Under the private equity fundraising model, every few years fund managers secure 10-year capital commitments and collect management and advisory fees during the lock-up period. Although older products have emerged over time, the basic pattern has remained essentially unchanged.
Unfortunately, fundraising is cyclical. Downturns require patience: fund managers must wait until the green shoots of recovery appear before returning to the market for a new vintage.
Overcoming the fundraising hurdle
The economic slowdown affects the supply of credit, the availability of capital and the health of portfolio assets. In the wake of the Global Financial Crisis (GFC), even large firms such as UK-based Terra Firma were unable to close a new vintage, while others, BC Partners for example, barely survived , maintaining their asset bases but never really expanding again. .
Global carriers also struggled to get back on the growth path. Some, such as TPG and Providence Equity, struggled to attract new commitments and raised far less than they had for their pre-GFC vehicles. It took KKR eight years to close a new flagship buyout fund, which raised $9 billion in 2014, barely half the $17.6 billion it had generated for its previous vintage.
While smaller fund managers were stuck with the legacy model, bigger players looked elsewhere for solutions. Vertical integration was one way forward: for example, Carlyle acquired fund manager Alpinvest from pension funds APG and PGGM in 2011.
Warren Buffett’s Berkshire Hathaway offered PE firms a new template. Thanks to the float of its auto insurance unit, GEICO, the company has permanent access to a perpetual pool of capital. Apollo, Blackstone and KKR, among others, acquired insurance companies over the past decade to raise a similar source of capital and tap into a perpetual source of fees.
indecent exposure
But there is a problem. Insurance is sensitive to random variables: rampant inflation, for example, leads to higher claim costs and lower profits, especially for liability insurers. Sudden movements in interest rates or, in the case of life insurers, unexpectedly high mortality rates (for example, due to a pandemic) can have outsized effects on results.
The US Financial Stability Board (FSB) suspended the global systemically important insurer (GSII) designation two years ago, recognizing that the insurance sector, unlike its banking counterpart, does not present a systemic risk. But the macroeconomic context is much more difficult to control than business affairs and can hamper cash flows.
As such, the failure of an individual insurer may not have a domino effect, but could be precipitated by a severe lack of liquidity. This outcome is more likely when the insurer is exposed to illiquid private markets. Therefore, a sustained economic downturn could impede a PE-owned insurer’s ability to write policies, issue annuities or settle claims.
Insurers have the public mission of covering the health or property of their various policyholders. PE firms, on the other hand, have a primary fiduciary duty to institutional investors. In fact, unlike private equity, the insurance industry is highly regulated with strict legal obligations. This has critical implications. For example, past customer service and corporate governance issues at life insurers Athene and Global Atlantic, now owned by Apollo and KKR respectively, resulted in hefty fines. Such incidents can expose private equity to public scrutiny and make trading more unpredictable, especially when insurance activities represent a large part of the business. Last year, for example, Athene accounted for 30% of Apollo’s revenue.
Alternative Supermarkets
Another solution to the PE fundraising dilemma was asset diversification, a plan first implemented by commercial banks in the late 1990s and early 2000s.
Citi and Royal Bank of Scotland (RBS) acquired or established capital markets units and insurance activities to provide clients with a one-stop shop. Cross-selling has the dual benefit of making each account more profitable and increasing client stiffness.
Blackstone, Apollo, Carlyle and KKR ( BACK ) built similar platforms to help yield-seeking LP investors diversify across the alternative asset class. They now offer single-digit yield products such as credit alongside higher-yielding, riskier leveraged buyout solutions, as well as long-standing but low-yielding infrastructure and real asset investments.
By raising funds for separate and independent asset classes, BACK companies protect themselves from a potential capital market shutdown. While debt markets suffered during the GFC, for example, infrastructure showed remarkable resilience.
However, these innovations have drawbacks. “Universal” banks underperformed their smaller, more closely managed rivals. Making opportunistic deals betrayed a lack of concentration. For example, RBS acquired used car dealer Dixon Motors in 2002, despite little evidence of potential synergies. Furthermore, a pathological obsession with return on equity (ROE) failed to take into account the declining quality of the underlying assets. In addition, retail bankers often proved to be mediocre traders, M&A brokers, corporate lenders and underwriters.
Early indications suggest that multi-product platforms like BACK may not be able to produce the best results across the spectrum of private markets. Carlyle’s mortgage bond fund operations and its activities in Central Europe, Eastern Europe and Africa, as well as KKR’s European buyout unit, have failed or struggled in the past, demonstrating oversight and maintaining overall performance while managing a financial conglomerate. Cloudy product pooling can further hamper returns for these alternative asset supermarkets straddling the globe.
A performance conundrum
That diversification reduces risk while reducing expected returns is one of the fundamental principles of economic theory. However, in 2008, the diversification of “universal” banks showed how risk can be mispriced when the return correlation between products is underestimated. Risk can increase when full growth strategies are not accompanied by adequate checks and balances. The near-exclusive emphasis on capital accumulation and fee-related earnings by publicly traded alternative fund managers can come at the expense of future returns.
This is a lesson from Berkshire Hathaway’s business model that the new generation of PE firms may not recognize. Getting unconditional access to a pool of capital is one thing; putting that capital to work is another thing. The insurance fleet’s excess cash, more than $100 billion as of June 30, has made it virtually impossible for Berkshire Hathaway to beat public benchmarks, especially as negative real interest rates fuel competition through unrestricted credit creation and asset inflation.
PE firms raising funds to expand beyond their core competition will face similar headwinds. Perpetual capital has become the most critical division of the high specialist. Blackstone grew 110% year-over-year (YoY) in the quarter ended June 30 to $356 billion, or 38% of its total asset pool, while its perpetual capital base of $299 billion of Apollo dollars increased to 58% of assets under management (AUM). Blackstone had $170 billion of undrawn capital at the end of June, while Apollo had $50 billion to play with. That’s a lot of dry powder to put to work, which could only drag yields down.
A permanent and diversified capital base may assuage the appetite for PE fundraising, but the associated underwriting activities and multi-asset strategies could lead to a full-blown case of investment performance indigestion.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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Sebastien Canderle
