Buy & Hold with Permanent Capital: The New Playbook for Private Equity?
May 31, 2022
The evolution of private equity, since its birth in the 1970s, has been truly fascinating. The asset class began life in the form of leveraged buyouts (LBOs), with deals being orchestrated on a case-to-case basis.
However, buyout firms soon realized this capital-raising mechanism was tedious, impacting their agility to swoop in on attractive investment opportunities. Hence, trailblazers came up in the 1980s with so-called vintage funds, investment vehicles intended to secure capital commitments – typically for a seven- to 10-year period – from external investors called limited partners (LPs). LBO specialists operated as general partners (GPs) of these buyout funds, securing commitments from institutional investors such as insurers, pensions and endowments.
GFC – The game changer
Such blind pools of capital worked spectacularly for the PE industry for the ensuring two and half decades, with marquee buyout firms making windfall gains by restructuring and selling portfolio companies and delivering risk-adjusted superior returns. However, the tide turned with the global financial crisis (GFC) of 2008-09, which upended many of the core underlying assumptions of the PE operating framework. Almost 25%1 of buyout firms worldwide failed to raise a new vintage fund post GFC, as several mispriced investments struck during the boom years came unstuck.
Constraints of vintage funds
This dynamic prompted several PE firms over the past few years to fundamentally rethink their investment approach, with other structural factors at play as well. To begin with, vintage PE funds, while having the potential and the track record of posting handsome returns, can have an erratic performance curve – depending on the broader market cycle they operate in and whether the GPs maintain pricing discipline or not while striking deals.
Secondly, such blind capital pools by their inherent structure are mandated to return all capital to investors ultimately, meaning PE firms have to again seek fresh commitments from LPs for new funds. Thirdly, LBO funds tend to spend the bulk of their capital in the first three or four years, resulting in lack of adequate resources for financial sponsors to strike opportunistic deals during the remaining tenure.
Case for permanent capital
Because of the above reasons, so-called permanent capital pools, or perpetual investment vehicles, have emerged as an alternative playbook for many leading lights of private equity today. By virtue of cash being pooled in for perpetual investing and no force-fitted structure for returning capital to investors, such capital vehicles can enable PEs to levy annual asset management fees and keep investing the capital continuously.
These open-ended funds are also particularly relevant for long-term investment strategies catering to asset classes such as real estate and infrastructure, which can have long gestation periods. For instance, real estate investment trusts (REITs) give PE sponsors significant leeway in deciding on when to exit portfolio assets.
No wonder, the promise of building a more stable capital base that in turn can generate a more consistent revenue stream has driven industry titans to increasingly gravitate toward permanent capital structures in recent years. At Blackstone, perpetual capital soared 47% to $149.1bn2 in Q1 2021, at a faster pace than their overall assets under management, while at KKR it accounted for over 30% of the total.
Emerging pool structures
These investment vehicles can come in different shapes, including stock market-listed funds, or special purpose acquisition companies (SPACs). Some PEs have been innovative by setting up quoted life insurance companies to raise permanent capital, taking a leaf out of Warren Buffett’s playbook. Berkshire Hathaway has long used the premiums collected by its auto insurance arm GEICO as a quasi-free margin loan to bankroll investments.
After all, annuity providers and reinsurance companies constitute a solid, steady stream of capital that PEs can use to finance deals.
Private equity’s ongoing transition from traditional buyout funds with a fixed time horizon to open-ended “permanent capital” sans “expiration dates”, a la Berkshire, also reflects a shift in its rapid diversification beyond LBOs. Many major buyout firms have been expanding their footprint by evolving into alternative asset managers, wherein they straddle multiple segments of the “shadow banking” ecosystem including private credit, hedge funds, etc.
As part of this metamorphosis, several PEs have also gone into building real estate, infrastructure and other investing platforms, in a bid to broaden revenue streams, and de-risk their business models from an overreliance on LBOs.
What does all of this mean for private equity? To begin with, this will fundamentally alter the way financial sponsors make deals and exit portfolio assets as well as how they price those holdings over the long term. Permanency of capital is likely to empower PEs to keep owning valuable, well-performing assets with sound structural growth dynamics through several market cycles, instead of sponsors being forced to sell them off quickly in case of vintage funds’ rigidity.