BRIAN KANTOR: Meet the new Titans of Wall Street — private equity partnerships

Over the past 20 years institutional fund allocators have fallen in love with high-fee paying, internally valued and illiquid private investment strategies known as private equity (PE). The PE industry has evolved from a small cottage industry to an important asset class.

The PE partnerships that manage the process have gone the other way, converting from small private partnerships to highly valued public companies, with their revenue and earnings and market value propelled by the increasing inflow of assets they have captured from institutions.

Supporting strategies that promise to ignore the “hated” and unavoidable volatility associated with owning listed stocks, their founders are the new Titans of Wall Street. 

These PE managers typically invest alongside their pension fund and endowment partners in the series of multiple separate funds (partnerships) they initiate and raise capital for. The largest, Blackstone Group, has more than $1-trillion of assets under management and a stock market value of $155bn. Other prominent names in the category include KKR, the Carlyle Group, Apollo, Ares, BlackRock and Brookfield. 

For privately owned operating companies, sourcing capital from these private equity funds has become a viable alternative to an initial public offering of their shares. The number of publicly listed companies traded on US exchanges has fallen dramatically, from a peak in 1996 of more than 8,000. Now only 3,700 companies are listed in the US. There are now about five times as many private equity-backed firms in the US as there are publicly held companies, according to Wells-Fargo bank. 

Staying or going private works because the private co-owners and managers of their business operations are likely to focus narrowly on realising a cost-of-capital-beating return on the capital at risk, including their own capital. The controllers of the private equity funds are aware of the advantages of appropriately incentivised owner-managers, and design their contracts with the private companies they oversee accordingly. The private companies the funds invest in will also be encouraged to raise debt to improve returns on less equity capital.

Smoother returns

However, regular fund valuations and annual returns on the funds are conveniently based on internal calculations of net asset value. Reporting smoother annual returns than provided by listed equity plays well in the annual performance reports provided to trustees of pension funds and endowments. Moreover, if returns on equity generally exceed the costs of finance in the long run, the case for leveraging returns on equity capital with more debt is powerful.

Lenders also like smoother, predictable returns, especially when secured by the pre-commitments to subscribe funds when called. The longer the call for capital by the funds can be delayed, the higher the returns on the lesser equity capital invested.

A further advantage is that their private companies supplied with capital will be given time — up to 10 years — to prove their business case before the funds have to be liquidated, perhaps via an initial public offering of shares, public market conditions permitting, a sale of assets to another PE fund, or perhaps even rolled over to a new fund raised by the same fund manager.

The performance fees paid to the private equity firms themselves (perhaps 20% of the capital gain) will be realised on the final liquidation of a fund. Management fees of typically 1%-1.5% per annum will also be collected. These account for a large proportion of the fund manager’s revenue. 

Paradoxically, it would have been an even better idea to have become a general rather than a limited partner in these burgeoning private equity funds. That is, owning the shares of the listed private equity managers as an alternative to subscribing to one of their funds.

The shares of six of the largest listed PE managers have outpaced the excellent performance of the S&P 500 index itself. And, paradoxically, they have outperformed most of the funds they have managed. 

• Kantor is head of the research institute at Investec Wealth & Investment. He writes in his personal capacity.