Private equity investors are likely to favour cycle-tested managers this year, says Tom Franco, Partner, Clayton Dubilier & Rice…
If global markets become jittery over the coming months, investors are likely to retrench and maintain their private equity allocations with a smaller number of trusted managers who have proven their worth through different economic cycles.
During any period of economic uncertainty, confidence among corporate CEOs diminishes and affects capital expenditure, investment plans etc. That impacts the stock markets and has a ripple effect on investor sentiment.
Speaking exclusively to Private Equity Wire, Tom Franco (pictured), Partner at Clayton Dubilier & Rice, says
that recession fears could impact PE allocation decisions this year.
“We’ve already seen a trend over the last few years where LPs are narrowing the number of GP relationships in their portfolios and by doing so they are also increasing the size of their capital commitments,” says Franco, who is responsible for managing several of Clayton, Dubilier & Rice’s key external relationships as well as lead the fund raising team.
Currently, there is a secular shift in to private assets. The opportunity set in private markets is growing while at the same time it is shrinking in public markets. Back in 1998, there were 7,531 US publicly listed companies but by the end of 2017, this number had halved to just 3,618 companies (according to Bloomberg figures).
While demand for PE investments has also increased, this doubling of the supply of assets permits a high degree of selectivity among investors, in Franco’s view.
“The numbers, on aggregate, remain strong, but the tale of two cities may become more extreme; i.e. the most trusted PE groups will continue to attract the majority of LP allocations. In uncertain times, there tends to be a gravitational pull towards the familiar – now might be one of those times,” he says.
Last year saw a number of significant fund launches among some of the industry’s leading PE groups. Triton, for example, announced it had raised EUR5 billion for its latest flagship fund, according to PitchBook; making it the 13th PE manager to raise USD5 billion or more for a buyout fund in 2018.
Franco feels that 2019 is going to be a market driven by cycle-tested managers and LPs are going to be looking not only at what a manager’s strategy is and what the make-up of the investment team is, but will also focus more closely on how these strategies have performed in tougher, more turbulent periods.
“I’m not in any way suggesting we are heading for another global financial crisis, but I do think for any LP who analyses a PE firm, their investment committees will be challenged and LPs will be asking themselves, ‘Are these managers who have sailed through troubled waters or have they only operated during settled waters?’” remarks Franco.
There have been countless new private equity firm launches over the past 12 months, including SP Capital (a PE seeding platform backed by Sixpoint Partners), Aretex Capital Partners and Milton Street Capital.
The challenge for new managers – even if the partners have distinguished track records in their former roles at established PE shops – is to convince investors that they have the skills to grow companies in stressed markets and that they have a battle-tested strategy.
Franco says that to be selected by LPs, a key criterion will be the manager’s ability to demonstrate capacity to operate in choppy waters. “That requires a well-established track record, [with evidence of delivery,]and will therefore favour those managers who have been around longer.
“It is going to be crowded in 2019, and that just emphasizes the need to be able to articulate a clear and compelling value proposition.
“You’ve got to demonstrate an advantage, and that advantage might relate to deal sourcing, it might relate to deal structuring, it might relate to deep sector knowledge and insight. Whatever it is, it’s got to be some secret sauce that is truly compelling to a selective LP,” comments Franco.
In order to compete with the established names in the industry, newer PE firms who bring a creative mindset to deal making are likely to fare well because even though LPs continue to gravitate towards core GP relationships, it is not to suggest that they will completely overlook a newer manager with a shorter track record.
There is a degree of fatigue with older, established firms. Any manager with a fresh approach and a high quality team is likely to catch an LP’s attention but as Franco stresses:
“If you are a first-time fund, you’ve got to be able to articulate your edge and convince an investor that that edge is sustainable and can perpetuate across different economic cycles.”
“Those managers who have spun out of high pedigree PE firms with good reputations might need to dial back their fund raising targets. Proof of concept is essential for first-time funds, and it’s a journey. It may be that you are better off doing serial deals and knocking on investors’ doors to do co-invests to establish the track record. It’s not as convenient as a fund structure, but it’s a way to show that you can apply the magic that you may have demonstrated in your previous role.”
With so much capital floating around, some investors might be ready willing and able to support investments on a deal-by-deal basis.
When asked about the need for new managers to demonstrate creativity in deal making to compete with their established cycle-tested peers, Franco adds:
“You’ve got to show more creativity in structuring deals to mitigate downside risk and protect the upside; so the way the deal is structured is very important. And you’ve got to be able to show that you’ve got specialized capabilities: be it deep industry expertise, deep functional expertise. Basically, some kind of post-acquisition value-add that is meaningful to an investor.”
2019 could well favour PE firms with decades of experience but if new firms can think creatively and articulate their investment strategy, they could well catch the attention of global investors. Even if it means agreeing to start the relationship with a few co-invest deals.
But don’t be surprised if the blue chip names break free of the peloton this year and continue to attract the lion’s share of LP capital.
