Perspectives on Private Equity and the Evolution of the Industry
The article below is from our BRIEFINGS newsletter of 29 April 2019
The private equity industry has had years of growth and evolution. At the Goldman Sachs Private Markets Investor Forum earlier this month, Chris Kojima, Global Head, Alternative Investments & Manager Selection (AIMS) Group, Sumit Rajpal, Co-Head, Global Corporate Equity, Merchant Banking Division (MBD), and Andrew Wolff, Head, MBD International, shared their perspectives on the industry’s and opportunities for investors.
Can you describe the growth of the PE industry in recent years?
Chris Kojima: We’ve seen dramatic growth in the private equity industry, particularly over the past five years. Whether measured in capital raised, invested, or returned to investors, we’re observing record levels of activity. Many limited partners (LPs) – the underlying investors in PE funds -- are attracted to the potential for outperformance relative to the public markets, and are increasing their allocations to alternatives more broadly. And the general partners (GPs) – the teams managing the PE funds – are evolving their investment processes and strategies.
LPs have thousands of firms from which to choose, and can today access these options in the primary market, secondary market, or through direct investments. They face the challenge of finding the great, while avoiding the bad, in a space with high performance dispersion and imperfect information. So today’s investors have some special opportunities, but they also have some real challenges to overcome.
Sumit Rajpal: Investors are also considering the industry’s evolution. We believe the PE industry, and private markets in general, are in the stages of a two-decade long maturation period. In some ways, the PE industry is where the public equity active-management industry was 20 to 25 years ago. We’re in the early innings of a longer-term PE cycle.
What have been the ingredients for success?
Andrew Wolff: Different GPs have different ingredients for success. There’s no one-size-fits-all model. Some managers focus on a specific area of expertise, while others are generalists. In our own team in MBD, we’ve developed deep expertise in certain sectors and subsectors, such as in digital, financial services and healthcare. But we’re also able to implement changes on a broad, global scale. For example, there are certain processes and strategies -- such as dynamic pricing strategies, or efficiency solutions in procurement – that can add value. These are repeatable approaches across industries and geographies.
SR: Digital enablement is another industrialized approach that PE funds are applying across their portfolio companies. In our own team in MBD, for example, we’ve created a program called “Digital Edge,” where we help companies accelerate the development of their own digital solutions, or enhance their cybersecurity, or empower their migrating to the cloud. At some level, every deal is a technology deal in the sense that the impact of new technology, insights from data science and the possibilities of AI all have the potential to shape every industry at every point in the value chain.
CK: When assessing new PE managers today, investors have to remember they’re being asked to commit capital well into the 2020s – the best managers know that yesterday’s solutions can be easily appropriated and disrupted. In AIMS, we’re looking for managers who are adapting to the operational complexity underpinning value creation today. Today’s heightened valuation levels demand serious confidence in execution, when yesterday’s upside case is effectively today’s base case. We’re looking for an intense and skillful appreciation for the importance of innovation.
What does the competitive landscape look like? And how does that shape your thinking around returns?
AW: Private equity has generally performed well compared with public equity markets in part because there’s a considerable alignment of interests between the GPs and the underlying company management teams. PE firms with the right resources and operational plan can be in the position to help their portfolio companies achieve some impressive outcomes.
Sumit: Across the past few decades, the PE model — where investors, managers and company owners are all thinking like strategic owners of the business — has proven to be an effective model for governance. We continue to see the number and value of companies in the private markets steadily increase.
SR: Across the past few decades, the PE model -- where investors, managers and company owners are all thinking like strategic owners of the business -- has proven to be an effective model for governance. We continue to see the number and value of companies in the private markets steadily increase.
CK: As we look into the next decade, one differentiator will be the skill with which the PE firms are managed. This is quite different than asking about investment skill. Here, we’re talking about managerial skill, what you might call “the business of the business”. This is about corporate strategy, capital management, new product development, operating efficiency, human capital, and culture. As competition and technology disrupt the production of “investment alpha,” we think this “managerial alpha” will rise in importance. Of course, managerial skill alone can’t make mediocre investors great, but it can increase the probability that great investment performance happens.