Historically PE seemed like it could do no wrong as an asset class. It offered higher returns than public markets, with way fewer blow ups than HF. I think that the asset class as a whole is at an inflection point. These are solely the views of an outside observer, so take it for what it’s skillset.
The Professionalization and Diffusion of PE
In the early days of PE, everything was a boutique. If you have read books like King of Capital or Merchants of Debt, KKR and Blackstone were boutiques having to kiss the LP ring and explain what the hell an LBO was to insurers and pensions. It was the Wild West back then, these shops were founder led and much flatter. Opportunities were more plentiful, the conglomerates had mostly been broken up e.g. Ling-Temco-Vought (mid 80s), Gulf and Western, leaving lots of opportunities and others were actively divesting. While M&A was a popular tool, merger mania hadn’t looked to the same level of consolidation that we see today. It was easier back then to find good acquisitions. As these boutiques grew into the behemoths we know today they trained a whole generation of PE fund founders. There’s second generation folks left the early funds to follow the call of starting their own and many have become upper middle market funds. These founders subsequently begat even more founders, no longer was the skillset restricted to a select few, increasing competition for acquisitions.
Changes in Debt Capital Markets and Targets
The early financings were at rates that would be considered rapacious today and the sophistication was markedly less than today. First lien debt then at a lower multiple was pricing in the mid teens, when I worked in corporate banking in the late 2010s it was L+450 with a 1.00% LIBOR floor which back then meant 5.50%. Debt has become cheap. Assets had become subsequently more dear and multiple expanded. PE firms started going further afield from the traditional industrial and B2B services and the platform/roll up came in vogue. Gone was the sole focus on financial engineering to drive value and operation improvements were the new watchword. Platforms were bought at crazy multiples with bolt on acquisitions to “buy down the multiple”. It’s a valid strategy assuming post merger integrations go well and that there’s actual value to integration. With a five year hold period and the fact that an integration depending on the size/complexity can easily take eighteen to thirty six months, you can imagine how well these integrations actually go.
Sellers Get Smarter
The same diffusion of talent was happening elsewhere on Wall Street. Mergers and acquisitions were moving down market and increasingly auction processes were being run on middle and lower middle market companies, in turn driving up multiple and making proprietary sourcing more difficult. There has been a huge number of firms that have grown massively to represent middle market and lower middle market companies. The same is true for legal knowledge as the white shoe firm M&A practices, now it’s pretty much every regional law firm in the hinterlands with 50+ attorneys has at least one M&A practitioner.
Just Another Middle Market Buy Out Fund
All of these contributed to the rise of undifferentiated middle market buy out fund. There’s no difference in strategy, they participate in the same auctions, the partners have the same pedigrees. In short the middle market became commoditized. Commoditized offerings lead to fee compression, particularly because LPs have options, lots of options. This is likely to lead to increased fee pressure.
Where are things going? A winnowing, perhaps.
My sneaking suspicion is that there will be fewer funds in a decade, this is pretty common in most markets. There’s a cycle of growth both in terms of revenue and companies, maturity paired with consolidation and finally a downhill shoe. What I think will happen is at the top of the market I view mega funds as asset managers, living for the management fee with the performance fee as gravy. The upper middle market will likely see some pruning, but the middle market will probably be a bloodbath. Fee commission on asset management is probably a good guide, the big boys are all price competitive and it’s true whether active or passive, the middle market gets thinned out, the survivors stay small but can charge a premium. In essence, the glory days are probably over. At the biggest funds there will be fee pressure, but given the dollars per investment professional it will still be lucrative. The middle market JAMMBOs will feel the most pain, with sharper fee cuts and fewer dollars per professional. There will be fewer funds as LPs ask “What value do you offer over just buying a small cap index?” Lower middle market funds that specialize will probably do well, if they have sector or geographic expertise that allows for outperformance. If they follow the JAMMBO model, but smaller it’s going to hurt.
Sir, I asked if you’d like to add fries or a shake?
Your "sneaking suspicion" literally is the consensus view.
del
I generally agree, but at the same time the current state of affairs is the result of absurdly low interest rates for so long making most funds fat and lazy. We now have an entire asset class that has rewarded financial engineering rather than operational expertise. There are exceptions, but most PE professionals are not directly engaging with their portfolio companies in the way they claim.
And given the size of the funds and number of investments, how could you? Public equity PMs stick with 10-25 positions to follow, and they have materially less information to go off of and have little to no governance authority.
My take is you will see a changing in the actual skillset of PE professionals to also include operational know how at every fund size. The meme of PE people cold calling HVAC professionals and pretending they know more than them is true, and reflective of the problem in the industry.
Tfw golden age of secondaries
Secondaries is the dumbest shit ever and the epitome of PE being musical chairs with companies.
“Oh we have a total shitco that is going to ruin fundraising dynamics if we try to market it? Fuck it, let’s just sell it to ourselves.” Cant take an L if you never sell.
Sure SACFs can be abused but you can’t deny the real use case of resetting the holding period and maintaining control of a trophy asset to let it run a little longer. Why sell in a shit market if you have conviction on the core business?
I think NAV loans on highly marked (read: delusional) portfolios are the more brazen trend.
In my opinion, large caps will (generally) be fine because of how much capital there is to deploy for investors, and as a large cap of I can deploy a billion+ per investment and get a net return of >10% that’s a win and LPs would be happy. That same concept doesn’t work for MM or LMM firms that need to justify the headache and infrastructure required to allocate capital to a bunch of them vs 1 large cap. I think you’ll have a decline in number of these over the next decade or two, however there will still be a lot of them that are around that just have good relationships with their LPs, and while they won’t get 2x fund sizes each raise, they’ll see steady small increases.
While this isn’t my current strategy, I’ll ultimately like to be at a MM where I can acquire a business in the $0.4bn - $0.8bn TEV range with a strong mgmt team that wants to roll a lot (and not just cash out), do a few strategic add-ons, and ultimately sell to MF that will pay a premium to allocate over $1bn of equity in a good company, with a strong mgmt team they don’t have to spend a lot of time with and can get a decent return (or even just a public co).
Typing this out it seems like an oversimplification and an obvious thing, but ultimately that’s where I think the over-performance will occur in the next decade or two.
The original post stated that middle market PE was commoditized and you pitched middle market PE as a solution
On the LP side and I think MM is what will die, not LMM that wants to stay LMM, and not LC for reasons OP above stated (pensions have no choice but to invest in these funds due to their own size). MM has no advantage and since they're probably the second PE buyer of a business there's less juice to squeeze. LMM/IS has been and will be the most sustainable way to make outsized returns in PE.
Not a bad summary
Agreed. Although it’s surprising people didn’t see this coming. Obviously at a certain point it’s all commoditized and the biggest players win. FFS look at hedge funds
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