Private Equity and Build Back Better
Originally published at Jackson Hole Economics
Boston Consulting Group’s latest ‘state of the nation’ on the asset management industry is a data-rich confirmation of the seemingly irresistible rise of private equity and its private asset brethren in real estate, infrastructure and private debt.
Having grown at 9% annually since 2008, private assets, writ large, are the dominant driver behind the consulting firm’s forecast that alternative assets will swell to 17% of global assets under management by 2024 and represent an eye-watering 49% of all asset management revenues.
In what follows, we sketch out the contours of the private equity business, why it is succeeding when so many other investment management endeavours are struggling, what role it can play in helping to rebuild a pandemic-ravaged global economy, and the pressures it will come under as the spotlight on it shines ever brighter.
To begin, what has driven the rise of the private equity business?
Momentum here has been building for some time as global public equity markets have de-equitized in a world of “private for longer”. Perceived long-term private equity outperformance, as well as greater depth and breadth across the asset class (private equity is very far from being just LBOs), have whetted investors’ appetites. That’s true, even if the debate is intensifying about what the genuine return numbers look like and how risky the asset classes truly is.
Investors have also increasingly realized that they don’t need the immediate liquidity nor welcome the higher volatility associated with listed equities. Many are skeptical of low-cost investing in market-capitalization weighted indices where value is increasingly clustered around a “Big Tech” play. The short termism hard-wired into the quarterly earnings cycle of publicly listed companies is also a turn-off, both for investors and corporate management teams who find public company reporting and regulations sub-optimal and cumbersome. Seen in that light, the recent uptick in US public equity issuance in May and June is deceptive. Mostly, it reflects follow-on investments in existing businesses that are already in decent financial shape, not the return of public markets, per se.
None of which is to say that private equity is a panacea or immune from a COVID “shock-down”. Short of a medical breakthrough or a benign mutation of the virus, uncertainty and investment risk will remain elevated for months, if not years. Nevertheless, the mood from private equity general partners, as well as investors, remains one of reasonable calm. Credit markets have tightened up, but largely thanks to extraordinary government and central bank backstops they have not frozen as they did during the global financial crisis. Participants are also more seasoned, with better data and transparency in areas like funding requirements. The industry is still waiting to deploy an estimated $2.5 trillion of commitments, and hence has ‘staying power’, affording managers time to be selective. The pandemic, at least for now, does not appear to be slowing the ascent of private equity as a share of investor portfolios.
With this rise comes increasing attention and accountability. The private equity industry has already moved on from the days when it preferred to operate out of sight and begun to more strongly articulate its social purpose. Where required, private equity managers have become more vocal public advocates of their role in boosting retirement plans, job creation, funding essential infrastructure and providing debt finance where banks cannot or will not.
With steadily increasing capital, leading private equity firms have also been building greater operational muscle. They have added more partners with deeper knowledge of company operations and sector expertise and have responded to investor calls for greater and more timely transparency by investing in enhanced performance and risk management reporting, as well as in client service.
Private equity, in short, is enjoying favourable tailwinds and has done much to tack in the right direction. At the same time, the ‘build back the economy better’ debate that lockdown has engendered has raised the stakes further on what it does and how it does it.
Just as many publicly listed companies are being more forcefully obligated to migrate from a primary focus on shareholder returns, so too private equity firms and investors in them will need to demonstrate more decisively that they are investing for the long term in workers, supply chains, communities and the environment, alongside delivering attractive, long-term returns on invested capital.
Arguably, the locked-up and longer-term nature of private capital, affording it a greater ability to work away from the noise and short-termism of public markets, will position it advantageously to build more inclusive and durable business models. While there is no assurance that private capital will move easily or rapidly in that direction, the more successful firms in the industry are likely to recognize the importance and business benefit of doing so.
In parallel, the discussion is progressing about how to broaden access to the asset class. Private equity has always functioned more like a “big investor” game, exclusive to pension funds, endowments, sovereign wealth and large family offices. The benefits to individual investors have largely been indirectly via pension plan exposures, with direct participation limited – an estimated 5% of US retail capital is allocated to alternatives.
Policymakers are beginning to grapple with whether and how access should be widened. For example, the SEC’s Asset Management Advisory Committee is due to hear back in September 2020 from its Private Assets Sub-Committee with a comprehensive examination of full cycle returns from private investments and an overview of the current exemptions and restrictions for access. In assessing this, the SEC will provide an “on the record” forum for putting the industry’s “feet to the fire” on performance, risk and whether the asset class is safe enough for consumers. While only a first step, this kind of scrutiny is necessary if ordinary investors are to participate in private markets.
For private equity to fully realize its potential, it must also not be perceived as abusing its position. One ongoing challenge is taxation, particularly as the debate intensifies on potential tax increases to pay for the response to COVID. Private equity firms have long enjoyed preferential tax treatment and typically face effective tax rates lower than those on similar levels of ordinary income. While the industry has tended to argue a “win/win” posture – private equity managers do well, but so does the broader economy – this is beginning to feel less sustainable in an age of mass wealth inequality.
Similarly, by its very nature, private equity benefits from proprietary information, including access to data. The world of “private for longer” implies much larger private investment portfolios made up of bigger private businesses, with the potential to leverage larger amounts of data generated by portfolio companies and the firms themselves. The safeguards of competition and data privacy laws are already there, but at some point this could begin to look and feel like an unlevel playing field.
The really large franchises recognize that their licence to operate is valuable and potentially fragile. As they think through their futures, they know that the bigger they get, the more subject to scrutiny and oversight they become. It is time for the industry to lead the way on how they build back better – if not, they risk having their future re-shaped for them.
Andy Knox is an independent consultant, working with CEOs, CFOs, PMs, Sales Heads and Boards across strategy, clients and communications and a frequent commentator on industry issues. https://www.linkedin.com/in/andyknox/