Under the private equity fundraising model, fund managers secure 10-year capital commitments every few years and charge management and advisory fees in the course of the lock-up period. While longer-term products have emerged over time, the fundamental pattern has remained essentially unchanged.
Unfortunately, fundraising is cyclical. Downturns require patience: fund managers must wait for the primary signs of recovery to look before re-entering the marketplace for a brand new vintage.
Overcoming the fundraising hurdle
Economic slowdowns impact credit supply, capital availability and the health of portfolio assets. In the wake of the worldwide financial crisis (GFC), even large firms reminiscent of UK-based Terra Firma were unable to finish a brand new vintage, while others – BC Partnerfor instance – barely survived, retained their asset base, but never really expanded again.
Global operators also struggled to get back on the expansion path. Some, reminiscent of TPG And Providence Equity, had difficulty attracting recent pledges and picked up far lower than they did for his or her vehicles before the financial crisis. KKR took eight years to shut a brand new flagship buyout fund, raising $9 billion in 2014, slightly below half the $17.6 billion it had generated for its previous vintage.
While small fund managers stuck to the old model, the most important players looked elsewhere for solutions. Vertical integration was a way forward: for instance, Carlyle acquired Alpinvest umbrella fund manager for the pension funds APG and PGGM in 2011.
Warren Buffett’s Berkshire Hathaway offered PE firms a brand new template. Through the IPO of its auto insurance division, GEICO, the corporate has everlasting access to a everlasting pool of capital. Apollo, Blackstone and KKR, amongst others, have acquired insurance firms within the last decade to generate the same amount of capital and a everlasting source of fees.
Indecent exposure
But there is a catch. Insurance firms are sensitive to random variables: rampant inflation, for instance, results in higher claims costs and lower profits, especially for property liability insurers. Sudden rate of interest movements or, within the case of life insurers, unexpectedly high mortality rates (e.g. as a consequence of a pandemic) can have an outsized impact on the underside line.
The Financial Stability Board (FSB) within the United States has suspended this received the award as a globally systemically vital insurer (GSII) two years ago, recognizing that the insurance industry, unlike its banking counterpart, doesn’t pose a systemic risk. But the macroeconomic backdrop is way more difficult to manage than corporate affairs and may hinder money flow.
Therefore, the failure of a single insurer may not have a domino effect, but may very well be triggered by a severe lack of liquidity. This consequence is more likely when the insurer is exposed to illiquid private markets. A chronic economic crisis could due to this fact impact a PE-owned insurer’s ability to underwrite policies, issue annuities or pay claims.
Insurers have a public mandate to guard the health or property of their various policyholders. PE firms, then again, have a primary fiduciary duty to institutional investors. In fact, unlike private capital, the insurance industry is extremely regulated and subject to strict legal obligations. This has crucial implications. For example, the past Customer service and business management Problems with life insurers Athena And Global Atlantic, now owned by Apollo or KKR, resulted in heavy fines. Such incidents can expose private capital to public scrutiny and make trading more unpredictable, particularly when insurance activities make up a big portion of the business. Last yr, for instance Athene accounted for 30% of Apollo’s sales.
Alternative supermarkets
Another solution to the PE fundraising dilemma was asset diversification, an idea first implemented by industrial banks within the late Nineties and early 2000s.
Citi and the Royal Bank of Scotland (RBS) have acquired or established capital markets units and insurance operations to offer a single point of contact for his or her customers. Cross-selling has the twin advantage of making each account more profitable and increasing customer loyalty.
Blackstone, Apollo, Carlyle and KKR (BACK) have built similar platforms to assist yield-seeking LP investors diversify into the choice asset class. They now offer single-digit return products reminiscent of loans alongside riskier, higher-return leverage buyout solutions, in addition to longer-term but low-yielding infrastructure and physical asset investments.
By raising funds for separate and independent asset classes, BACK firms protect themselves from a possible capital market shutdown. For example, while debt markets suffered in the course of the global financial crisis, infrastructure showed remarkable resilience.
However, such innovations have disadvantages. “Universal” banks performed worse than their smaller and more tightly managed competitors. Opportunistic business deals revealed an absence of focus. For example, in 2002, RBS acquired used automobile retailer Dixon Motors, although there was little evidence of potential synergies. Furthermore, the pathological obsession with return on equity (ROE) couldn’t explain the declining quality of the underlying assets. Additionally, retail bankers often turned out to be mediocre traders, M&A brokers, corporate lenders, and insurers.
Early indications suggest that multi-product platforms like BACK may not have the opportunity to deliver the very best results across the total spectrum of personal markets. Carlyle’s mortgage bond fund operations and its activities in Central Europe, Eastern EuropeAnd Africa in addition to KKR’s European buyout unit All have failed or struggled prior to now, showing how difficult it’s to watch and maintain a financial conglomerate’s performance across the board. Opaque product bundling could further impact the returns of those global alternative asset supermarkets.
A performance puzzle
That diversification reduces risk while lowering expected returns is one among the fundamental principles of economic theory. But in 2008, diversification in “universal banks” demonstrated how risk will be mispriced when the performance correlation between products is underestimated. Risk can increase if comprehensive growth strategies aren’t accompanied by adequate controls. The quasi-exclusive emphasis on capital accumulation and fee-based income by listed alternative fund managers could also be on the expense of future returns.
This is a lesson from Berkshire Hathaway’s business model that the brand new generation of PE firms may not recognize. Unconditional access to a pool of capital is one thing; Using this capital is something completely different. The excess money from the insurance book – over $100 billion as of June 30 – has made this virtually inconceivable Berkshire Hathaway outperforms public benchmarksespecially when negative real rates of interest promote competition through unbridled credit creation and asset inflation.
PE firms raising funds to expand beyond their core competency will face similar headwinds. Perpetual Capital has develop into essentially the most critical area of the legacy specialist. Blackstone’s grew 110% yr over yr within the quarter ended June 30, reaching $356 billion, or 38% of its total asset pool Apollo’s $299 billion perpetual capital base increased to 58% of assets under management (AUM). Blackstone had $170 billion in undrawn capital at the top of June, while Apollo had $50 billion to play with. That’s quite a lot of dry powder to make use of, which could only drag yields down.
A durable and diversified capital base may ease PE’s fundraising hunger, however the associated insurance activities and multi-asset strategies may lead to an entire disruption in investment performance.
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