Permanent Capital: The Holy Grail of Private Markets

In the 1970s, when trailblazers Henry Kravis and Teddy Forstmann helped launch one of the most successful financial products of the past half-century, leveraged buyouts (LBOs) were conducted on a deal-by-deal basis. The process was cumbersome.

To expedite and bring more discipline to the equity funding stage, LBO specialists soon established investment structures to secure capital commitments, typically for a period of 10 years, from third-party limited partners, or LP investors.

That readily available firepower made them more efficient during time-sensitive auctions, famously helping Fortsmann and Kravis to act as rival white knights during the highly contentious 1988 bid for RJR Nabisco.

Because it made their fee-based model more reliable, the creation of blind pools inspired the eventually rebranded private equity (PE) firms to strive for the ultimate prize: permanent capital.

The Global Killer

Vintage funds worked wonders for a long time. But the global financial crisis (GFC) gave rise to existential questions for a number of the sector’s bellwethers. It was the market equivalent of an asteroid impact or a pandemic, what astronomers and epidemiologists call a “global killer.”

It took TPG Capital eight years to close a new flagship fund, on the back of disappointing transactions like the buyouts of Harrah’s Entertainment, TXU, and Washington Mutual. At $10.5 billion, the 2016 vintage was about half the size of its predecessor, TPG VI.

Many UK firms — which, as a general rule, like to adopt their US counterparts’ worst investment strategies with a one-to-two-year time lag — were even less fortunate.

In mid-2009, 3i Group Plc, the largest publicly-listed LBO shop in Europe, needed an emergency £732 million ($1.1 billion) rights issue to spruce up its overstretched balance sheet.

After the £4.2 billion take-private of distressed music publisher EMI in 2007, Terra Firma failed repeatedly in subsequent fundraising attempts. Understandably so: Its 2006 Fund III delivered a negative annualized rate of return of 9%, destroying more than half its LPs’ capital.

Candover, once a top-10 firm in Europe with over €6 billion under management pre-GFC, was liquidated three years ago due to several disastrous deals, including the secondary buyout of yacht builder Ferretti in 2006, and the mega merger between gambling operators Gala and Coral Eurobet the year before.

A Persistent Threat

A quarter of buyout firms worldwide never raised a fund post-2008. And after flirting with death so uncomfortably, for the past decade the survivors have had to contend with a less violent but more tenacious challenge.

The financial crisis made LP investors realize that buyout sponsors were opportunistic by nature rather than endowed with a unique skillset. LPs had previously acted exclusively as capital providers. A growing number of them have since elected to make direct investments.

There are various reasons behind this move. One of import is the PE firms’ bountiful fees, which eat up a significant portion of capital gains. Another factor is that the great majority of fund managers do not return LP commitments within the contractual 10 years.

A more recent motive is related to the commoditization and saturation of the sector. There are over 5,000 firms worldwide and $2.5 trillion-plus in dry powder across the full gamut of alternative assets, including real estate, credit, and buyouts. Proprietary deals in advanced economies are a thing of the past.

The standardization of investment techniques — from covenant-light stapled financing to vendor due diligence — has shrunk equity returns and made LBOs more accessible to generalists. Retirement plan managers like Canada Pension Plan and sovereign wealth funds such as Singapore’s GIC can match the capabilities of most PE groups.

Countering the Influence of LPs

To soften the effects of intense competition and render their revenue model more sustainable, rather than try to abide by their obligations to return capital within the contractual 10 years, PE fund managers devised a new business line.

In 2016, Blackstone raised a $5 billion “core” PE vehicle to invest in market-leading, slow-growing but hopefully safer companies. The goal? To mimic Warren Buffett’s buy-and-hold strategy. That same year, Carlyle secured a $3.6 billion long-dated fund and European rival CVC targeted a 15-year $5 billion.

Conduits of an indefinite duration improve the recurrence of fee generation. As a quid pro quo, however, performance fees are charged at a lower rate — usually, half the 20% of traditional 10-year funds. Longer-lifespan vehicles have since turned into a key instrument of asset gathering, with Blackstone closing a second long-hold vintage at $8 billion last year, keeping the holding period conveniently vague.

Besides lengthening the maturity of third-party funds, PE firms adopted
a complementary course of action to regain the upper hand vis-à-vis LPs:
collecting fresh equity from outsiders.

The Big 5 —
Apollo, Ares, Blackstone, Carlyle, and KKR — took the IPO route, either
shortly before or after the 2008 crisis. Sweden-based EQT followed suit two
years ago. But most second-tier players, such as BC Partners and Bridgepoint in
Europe, elected to sell minority stakes in their management company through
private placements.

These public listings and private stake disposals provide liquidity and monetize the shares of the PE firms’ executives. But they are far from cycle-proof avenues for capital accumulation. The 40%-to-50% drops in the stock price of the Big 5 during the first quarter of 2020 testify to the inherent limits of this strategy. It will be hard to attract capital, other than at a deep discount, in a declining market.

Reducing the Dependence on LPs

A recent and more formidable innovation in this quest for the Grail has been the conception or acquisition of platforms that control long-lasting pools of capital. PE firms are trying to replicate the most attractive feature of LP structures: unrestricted access to assets and fees.

Indeed, LPs know all about permanent capital. Endowment funds at major universities, sovereign wealth funds, retirement plan administrators, and insurance companies manage money over several decades, enjoying regular cash inflows such as pledges by alumni, government tax income, pension contributions, insurance premia, as well as regular streams of interest and dividend incomes through bond and stock holdings.

The copycat policy was pioneered by Apollo with its 2009 investment in
retirement service specialist Athene. It is no coincidence that such a move
happened in the wake of a financial meltdown that endangered the PE species.

Annuities providers represent a bedrock of capital that can be used as security or lending facility to fund deals. Last year, KKR took a similar view with its acquisition of retirement and life insurance company Global Atlantic, adding $70 billion to its asset base.

Auto insurer GEICO supplies a dependable float to its parent, Buffett’s Berkshire Hathaway. Since the latter took full control of GEICO in 1995, the float has been used as a quasi-free margin loan to back investments and acquisitions. Plainly, Apollo committed a faux pas by introducing Athene to the NYSE in 2016. It backpedaled earlier this year to merge with its former portfolio company.

Weakening Corporate Governance

In short, these capital platforms will help PE dealmakers to battle it
out with traditional LP-backed investment vehicles and reduce the frequency of
time-hungry fundraises.

But permanent capital in private markets will also accentuate the risk of misbehavior in a sector notorious for questionable practices. In the aftermath of the GFC, several PE groups saw their reputations marred by claims of collusion, corruption, and inadequate disclosure of fees charged to capital providers.

Even if grossly underregulated, private equity remains under the supervision of LP investors who themselves have fiduciary duties to pension-holders or depositors. No doubt that explains why LPs played a vital role in the recent ouster of Apollo’s cofounder and chief executive Leon Black.

The merger with Athene could prove a valuable tool for Apollo’s senior management. Controlling a hoard of perpetual capital should lessen the power of its LPs.

While institutions like BlackRock and Vanguard are on the share register of NYSE-listed Apollo Global Management Inc, they are unlikely ever to have the sort of authority exerted by cornerstone investors in vintage funds. In fact, public shareholders might initially benefit from weakened LPs through better fee income visibility and lower stock volatility.

By removing the need for advisory boards granting monitoring rights to LPs, permanent dry powder could end any pretense of accountability at major PE groups. That does not bode well for individual investors, a year after the Trump administration gave them the option to invest via their 401(k) plans directly into private equity. These small investors would simply add “unsophisticated” funds to the private markets’ unregulated blind pools.

The Elixir of Immortality

Perpetual capital recalls the Inexhaustible Treasuries of the Buddhist monasteries in early medieval China. As anthropologist David Graeber chronicles, “by continually lending their money out at interest and never otherwise touching their capital, [monasteries] could guarantee effectively risk-free investments. That was the entire point.”

The point of PE fund managers’ inexhaustible founts of capital is more subtle. Their model must become less subject to the whims of LPs and, instead, secure an asset base as well as regular capital streams. As PE reeled from the financial crisis, in December 2009, Henry Kravis enviously commented about Buffett: “He can make any kind of investment he wants . . . And he never has to raise money.”

If listing unwieldy financial conglomerates on public exchanges and controlling immutable floats simulate Buffett’s blueprint, does it follow that quoted PE groups will underperform their benchmark indexes, just as Berkshire Hathaway has done for the past decade?

Unlike Buffett, PE fund managers have no qualms about charging commissions irrespective of performance. As long as the sinecure of relentless fee extraction is allowed to endure, KKR’s stockholders — including Kravis — should do better than LP investors in the underlying vintage funds.

In this tale of empire building and the pursuit of eternal life, the goal is to be impervious to the vagaries of the economic cycle and to outside interference. What the lords of private equity are digging around their castles are not so much moats à la Buffett as pools of permanent capital without drawbridges.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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