Josh Your Earlier Paper Suggests That If There Is Indeed An Element Of Adverse Selection At Play Its The Result Of Lps Participating In Larger Deals Near The Top Of Market Cycles Rather Than Gps Knowingly Sharing Weaker Deals For Commercial Reasons Can You Explain More
Josh Lerner: Thats right. When you look at the data we have, the co-investments are disproportionately concentrated in larger deals around market peaks. When you look at the co-investments made by funds, they tend to be the largest transactions that those GPs do. In general, PE and venture capital are intensely cyclical businesses. An investor performs a lot better investing in troughs than investing at market peaks. And the basic pattern is that the largest deals being done at market peaks are in general less attractive than those done in troughs. So if you have an uptick in size and clustering around peaks, thats not a recipe for great returns.
I think its fair to say that governance issues loom large, given the pattern of LPs jumping into co-investments at exactly the wrong time, which leaves one to wonder whether investment committees are trend-chasing.
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Top Three Private Equity Trends In 2022
Coresignal
On the one hand, there is some stability in how private equity operates. Investors will seek out opportunities that show signs of a return value that outweigh any predicted risks. On the other hand, when circumstances change, different places are explored for such opportunities. Thus, just like any other industry, private equity periodically experiences trend shifts. It is natural to expect that such monumental events as we experienced last year will shape the trends for 2022. To understand better what awaits us, letâs delve into the past, present, and future of private equity.
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Disadvantages Of Private Equity
Private equity has unique challenges. First, it can be difficult to liquidate holdings in private equity because, unlike public markets, a ready-made order book that matches buyers with sellers is not available. A firm has to undertake a search for a buyer in order to make a sale of its investment or company. Second, pricing of shares for a company in private equity is determined through negotiations between buyers and sellers and not by market forces, as is generally the case for publicly-listed companies. Third, the rights of private equity shareholders are generally decided on a case-by-case basis through negotiations instead of a broad governance framework that typically dictates rights for their counterparts in public markets.
Imperfections Aside What Should Lps Draw From The Research Results
Tim Jenkinson: Well if you believe our results, even though some investments are riskier than others, you could take the view that you should simply do every co-investment that youre offered and completely eschew due diligence because, on average, theyre good deals. If, on average, you achieve a perfectly normal distribution of deals, why wouldnt you do them all?
Funnily enough, a very large investor came to me after I made that observation when presenting this paper and said thats exactly what they do. They said its the GPs job to come up with deals and that they dont second-guess the GP. They are invested in the fund and dont make judgements about whether one deal will do better than another.
Corentin du Roy: Im not sure I agree with that. If we just went with every co-investment offered to us by a good GP, were not adding value. There are two reasons why I think selection makes sense. The first is obviously portfolio construction, which should be balanced and diversified if there is a bias in the market at some point for, say, growth buyouts in the software and healthcare space, you dont want to end up with a portfolio that is 70% exposed to those deals.
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The Rise And Role Of Private Equity
Although there have been some early signs of it at the beginning of the 20th century, private equity as we know it today formed after World War II. Since its emergence, private equity provided funds for great ideas to materialize, especially when it was hard to find alternative ways to finance them. After the war, American Research and Development Corporation, founded by the legendary âfather of venture capitalismâ Georges Doriot, helped veterans start their companies, which eventually played a key role in building the business landscape we know today.
Today private equity refers to a whole set of subcategories of investment strategies, connected by way of raising funds from private investors. Yet, venture capital is still among one of its most important strategies, which helps start-ups go into business or providing businesses with early development means. Today venture capital is primarily interested in technology firms with ideas for products and services that are shaping the modern way of life.
Now, private equity firms might be more associated with another crucial strategy of theirs â leveraged buyouts. Using borrowed funds to buy out and restructure companies levers the profits after the eventual sale, making this move extremely beneficial when successful. Thus, no wonder that leveraged buyouts have, at some periods, even become almost synonymous with private equity.
Rising Inflation Will Create Opportunities
The first key trend is the effect of rising inflation on the private equity market in Asia-Pacific. Many businesses have taken on excess debt in the past couple of years on the back of low interest rates.
As rates begin to rise, some of these companies may become distressed or need to be recapitalised. That creates an opportunity for private equity to step in.
Rising interest rates will also impact sector focus for private equity. The past couple of years have been marked by investments into high-growth tech companies with very high valuations.
We expect to see a shift from high-growth companies with weak balance sheets towards sectors and companies with solid earnings and strong pricing power elements that put businesses in a better place to weather inflation.
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What Is An Equity Co
An equity co-investment is a minority investment in a company made by investors alongside a private equity fund manager or venture capital firm. Equity co-investment enables other investors to participate in potentially highly profitable investments without paying the usual high fees charged by a private equity fund.
Equity co-investment opportunities are typically restricted to large institutional investors who already have an existing relationship with the private equity fund manager and are often not available to smaller or retail investors.
Why Limited Partners Want More Co
In 2018, consulting firm McKinsey stated that the value of co-investment deals has more than doubled to $104 billion since 2012. The number of LPs making co-investments in PE rose from 42 percent to 55 percent in the last five years. But direct investing LPs grew by only one percent from 30 percent to 31 percent during the same period.
Why would a private equity fund manager give away a lucrative opportunity? Private equity is usually invested through an LP vehicle in a portfolio of companies. In certain situations, the LP’s funds may already be fully committed to a number of companies, which means that if another prime opportunity emerges, the private equity fund manager may either have to pass up the opportunity or offer it to some investors as an equity co-investment.
According to Axial, an equity raising platform, almost 80% of LPs prefer small to mid-market buyout strategies and $2 to $10 million per co-investment. In simple words, this means that they prefer to focus on less flashy companies with expertise in a niche area as opposed to chasing high-profile company investments. Almost 50% of sponsors did not charge any management fee on co-investments in 2015.
Most LPs pay a 2% management fee and 20% carried interest to the fund manager who is the GP while co-investors benefit from lower fees or no fees in some cases, which boosts their returns.
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How Do Private Equity Firms Make Money
The primary source of revenue for private equity firms is management fees. The fee structure for private equity firms typically varies but usually includes a management fee and a performance fee. Certain firms charge a 2-percent management fee annually on managed assets and require 20 percent of the profits gained from the sale of a company.
Positions in a private equity firm are highly sought after and for good reason. For example, consider a firm has $1 billion in assets under management . This firm, like the majority of private equity firms, is likely to have no more than two dozen investment professionals. The 20 percent of gross profits generates millions in firm fees as a result, some of the leading players in the investment industry are attracted to positions in such firms. At a mid-market level of $50 to $500 million in deal values, associate positions are likely to bring salaries in the low six figures. A vice president at such a firm could potentially earn close to $500,000, whereas a principal could earn more than $1 million.
Real Estate Set To Be Buoyant In Asia In 2022
Commercial real estate will rebound in 2022, particularly in Asia, where the market is different for cultural and demographic reasons. Workers are likely to return to the office more swiftly because there is far less enthusiasm for working from home than in Europe and the US.
Many employees in Asia have struggled to reconcile homeworking with their limited living space and are eager to feel part of a team at their workplace. But they will expect strict hygiene and reinforced health-and-safety measures as well as improved facilities to minimise the risk of infection. As a result, real estate managers will have to upgrade their properties for the post-Covid world.
Another interesting trend is the shift towards rental space optimisation. Many employers plan to downscale office space to reduce rent.
This will reshape the commercial real estate market in large cities like Beijing, Sydney and Seoul, where employers will adopt a hub-and-spoke approach for office space, increasingly relying on coworking and flexible office solutions.
Companies will downsize the footprint of their main headquarters and open satellite offices in the outskirts, so staff need to visit the central office only once a week or a few times a month. This will boost commercial property valuations in some satellite cities around Asias sprawling metropolises.
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Corentin What Do You Make Of The Adverse Selection Argument That Some Have Put Forward
Corentin du Roy: Conceptually, it defies logic for a GP to offer their LPs inferior or less attractive opportunities. First of all, it doesnt make sense for the GPs to have deals in their fund that are less attractive, but it would be even worse to double up the exposure of what are generally their largest LPs by putting them directly into one of these deals.
If youre offering co-investment to attract LPs into your next fund, youre not going to put them into deals where you think the risk-return profile is poor.
What Ive observed over the past 14 years though I think this situation has eased over time is some GPs fear of showing LPs a deal that, although they think its great, doesnt work out and will stop investors from investing with them in the future.
Is it ever the case that a GP shows you a deal simply because they want to generate co-investment deal flow for LPs? That may happen, but its very rare and these are likely to be GPs that are struggling with their performance and need to create co-investments as an inducement for fundraising. This is a situation we can recognise and avoid very easily.
Private Equity Year In Review And 2021 Outlook
Andrew J. Nussbaum and Steven A. Cohen are partners, and Katherine L. Chasmar is an associate at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell memorandum by Mr. Nussbaum, Mr. Cohen, Ms. Chasmar, Jodi J. Schwartz, Nicholas G. Demmo, and Igor Kirman.
2020 was a tale of two halves: during the first half of the year, global private equity deal volume fell precipitously, declining more than 20% relative to the same period in 2019 in the second half of the year, private equity dealmaking roared back to life, ending the year at approximately $582 billion, its highest level since 2007, as private equity firms acquired and invested in companies and businesses in record numbers even as the global Covid-19 pandemic continued to wreak havoc on the broader economy.
We review below some of the key themes that drove private equity deal activity in 2020 and our expectations for 2021.
Rebound in Second Half. After a slowdown in the early months of the pandemic, private equity dealmaking activity surged in the second half of 2020, ending the year with the highest aggregate dollar volume of deals since 2007 and the highest number of deals struck since records began in 1980.
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Emerging Trends In Co
Offering co-investment opportunities to certain fund investors is a key trend for fund sponsors in establishing alternative investment funds.
Once an optional sweetener, today large institutional investors expect to benefit from co-investment rights primarily to enhance returns through lower fee arrangements, but also to gain increased exposure to specific assets and, for some, to gain experience in a more direct form of investment while building stronger relationships with sponsors.
However, the benefits of co-investments do not solely fall to investors. Sponsors may also benefit from fund investors co-investing in particular investments, especially where the fund would not otherwise be able to make the investment for example, due to investment restrictions in the fund documentation which impose a maximum exposure of the fund to a particular type of asset, geography, leverage etc. or where the sponsor determines that the fund should not or cannot acquire the whole investment for diversification reasons or other reasons.
Who gets what?
The perennial issues for both fund sponsors and investors involvewho gets what:
| Investors | |
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What co-investment rights should I ask for? |
To whom should I offer co-investment rights? |
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What rights is everyone else getting? |
How specific do I need to be in offering co-investment rights? |
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How will co-investments be identified and allocated? |
How do I retain flexibility in allocating opportunities? |
Identifying co-investors
Data To Train Algorithms
As we can see, big data analysis will remain a key theme in 2022 and beyond, as its significance has been increasing over the past decade. In one way or another, it will impact most of the private equity trends. Therefore, it is worth looking closer at the role data plays in machine learning, that is, as means for algorithms to be trained.
The important thing to understand is that well-trained algorithms donât just improve efficiency by doing the analysis faster. They can actually do more than itâs feasible by constant programming. One way to look at it is through an analogy with driving. One canât teach driving by simply explaining what to do. How to start the car, maybe, but not much more. Certainly not how to navigate all the different circumstances one might meet on the road. This must be learned by experience.
Similarly, it is hardly possible to program the solutions to every problem that might arise during data analysis. But algorithms can find those solutions on their own when they keep learning by encountering various types of data. Data to the machines is what experience is to the people.
Therefore, the trends in 2022 will dictate the continuous need for PE firms to get their hands on as much data as possible.
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About The Underlying Research
Adverse Selection and the Performance of Private Equity Co-Investments re-examined the performance of co-investments compared with other investments in the relevant sponsors funds.
The research draws on a broad sample from a commercial database of 1,016 co-investments by 458 LPs. In contrast with earlier findings , the paper found no evidence of co-investment underperformance resulting from adverse selection.
Rather, the gross-return distributions of co-investments and the deals that remain entirely within a fund are similar there is no significant evidence of selection bias, either positive or negative. Indeed, the similarity of gross returns, across the whole sample, results in higher average net returns to investors in co-investments, once their lower fees and carried interest are accounted for. This outperformance is observed for reasonably sized portfolios, which are defined as 10 or more buyout deal co-investments. Further, the higher cost to investors of running a co-investment programme does not reverse this result.
The Disintermediation of Financial Markets: Direct Investing in Private Equity is understood to be the first paper to analyse the relative performance offund-only investments and co-investments.
Private Capital Investments To Diversify Across Asia
While China will remain a key market for investors, limited partners will increasingly want to spread their investments across the Asia-Pacific region for diversification. Were seeing a lot of interest in private capital deals in India, Japan and South Korea, which are set to benefit from this trend.
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History Of Private Equity
While private equity has garnered mainstream spotlight only in the last three decades, tactics used in the industry have been honed since the beginning of last century. Banking magnate JP Morgan is said to have conducted the first leveraged buyout of Carnegie Steel Corporation, then among the largest producers of steel in the country, for $480 million in 1901. He merged it with other large steel companies of that time, such as Federal Steel Company and National Tube, to create United States Steel the worlds biggest company. It had a market capitalization of $1.4 billion. However, the Glass Steagall Act of 1933 put an end to such mega-consolidations engineered by banks.
Private equity firms mostly remained on the sidelines of the financial ecosystem after World War II until the 1970s when venture capital began bankrolling Americas technological revolution. Todays technology behemoths, including Apple and Intel, got the necessary funds to scale their business from Silicon Valleys emerging venture capital ecosystem at the time of their founding. During the 1970s and 1980s, private equity firms became a popular avenue for struggling companies to raise funds away from public markets. Their deals generated headlines and scandals. With greater awareness of the industry, the amount of capital available for funds also multiplied and the size of an average transaction in private equity increased.
