shot up, the carnage was real. Something about thinking about valuations in terms of cap rates instead of cash flow multiples really opens up people's eyes towards the concept of risk premium - like, why would anyone buy your multi-family property for a 3.75 cap when operating cash sitting on an investor's balance sheet can yield 4.5%?
I'll give some credit to the asset class though to be the first one to acknowledge that when rates go up, valuations have to decline. Our brethren in PE have a hell of a hard time accepting this fact - like, nobody cares about the market leadership or higher margins of your darling SaaS business. Rates go up = values come down. Simple as that. There's blood on the streets in real estate. My gut sense is that vultures likely will make a killing as the industry works out of this mess.
So I’m a bit torn on this post. On the one hand you’re clearly a grown man working in the space and have intelligent insights. But I feel like (maybe because of your personal incentives?), you’re laying out a lot of evidence correctly without really putting a point on the conclusion. So allow me to state that conclusion, at least as I see it, and I’m curious as to your thoughts (hey, I’m sure there’s things I’m not considering).
In layman’s terms: PE, in almost all its sub-sectors and manifestations, has become a crowded trade, both on the “buy” (LP) and “sell” (GP) side, eroding alpha. The space has also become rife with disingenuous self-serving bullshit from modern day plutocrats (cute uses of leverage, fucking your LPs with nonsense fees that have nothing to do with alpha, except maybe in your IR dept., etc). Furthermore the reality is that the bulk of the asset class pretends to be something it’s not - these aren’t sector experts making operational improvements, they’re venal mortals levering boilerplate roll-up plays with multiple expansion and free cash (at least they were until both of those wells dried up a couple years back…)
The list goes on, the conclusion is simple: the golden era of PE is in the rear view and the founding myth of the asset class is more and more at odds with observable reality with each passing day. I’m not chicken little saying that the asset class is going away, but the past is going to look drastically different than the future in our lifetimes. And why the fuck should anyone pay 2 and 20 for a squeezed lemon like many (most?) PE funds where some over-enriched clown IC cant even beat the index like they’re supposed to, as you say? I think this sector is in for some major boo-boos this lifetime as the pendulum swings back and the proliferation of managers that never should have really existed stop doing so, or alternatively get acquired by bigger large and mega cap multi strat managers that, due to their scale, will never be able to replicate the returns they achieved pre-2000 going forward. PE will largely become a levered beta play, and economics will have to adjust downwards in step.
In short, the emperor doesn’t have no clothes, but they’re pretty threadbare imo. And I don’t think most people have noticed that yet.
Thanks again for the thoughtful post, and looking forward to your thoughts (and others’) in due course.
Second paragraph spot on
Fair point on conclusions but that's why I titled these as "musings". Putting a point on conclusion would mean that I know what's going to happen in the future. I don't, and I have worked in this industry long enough to know that neither do you or anyone else for that matter.
But we can make a probability based assessment of where things go from here. My take? Very little will change, at least in the next 5-7 years. There is a lot of capital, maybe too much, earmarked for private equity in institutional capital portfolios that demand for PE funds will remain strong. Are we going to see the 20%+ AUM CAGR that we saw over the last 15 years? Unless these firms somehow crack the retail channel, which I am skeptical of, no chance!
What does that all that mean? Good private equity firms with thoughtful investors who are prudent about capital deployment will likely thrive. Remember there are still firms today that can raise oversubscribed funds in a matter of months - names like Union Square, Summa Equity, Ufenau, iCON infra, even CVC come to mind. It's hard to say what happens to those firms that deployed max capital at peak valuations during the ZIRP period. Some of these are well-known firms - Thoma Bravo, Insight, EQT. More than likely, they will have some dud funds and will need to re-calibrate fund sizes but these firms are probably still going to be around 10 years from now.
I'll say one more slightly unrelated thing: what is considered "prestigious" or interesting from a job-seeker's or industry participant's perspective is extremely different from the perspective of a LP. Investing in a BX or KKR fund is the LP equivalent of investing in SPY - completely uninspired, beta trade but something that you are probably forced to do if you have to deploy multiple billions in PE annually. The most interesting LPs are the ones going out there and backing smaller, LMM or true MM firms with a real operational angle and whose Principals are not just looking ahead to raising the next larger find as soon as possible. Very very tough to fund but they are out there.
LP here - I try to be mindful of echo chambers but your points hit too close to home. We've recently determined to push more into the LMM (thankfully our fund size still makes this practical) but its also something I've heard many LPs are trying to do, including those in the $100bn+ bracket - of course, I don't exactly know how they are defining LMM/MM (who knows if a $10bn fund forms part of that definition). I'm interested to see whether this newly trend amongst LPs will accelerate more GP spin-outs as no doubt there are folks on the GP side who want downsize and focus on companies where change is more readily impactful (execution risk will certainly be higher but that's why you're paid 2/20).
I am actually shocked and pleasingly surprised when we occasionally (read: rarely) come across a successful fund that's at Fund VII and fund size is still only approaching $1bn. I'm ashamed to say that part of me wonders "there must be something wrong with them" because I'm so accustomed to today's exponential fund size growth. As you point out, it is absolutely tough to find such groups and does require more travel and pavement pounding as a lot of times these groups aren't necessarily based out of the main financial hubs.
If you're comfortable doing so, it would be great to connect offline. Its refreshing to meet other cynical LPs (at a healthy level) and trade notes.
Hi OP - first of all fantastic post, as someone who works in (mid-market) PE I found myself nodding along in agreement to every one of your points! Myself personally, I found it frustrating at times in the ZIRP 2010-21 period where we would see rival PE firms buy assets for significantly inflated prices (in our view anyway), only to see them make a handsome profit by selling it to someone else for even higher within a few years! Made us feel like idiots for passing on those trades (I even made a comment on here about this, in Nov 2021 ironically so right at the end of ZIRP!)
But as you say those days are over now - so as others above have said, I personally think that whilst you won't see the PE bubble "pop" you'll instead see years of funds giving sub-par (but not terrible) returns, and PE becoming a levered beta play as the poster above mentions. This means that the dream days are probably over for people who are coming into PE now sadly - I wouldn't expect carry to be worth anywhere near what it was in the 2010s. I also have to confess a bit of jealousy at seeing ex-IB colleagues who went to work at MFs - many of them are now Principals/MDs and have probably made millions in carry. They were very smart and very hard-working guys of course, but I feel it goes back to the old adage of needing to be both lucky and smart. Some super-sharp associate joining a MF now will likely make a small fraction of what they made in the 2010s, just because of timing (this could be my jealousy talking somewhat to be fair!)
And yes I completely agree that PE getting involved with retail investors is a terrible idea. There's the BREIT debacle which you already mentioned. But you only have to look at the stock prices of MFs that went public through the 2010s - for instance Blackstone's stock price was below its 2007 offering price for nearly a decade, and only went up with the wave of QE from 2020 onwards. During that time Blackstone MDs and senior management made millions upon millions, yet basically none of it trickled down to the retail shareholders who actually owned the company! Same for any other publicly listed MFs that were listed before the financial crisis really. And it would be the same theme for any investment opportunities for retail customers - they will be structured in a way that makes lots of money for the people who work at the MF, but very little will trickle down to retail (whilst retail is taking most of the downside risk). So personally I'm quite against the idea - if a dumb LP invests then yes it is pensions/individuals' money ultimately, but at least you have the LP who is paying professionals to look out for its individual investors.
But yeah the next few years should be interesting for PE. At the end of the day it's still a great career path for most, but will it pay dramatically more than banking like it has over the last few years especially at MFs? I'm really not sure it will, as especially with all the 2020-22 funds still to mature/being held for longer periods, returns will likely be muted at best for the foreseeable future.
One big trend I would add to this list is PE’s growing reliance on insurance assets for stable AUM. Apollo, Blackstone, Brookfield, Carlyle, KKR, and Ares have all made growing their insurance AUM a priority. Every firm has a slightly different approach, but in some cases this has involved buying loan origination platforms that now compete with regional banks for the investment grade part of the loan market vs. the leveraged loan market that has historically been the focus of private credit.
great post btw, but I also have to disagree on the infra pe take. on the lower end of the risk return spectrum, you’re a glorified debt / special sits investor. a lot of infra deals are highly structured so that you’re getting a pref return and your contract only IRR unless the company goes bk is 8-10% with real upside participation through warrants, convertible options, liquidation preferences, step in rights, etc … I think these returns can compare favorably to just buying IG fixed income in the public markets. a lot of corporates are also willing to take the higher cost of capital in order to get equity treatment by the rating agencies and not have to deal with some of the restrictive covenants you’d see in the bank market or even from private credit funds. there’s more competition for these deals now than 5 years ago from insurance money (e.g. athene intel deal) but still decent opportunities. are you adding any value operationally? nope, but you’re adding value through sourcing and financial engineering. on the other end of the spectrum you can earn private equity (25%+) returns by taking private equity level risk… look at the data center platform take privates that all took place from 2017-2021. those deals have been absolute bangers. could you have also done well just buying DLR or Equinix stock? sure, but the same could be said for SaaS / other sectors. And those companies have performed well under private ownership.. DLR and Equinix have come under pressure to de-lever at various points in time and have to worry about when the next time the ECM/DCM will close up and they’ll have to recycle capital through sell downs and JVs not to mention needing to focus a lot of effort on hitting quarterly earnings earnings targets while QTS and other private players moved quickly to build huge land banks and secure new contracts. Under BX ownership, QTS also played a big role in opening up the ABS/CMBS market to DC issuers and leveraged BX’s capital markets arm significantly to create value. lastly, there are tangible examples of infra funds bringing real operational expertise to create value. GIP famously 8x’d one of their airport deals (forget which one) by streamlining the security process to increase throughout and get people to spend more time spending money in the lounges and less time with TSA.
so at the end of the day, I think infra PE is no different than regular PE in that sure there are some dummies just discounting cash flows at a lower cost of capital than the first guy and pumping up multiples same as in SaaS where you just say okay i’m buying this company at 15x EBITDA so that means I can also exit it at 15x EBITDA without considering if that’s sustainable. so in conclusion, there are probably good investors in both sectors and bad investors in both sectors! but just because the marketed returns are generally lower doesn’t really mean much by itself. a lot of funds will also take a portfolio construction approach so you have a mix of cash yielding, downside protected deals with all in 12% returns mixed in with more buyout style platform bets with 20%+ base case underwrites
the fact that people are even coming for infra pe these days i’ll take as a compliment. this wasn’t my fist choice when I entered the space 7 years ago but i’m glad I stuck around
I have explained some of my reasoning on infra as a reply to an earlier comment. But you touch on a few other points. Overall, you have a good take but I can't say I am convinced. A few notes on your points:
1. Sure, a lot of infra deals are highly structured. I don't think there's anything unique or anything that's such an attractive risk adjusted return there. You can invest in preferred equity securities of PE backed companies today and earn as much as investing in the common equity of the best performing true infra assets; i.e. ~15% - 16%. Structure in and of itself can't or should not make an asset class more or less attractive.
2. Why would you compare infra equity's returns to IG fixed income? Not matter how much you structure the security, I'd wager that IG fixed income is still way lower risk than anything equity.
3. Infra funds add value through sourcing and financing engineering. Sure, I'll agree to this and that's probably worth something. Is it worth 1.5% management fees and 20% carry to get me as an investor to get to a low-mid teens net returns at best? Meh, I am not so sure considering I can invest in PE with that same fee drag and expect much higher returns.
4. GIP did make ~8x on an airport deal. I might be wrong here but I think it was Gatwick and those returns were generated primarily through a GP-led CV transaction......right before COVID. Not sure how it's doing now but I will agree that there will be individual transactions, especially in the value-add space, that will offer strong risk-adjusted returns. But I would also say that value-add infra is just PE masquerading under a slightly lower cost of capital. In fact, a lot of infra sectors today - data centers, towers, fiber, even utilities used to be done in PE funds pre-GFC.
5. PE firms arguing their SaaS business needs to trade at 15x because they bought it at 15x without considering the sustainability of the business' earnings power - yeah, no arguments there. A lot of that behavior is coming to roost, especially within growth equity and VC. I'd be the first to say that market is due for a healthy reset.
6. Lastly, just one question for you, and this really is the crux of my argument - what role does infra play in your client's (LP's) portfolios? How does it positively impact the asset allocation and the total portfolio risk-adjusted return for your LP? I can answer that question for public equities, fixed income, PE, private credit and real estate. I haven't heard a satisfactory answer for infra just yet.
okay i’ll give this a shot from an LPs perspective and let’s just play pretend for a second and assume that the risk adjusted returns for each of the asset classes (real estate, equities, buyout PE, fixed income, private credit, etc.) are appropriate:
1) cash yield: most infra funds will target a cash yield of 4-8% depending on whether you lean more core vs value add.. that’s not nothing considering you’re also marketed a 12-16% all in return, which is nice if you’re an LP with recurring, predictable expenses (pensions, endowments, retired high NW, life insurance, etc.)
2) tax efficiency: infra funds tend to be 10-12 years with a few auto extensions or even increasingly open ended vehicles so you build MOIC (2-3x) over a longer hold period without having to pay taxes. PE as an industry I think is overly focused on IRR, which makes sense a lot of the time for single investments but when calculating a fund level return can be kinda misleading given you reserve capital for the fund life, but on a deal by deal basis it’s often called significantly after you committed and then not all returned at the same time. you can end up with a fund level IRR of >25% and a MOIC of like 1.4x, which is pre cap gains taxes since most funds report returns pre-tax. warren buffet figured this out first
3) scale: the capital deployment opportunity particularly in digital and energy/power infra today is huge. I talked to a lifeco a few weeks ago that’s allocating $30bn/year to infrastructure (across private credit and equity).. much of which will be through no fee coinvest… but also fund allocations.. their AUM is growing $100bn+ every 12 months. infra’s long duration cash yield ties nicely to their long-dated annuity payment liabilities and lets them sink billions into single transactions / funds. idk if they’re getting out of bed for some HBS grad’s HVAC install roll up strategy
4) inflation / interest rate exposure: people will disagree with this one because it’s not always true and maybe it’s reflected already in the lower returns, but a lot of infra investments have inflation linked contracts and these are typically highly levered assets because of these long-term contracts with IG counterparties so there’s a lot of focus on hedging base rates for extended duration (typically this will look like a bridge to long-term USPP take out). debatable but somewhat more attractive in comparison to real estate in particular, which gets totally eff’d every time the fed hikes rates 25bps because they can’t get long-term paper on one year leases.
5) vibes: I think LPs just simply feel good about giving money to GPs that are going to use it to (at least sometimes) go build sh*t that the world needs whether it’s a massive data center campus for microsoft or a chip fab for intel or a ton of solar / wind projects or a huge LNG terminal on the gulf. PE has kind of a yucky rep because of all the focus on trimming g&a, selling companies for parts, overlevering businesses, etc.. it feels better to be like we’re going to go use this money to form a JV with intel to onshore our semiconductor supply chain and create thousands of jobs in texas or whatever
I recently started working at a PE Advisory shop, we perform financial due diligence on targets and offer other transaction advisory services. I was legitimately shocked to see funds asking us to provide a different version of FDD reports for the banks who should provide the financing.
Seeing this i'm not surprised that their returns are declining, if you price deals on an ebitda basis, how do you expect to buy at an inflated valuation and still achieve high returns?
I’m an LP, great post! Fully agree with you on Infra not so much on PE.
Interesting. Throughout the comments on this post, I have had many more people disagree on infrastructure rather than PE. Curious to hear what you don't agree with on PE?
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