What’s wrong with private equity? Not much, if you look at the numbers. Record dealmaking, record fund sizes, record amounts of cheap debt to juice profits. That’s made everyone a winner. Investor returns are outpacing other asset classes. Private equity firms, and their staff, are enjoying bumper pay days.
BlackRock, though, sniffs a competitive opportunity. The world’s biggest asset manager — with nearly $7tn of funds at the last count — has so far only dabbled in alternative investments. But its debut primary private equity deal last week, when its new Long Term Private Capital fund bought the bulk of the Authentic Brands marketing business for $870m, signalled a fresh departure.
Larry Fink’s business owns more listed equities than almost anyone else. But as the launch blurb for the LTPC fund makes clear, public companies are going out of fashion: the number of US groups has nearly halved in 20 years.
Moving into private equity seems logical. It should secure a slice of a higher-margin business at a time when public equity managers are suffering an ongoing squeeze on fees.
Aping his record in listed equities, Mr Fink’s plan is to take business from the incumbents by disrupting what he sees as a cosy and costly business model. LTPC will undercut their fees and derisk investments by reducing the debt levels of portfolio companies.
One rattled senior executive at a big buyout firm said: “BlackRock incinerated the fee structure in equity funds. Are they going to do the same for private equity?”
The pitch has been enough to raise nearly $3bn from five big investors, led by the Minnesota State Board of Investment, plus a small chunk of BlackRock’s own cash.
The group is coy about the exact fees it will levy but it is fair to assume they will be substantially less than the 2 per cent management fee plus 20 per cent “carry”, or performance fee, that is the private equity norm. As the LTPC fund grows towards its $12bn target, BlackRock says the management fee will fall further.
So far, so laudable. But this is not a risk-free initiative.
For one thing, valuations make this an odd time to break into private equity: deal prices are at record highs. The Authentic Brands transaction is estimated to have been done at a multiple of 16 times core earnings.
For another, the private equity bubble is widely expected to burst. The downward trend in interest rates means the pin-prick won’t come from higher debt costs, as seemed likely six to 12 months ago. But the risk of recession across much of the west now seems high, potentially dangerous for highly leveraged companies that often have little headroom if business dips. BlackRock’s plan is to cut debt levels, but that cuts potential returns.
Of potential concern, too, is another quirk of BlackRock’s model: making its fund a “perpetual capital” vehicle, rather than the traditional 10-year structure. This is not unprecedented. There has been a clutch of perpetual capital launches from established operators of late. Brookfield is poised to create a $5bn fund, with a potential open-ended structure, into which it would reverse Genworth, a Canadian mortgage insurer acquired last week.
But the open-ended nature has obvious pitfalls. Returns are designed to be lower. And there is no set time horizon for investors to be paid out.
Most seriously there are obvious, if crude, parallels with the liquidity mismatches that have haunted the likes of GAM, H2O and Woodford in recent months. If investors are not tied in for a fixed period and are allowed, in theory, to make short-term redemptions, it is easy to see the scope for stress when the underlying assets are unwieldy holdings in a small number of private companies.
Some perpetual vehicles are stock-exchange listed, boosting potential liquidity. BlackRock’s recipe for dealing with the issue is to limit investor redemptions to an annual three-month window, with an initial tie-in until 2022. Investors can sell to others in the fund or to a new investor if one can be found. Underlying holdings could also be sold. But the model is untested in a stressed market.
Investors should welcome BlackRock’s entry to the market, with its promise to cut the cost and the risk of private equity. For Mr Fink and his team, though, it is not without danger.
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