What’s Next: Navigating a low-return environment

The overall consensus at the PartnerConnect West event in San Francisco last month seemed to be one of concern: money is flooding into the market at a time of sky-high prices. Returns are being pressured, even as general partners exercise their power to negotiate better terms for themselves.

It seems like a precarious situation, and that anxiety revealed itself in panels and keynote speeches at the event, which was held Sept. 27 and 28 at San Francisco’s Hotel Nikko.

“When I started, inflation was 12, 13, 14 percent. When you’re doing well, you’re going to make 25 percent compounded,” Pantheon founder Rhoddy Swire told the audience after accepting his lifetime achievement award. “We’ve got to readjust to a lower base rate from the point of view that, actually, 5 percent real is a decent return.”

Swire’s comments echoed a growing chorus of private equity market participants arguing the industry’s returns may fall as general partners deploy capital in an increasingly unfavorable deal environment.

In September, Andrea Auerbach of Cambridge Associates said she was “nervous” about the high prices firms pay for new assets. Earlier this month, investment advisory firm Verus signaled its bearishness on the U.S. buyout market, citing downward pressure on buyout returns as managers load more equity into their deals. Blackstone Group’s Joe Baratta called the deal environment “the most difficult period we’ve ever experienced,” according to Bloomberg.

According to Swire, declining returns could cause fund investors to pressure private equity firms and other alternative asset managers to reduce fees.

In the early 1980s, around the time Swire launched Pantheon, funds collecting a 2 percent management fee on committed capital often generated internal rates of return in excess of 25 percent, he said. According to Cambridge Associates data, the median IRRs for mature buyout and growth equity funds raised in 2006 was 8.47 percent.

“Those are the dynamics one has to come to grips with. You have to make sure it’s fair and reasonable,” Swire said. “If you upset your investors, it tends to not be repeatable.”

Alternative structures

While Swire cautioned GPs about investor concerns around fees, he also attributed some of Pantheon’s success to his decision to charge management fees off the amount LPs commit to his funds, as opposed to the amount ultimately invested.

Swire launched Pantheon in 1982 and shepherded the $33 billion asset management firm through multiple economic cycles. He does have at least one regret, however.

“[One] thing I got wrong is we give our money back to the clients. You know, it’s a little unfortunate,” Swire said. “There are companies out there I wish we could have owned for much longer than we did, but that’s life and you have to move on.”

Most of Pantheon’s investment vehicles are traditional closed-end funds that must wind down their holdings after a certain period, usually between 10 and 15 years.

The firm operates one permanent capital vehicle, Pantheon International, which had around $1.3 billion under management, Swire said. Pantheon International was launched in 1987. Its shares are publicly traded on the London Stock Exchange.

The vehicle typically invests through the secondary and co-investment market, and its holdings include funds managed by firms like Bain Capital, Kohlberg Kravis Roberts and Summit Partners, according to its website.

GPs push back

Even as returns are pressured, those GPs that have shown strong performance are highly sought after by limited partners, giving them negotiating power when they come to market with a new fund. Capital continues to flood into private equity, with total fundraising expected to hit around $300 billion this year.

Examples of this kind of GP leverage is showing up in various ways. Michael Hacker, managing director at AlpInvest, said the pace toward 100 percent management fee offsets has slowed as GPs push back.

“LPs have less leverage today,” Hacker said during his September 27 keynote at PartnerConnect West. “We’ve had a lot of inroads from 10 years ago, but LPs were hoping to get 100 percent fee offsets by now. It’ll take the next market correction to make more progress on this.”

Hacker hasn’t seen GPs backtrack from 100 percent fee offsets to, say 50 percent fee offsets. Rather, some groups have had 50 percent fee offsets and may be going as high as 75 percent or 80 percent, but not all the way up to 100 percent, he said.

Another way GPs are pushing back on economics is through preferred return hurdles, which require a manager to guarantee a certain return on a fund before starting to collect carried interest. In one high profile example, Advent International dropped a preferred return in its latest flagship fundraise. Hacker did not mention any specific GP names in his remarks.

“We like to see GPs have preferred return in the GP carry waterfall,” Hacker said. “If the GP is in it to maximize carry for themselves and it’s not taking into account its LPs, that’s not a fund we want to take part in.”

To be sure, GPs who don’t offer first- or second-quartile returns continue to struggle in the fundraising market and don’t dictate terms as favorable as shops drawing larger LP interest, he said.

Asked about his specialty in the secondary market, Hacker said the business is only in the middle innings of its development.

“Most LPs weren’t thinking about it six or 10 years ago,” he said. “Today it’s a different ball game. If you’re not thinking about secondaries, you’re missing out on an important element of your portfolio management repertoire.”

AlpInvest takes part in a variety of secondary transactions including restructurings and spin-outs from older firms.

“It’s an interesting space and it’s changed,” Hacker said. “It was the Wild West in the early 2000s. Today, it’s a more standardized market. …But in terms of major secondary specialists, there aren’t many new entrants. It requires a lot of work and expertise so it has pretty interesting barriers of entry.”

Tread carefully

A panel of private equity executives agreed that a U.S. recession lurks at some point in the future and said lining up favorable financing partners will be critical in the next downturn.

The two GPs and one LP on stage at the PartnerConnect West 2016 conference in San Francisco disagreed on how soon a more severe economic slowdown will kick in, but they said portfolio companies need to be ready for it when it comes.

Among the storm clouds on the horizon: weak U.S. job growth, downward pressure in the energy, retail and industrial sectors, lower corporate earnings, continued gridlock in Congress despite the outcome of the November elections and the prospect of higher interest rates.

Speaking at a panel called, “Bulletproofing Portfolio Companies for the Next Recession,” the buyout pros emphasized the importance of strong balance sheets, with the right debt providers.

“If you have a lender that will work with you, as you hit these bumps in the road you’ll more likely have the staying power to get through it,” said Kenneth Clay, executive managing director of Corinthian Capital.

It may be better to avoid more aggressive lenders looking to extract value or gain control of a company in favor of more relationship-based ones, he said.

“A recession is always coming – the question is how quickly,” Clay said. “As we look at potential headwinds, there are lots of things to be concerned bout. I think caution is warranted.”

Taking a more bearish view, Quinn Morgan, co-founder and managing director of Centre Lane Partners, said he expects a recession as early as next year. An election of Donald Trump could cause equity markets to take a double-digit percentage dive, not unlike the move following the Brexit vote, he said. A win from Hillary Clinton may spark a short-lived rally but attention will turn back to economic fundamentals, which continue to signal trouble.

“When we look at our portfolio we’re trying to sell everything that’s ready or sort of ready,” Morgan said. “The general mantra of the firm is do we really understand where cash is generated and what happens to it if we cycle down.”

Offering an LP perspective, Miguel Luiña, vice president on the co-investment team at Hamilton Lane said the firm doesn’t expect a recession in the near term, but a year from now there may be a higher chance.

“If you do think a recession is coming, the best place to be is in private equity, based on our data,” Luiña said. The key to weathering a downturn is diversification among private equity investments, he said. GPs need to put flexible capital structures into place to get through harder times.

Hiring for low growth

In the low-growth markets, the most vital roles a portfolio company needs to fill is that of sales and marketing leaders, according to another panel at the conference.

While the chief executive is always the most urgent position to fill, because the role “sets the culture for the company,” senior sales and marketing leaders are “more critical than ever” with growth at a premium, according to Jean-Pierre Conte, chairman and managing director of Genstar Capital LLC. Conte spoke on the panel “Bringing Operational Talent to Bear on Portfolio Companies.”

Aaron Money, a partner at Friedman, Fleischer & Lowe LLC, said the head of sales is usually more fundamental in driving growth at portfolio companies than other positions like the CFO. Friedman, Fleischer will sometimes use its investment professionals to supplement a CFO’s efforts, said Money, who also spoke on the panel.

This is more difficult to do with sales or operations, he said. “We can live with a CFO who is not at the top of his or her game,” Money said.

CFOs are critical to portfolio companies but they’re easier to find, Conte said. In contrast, strong sales and market leaders, or chief revenue officers, are more difficult to find, he said. “There is a lot of good CFO talent to choose from,” he said.

Kaustuv Sen, a principal with Blue Sea Capital who spoke on the panel, said his firm can wait six months before hiring a portfolio company CFO.

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Photo: Buyouts Senior Editor Steve Gelsi (L) listens as Pantheon founder Rhoddy Swire speaks at PartnerConnect West in San Francisco on Sept. 28, 2016. Photo by Audrey Daniel for Buyouts Insider