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Higher barriers to entry with rising competition and regulation

By A Paris – Despite any headwinds caused by the pandemic, the private equity industry has remained strong, with investor demand and planned allocations continuing to grow. However, with high levels of dry powder and increasing regulator scrutiny, startup private equity funds have much to contend with.

“There is currently more money available in private equity. The among of dry powder has exploded and is the highest it’s been in 10 years,” remarks Alain Kinsch, co-chairman of the Association of the Luxembourg Fund Industry (ALFI) Private Equity Committee and Vice-President of the Luxembourg Private Equity and Venture Capital Association.

According to Hugh MacArthur, Partner, Bain & Co: “Total investment value last year was supported by ever-larger deals, not more deals. This fact is important because it means many GPs did not get the deals done that they had intended to in 2020. 

“With soaring levels of dry powder, robust credit markets and recovering economies, 2021 deal markets promise to be incredibly busy.”

Reportedly, 80 percent of LPs are confident private equity will continue to perform in 2021. Around 40 percent say they are underallocated to the asset class, with the vast majority planning to either increase or maintain their commitments in 2021. Within this context, managers planning to launch new PE funds have a few key considerations to make.

Regardless of the economic background, experts note that the fundamentals of investing in venture capital or launching a new fund in the private equity space remain the same. Mainly it’s about spending time to find a good time with the right commitment, in the right sector within a certain market niche worthy of developing.

What does make a difference in the current environment however is that there are more hunters than there is prey: “There are more and more players coming into the market because the stock markets are not delivering the expected results. In addition, governments are now allowing pension funds to invest higher percentages into private, non-liquid assets which means demand from these entities has also increased,” Kinsch says.

Clarity and differentiation

Therefore, emerging and startup managers need to be clear about their strategy. “You need to create your strategy and differentiate your financial plan from those offered by competitors. This requires significant, in-depth research into a defined market or individual sector,” writes consultancy Intertrust Group in a piece providing advice to new launches. “You need to find the ‘secret sauce’. Learn everything there is to know in your chosen area so that you’re familiar with the history but can also predict future outcomes. In this way, you can position yourself to investors as a source of real expertise and thought leadership.”

Kyle Dunn, business development at MJ Hudson advises managers to align their marketing strategy with their investment strategy. He writes in an article: “The strategies they [PE investors] deploy are sophisticated, deeply thought-out, technical, and innovative. Although the manner in which they present themselves is often elementary, unrefined, uninteresting, and antiquated.”

Dunn says managers can’t profess to be modern and relevant if they don’t look modern and relevant: “For example, does your website portray you as dynamic and progressive, or does it look like it was built in 2002.  In my experience, as it pertains to this industry, the latter is more common.”

Having a marketing stance which is out of synch with the investment proposition can discourage limited partners (LPs) looking to invest.

Once they make the decision to allocate, LPs want managers to follow through with strong performance. In order to provide this, PwC believes private equity funds need to reconfigure their value creation playbook to outperform in the current environment. “You’ll need a strategy that focuses more closely on strategic positioning, operational excellence and capital efficiency in your business and the portfolios you manage,” write Will Jackson-Moore and Mike Greenstein in a report entitled Prime Time for Private Markets 2021.

“Private equity is the ‘asset class of the moment,’ as opportunities for acquisition and corporate turnaround increase. Strong fundraising has heightened pressure to put dry powder to work and has therefore inflated valuations. The challenges will have managers looking for new ways to create value,” the report outlines.

In Kinsch’s view, one of the key ways managers can differentiate themselves is through specialisation: “The managers who specialise in certain industries and really understand those sectors have the potential to identify better performing target companies. This will help distinguish them from the pack which is investing more broadly. Another way for startup or emerging managers to stand out is by having a deep technological understanding.”

The 2021 Preqin Global Private Equity and Venture Capital Report highlights: “Disruptive technologies such as artificial intelligence are helping fund managers to improve operational efficiencies and identify new opportunities. The rich pipeline of companies that are successfully innovating with these technologies will also attract investors’ attention.”

Eye on regulation

As the scope of the PE market continues to grow, smaller investors are now allocating to the asset class, with structures like Special Purpose Acquisition Companies (SPACs) even being offered to retail investors. This is leading to increased scrutiny by regulators, an element which startup and emerging managers need to be aware of.

“Private equity is becoming less ‘private’ and more regulated, like other investment classes. This increased regulation is becoming a bigger hurdle or barrier of entry. Managers cannot launch a fund with minimal resources. They need to be registered and have a set up to handle any potential complaints,” Kinsch warns.

The way the market is structured at the moment means funds need to carry out a lot more reporting which has an impact in terms of time and money spent on compliance. However, according to Kinsch, this is a positive development as it deters any potential ‘cowboys’ from entering the market. 

Regulatory concerns are of particular relevance in the context of the growing focus on environmental, social and governance (ESG) factors. This dimension is now one almost all startup and emerging managers need to take into consideration.

The McKinsey Global Private Markets Review 2021 identifies that global ESG regulations and laws have grown by 90 percent since 2016, with 2020 seeing efforts to standardise existing frameworks and taxonomies. “With EU regulation already pushing companies in this direction and comparable legislation widely expected in the United States, it is broadly acknowledged that the regulatory environment is shifting, and PE firms and investors are working quickly to adapt,” the report concludes. n

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