The (Not So) New Game In Private Equity Why Leadership Matters More Than Ever by Kerry D. Moynihan Partner, Boyden Private Equity & Venture Capital www.boyden.com The (Not So) New Game in Private Equity Why Leadership Matters More Than Ever w Executive The (Not So) New Game In Private Equity Why Leadership Matters More Than Ever A Very Brief History of Private Equity in software, semiconductors, and telecom fuelled the venture side, while widespread The origins of today’s private equity industry consolidation and globalization industry (which I would define as including largely propelled the LBO market. both venture capital and leveraged buyouts) date to 1946 with the foundations As ever more money flowed into pensions of American Research & Development and other institutional investor funds, the Corp. (ARDC) & J. H. Whitney. Prior, risk demand for higher yields accelerated. This capital had almost exclusively been the put more capital into the financial markets domain of wealthy families. Venture capital seeking higher returns and the boom pioneers Mayfield and Kleiner Perkins were continued. Of course, there were blips and founded in 1969 and 1972, respectively. In shocks, including the Foreign Debt crisis of the buyout realm, the origins of LBO 1997/98, the bursting of the dotcom bubble pioneers KKR began at Bear Stearns with around 2000, the cessation of normal “bootstrap” investments in the early 1970s, market activity following the 9/11 attacks, forming the foundation of the firm as we and perhaps most seriously, the major know it today. TH Lee; Forstmann Little; Financial Crisis after the collapse of Lehman Welsh, Carson, Anderson & Stowe; and Brothers and Bear Stearns in 2008. GTCR were all in operation by 1980 and became major players. The modern private However, markets rebounded, time and equity business continued to emerge in the time again. Institutional capital, which 1980s with the realization that there were seems to have a short collective memory, major discrepancies between public always seeks ever higher levels of Alpha company management interests, the age (relative return) and will accommodate old “agency problem” and the values that Beta (risk), often in unison, seemingly could be unleashed were business units to without independent, objective decision- be decoupled from large public companies. making. The year 1980 saw some $2.5 billion raised dedicated to the emerging alternative asset Institutionalization & Growth of class and in the decade that followed nearly the PE Industry $22 billion was raised by venture and buyout funds. Funds were usually (relatively) small and privately held, and made individualized, Institutional capital, The wide availability of junk bond financing partner-driven investment decisions. Yet which seems to have fuelled a boom during the 1980s, followed as their size has increased, and in many a short collective by a crash as the stock market tanked in cases the larger funds went out to the memory, always October 1987. High yield financing, or public markets, the industry has seeks ever higher “junk bonds,” dried up for a time, and fundamentally changed. Now publicly levels of Alpha (relative return) and Drexel Burnham, the leading purveyor of traded, firms like Apollo, Blackstone The will accommodate these instruments, later went down. Carlyle Group, and others are, as the co- Beta (risk). However, institutional investors had founder of one confessed to me “No longer certainly picked up on the higher returns in the business of making extraordinary, available to PE than in the public markets. outsized returns on unique investments. We are now in the asset management Key to these were the availability of debt business. If we can beat the S&P by 150 financing, the disparity between basis points and put huge sums to work management that were merely salaried and from institutional investors, we are happy those that were incentivized by equity, and and the investors are happy.“ With the the discrepancy between public and private traditional model of a 2% management fee market information. For much of the next on assets under management (AUM) and two decades private equity vastly 20% capture of the return on investment, outperformed the public markets. Clearly, the carried interest, who would not be? the emergence of technological innovation 1 The (Not So) New Game in Private Equity Why Leadership Matters More Than Ever Where a billion dollar fund was once Without naming names, an informal survey considered a large player, there were over confirms the general thesis that by training 350 by 2018 and even more today. There they are not prepared to run the businesses has been a veritable explosion in that they buy. Increasingly they recognize investment in the sector, as uninvested these facts, despite being “the smartest cash, or “dry powder“ at PE firms exceeded person in the room“ on virtually any topic $1.5 trillion by the end of 2019. Blackstone (sic), in the not so distant past. alone, the Wall Street Journal reported, had $150 billion in cash to invest at the end of Where Are We and Where Are We last year. Institutional Investor reported in Going July 2019 that 4000 funds were seeking to Fast forward to today, the late 2010s and raise an additional $980 billion, up from early 2020s. The game has changed 1385 funds seeking to raise $417 billion significantly, to say the least. Not just four years earlier. surprisingly, many of the factors that led to the tremendous success of the industry in Yet in the 2010s the number of publicly years past have changed dramatically. traded companies stayed roughly the same There is a changing reality and investment while global AUM for PE firms and the firms have, with varying degrees of number of PE-backed companies doubled, success, made adjustments. according to McKinsey & Co. It comes down to simple economics as more money is For example: chasing fewer good assets, hence driving up prices, and reducing returns. S&P Financial engineering is no longer reported in November 2019 that the adequate. Given the low interest rate average pro forma EBITDA multiple was environment of recent years, and explosion 12.9, up over 30% from pre-Financial Crisis of alternative lenders such as credit funds, pricing. The massive leverage, low prices, beyond the traditional large banks, a giant and eye-popping returns of the 1980s are fund enjoys little advantage over a smaller but a memory. What is a simple fund to do? one on the availability of financing or borrowing terms. And, let’s face it, even if Adding Operating Expertise KKR or TPG can borrow at 25 basis points Importantly, funds have changed their own lower and with slightly less restrictive internal structures over the last several covenants than XYZ Capital Partners can, decades. Almost no funds had seriously that factor alone is unlikely to be the tenured operating executives as part of deciding factor between the success or their investment teams in the 1980s, being failure of an investment. almost exclusively comprised of “recovering investment bankers.” The Globalization of the industry. Where 1990s saw a bit of a change, but now venture capital and leveraged buyouts almost every major fund has hired people were virtually exclusively a US who have more than an investment phenomenon just a few decades ago, today banking/finance background and have according to various studies, only about been senior operating executives who have 55% of global private equity activity is in actually run P&Ls. In many cases these are North America today. While Africa and Latin actual full partners in the funds, as the America are somewhat underrepresented, Silicon Valley venture capital community Europe and Asia are booming in this was quicker to adopt this model, typically respect and the former may well catch up by adding tech CEOs to their rosters, than over the Wall Street LBO community. Many are termed Operating Partners or Management Associates, but whatever the nomenclature, there has been a collective recognition that strictly financial engineering and financing skills are necessary, but not sufficient, to create outsized shareholder returns. Most of my clients and many of my good friends are private equity professionals. 2 The (Not So) New Game in Private Equity Why Leadership Matters More Than Ever over time. It has become, as in so many Executive Leadership Matters, Now industries, a much more competitive, truly More Than Ever international playing field. Over time, more and more funds have gone to a model of backing individual executives Ubiquity of information has changed or executive teams in what I call the “Back- the game. The asymmetry of information able, Bankable Leadership“ model, or BBL. that led to smart buyers and uninformed Both venture and buyout funds have sellers is simply no longer the case. The increasingly backed executive leadership incredible proliferation of information and that has had prior success and will continue ease of access on a global basis means that to do so. The proverbial “Holy Grail“ for Operational excellence, sellers, even of relatively small and investment funds is to find management coupled with the unsophisticated businesses, have a much teams that are proven and have as close to genuine ability to better handle on the overall market than in a proprietary idea as possible. By this I inspire, will always the past. An investment banker friend and mean either a specific target company(ies) be valued. I have a running joke that Old Uncle Burt, for acquisition or a well-developed selling his cornfield in Iowa, knows that he investment thesis with demonstrable can command 7.8 to 9.3 times EBITDA potential acquisition targets. these days and will have five buyers lined up! In short, because of this the market is How much better to create a situation much more ruthlessly efficient, further where you have an organic genesis of an evidenced by the dramatic expansion in the investment, rather than competing in a number of deals done and in the ever broad auction scenario against many other higher multiples paid for them.