At the World Economic Forum 13 years ago, the then-head of Apax Partners, Martin Halusa, predicted the emergence of $100bn private equity funds. Since then, the aggregate amount of capital raised by private equity managers has ballooned, but the median fund size is barely above $500m. Most mega-buyout funds are comfortably below $20bn despite more than a decade of ultra-low interest rates and benign economic growth.
This shouldn’t be so surprising, since private equity investing is not particularly scalable. This is as true for fund managers as for fund investors.
Private equity is a reputation-based industry. Because LPs invest in a blind pool, they do not assess assets, they assess professional judgement and skill. These are things that cannot be easily systematised or burned into a culture. They are idiosyncratic, situation-specific and fleeting. This makes fund investment – and thus GP investor relations – labour intensive exercises.
In the past few years, this labour intensity has prompted many LPs to slash their number of GP relationships and to invest larger cheques in fewer managers. But there is a natural ceiling to such attempts at scalability because fund managers themselves face inherent scalability limits. They invest into a highly opaque and heterogenous market of private companies and orphaned assets. Such investment requires networks and personal relationships. Putting more money to work therefore involves either buying ever larger companies (or paying more for them, or both) or buying more companies. The former strategy is associated with lower returns, and the latter with organisational diseconomies of scale.
Admittedly, one element of private equity has proven rather scalable – its fee structure. This, combined with growing regulation that punishes a lack of scale disproportionately, has given rise to the private equity conglomerate: multi-product private capital fundraising machines. But at the level of individual funds and individual deals, these ‘brand name’ private equity groups are swimming in the same waters as everyone else.
To me, private equity’s lack of scalability is (to borrow a phrase from a highly scalable industry) a feature, not a bug. For one thing, it makes the industry extremely resilient. Structurally, it arises from self-terminating funds and their constant, in-built need for renewal. Managers can’t just hold on to their assets, they must continually distribute and go back out, to find the next scalable businesses to invest in. Private equity is the bow, not the arrow. It is a cycle of tension and release that requires a perpetual nurturing of relationships if the quiver is to be kept stocked.
Private equity’s success through fragmentation stands in contrast to the growth of cross-sectoral internet-enabled monoliths, as well as the investment approaches that support such monopolies – for instance, ‘buy-and-hold-forever’ (Berkshire Hathway) and ‘buy-the-market’ (Vanguard). The new corporate Darwinism promotes survival of the biggest. Private equity, therefore, has a crucial role to play in supporting the fittest.
So, are individual private equity firms consigned to an analogue age of shoe leather, air miles and endless conference calls, as they perform their noble, if Sisyphean, function?
Not at all. It is quite possible to increase reach and engagement with investors and stakeholders – all it takes is a shift of mindset and some communications technology.
First, communicate the kind of information people seek from physical meetings. People don’t really want to know ‘what you’ve done’, but how you think. This is completely at odds with most private equity communications and PR, which are essentially post-hoc factual reporting.
Instead, cultivate communications that are qualitative, opinionated, authentic, forward-looking and open. Investors love the feeling of being let-in. Hedge funds have been better at this kind of direct yet informal style: think Howard Marks et al. Private equity firms tend to prefer more structured communications than the late-night missive fired off by the managing partner, and that is fine. The message is all.
Second, embrace technology. Even with an army of deal-makers and IR professionals, you can only reach so many CEOs, corporate financiers or LPs, so many times a year. But if you can share your expertise (i.e. how you think) directly with a global online community of your peers, then you allow part of that reputation-based assessment to achieve scale. Fund Shack is just such an online community. It provides on-demand ‘fly-on-the-wall’ interviews to vetted private capital professionals.
To be sure, these aren’t radical re-imaginings of fund management processes. In a market as successful as private equity, small adjustments are best. In a market as competitive as private equity, they can make all the difference.
Ross Butler is CEO of Linear B Media and founder of Fund Shack (ross.butler@linearB.media).