Is Permanent Capital The Holy Grail Of Private Equity?
The friction between private equity sponsors and limited partners over the past few years has largely involved one key issue: liquidity. On one side of the debate, LPs have been frustrated with the slow deployment of capital and longer hold periods that they have experienced over the most recent fund cycles. On the other side, sponsors have been equally frustrated by juggling the demands of investors and their responsibilities as fiduciaries of the capital that they have been asked to invest.
Pre-Global Financial Crisis fund vintages (2005-2008) struggled with deal pacing as the debt markets seized up and business owners held on to their companies. Exits were just as difficult for sponsors during this time period. Today, the market has the inverse problem with overheated company valuations causing a challenge for prudent GPs to put capital to work. The response to this mismatch of liquidity needs and what the market is willing to bear in terms of attractive opportunities and exits has led parties on both sides to take a harder look at the terms of traditional fund structures itself and ask: is this model working? Some GPs feel like the “5 and 5” structure – investment period and harvesting period – forces them into an artificial timeframe that doesn’t allow them to invest the capital prudently. The counterargument is that LPs have liquidity needs that private equity structures already stretch the parameters of, so how can we make longer-duration strategies work for both parties?
Longer duration or permanent capital has compelling attributes for both LPs and GPs. First, from the LP’s perspective you can compound growth tax free while reducing the risks associated with capital re-investment. Second, from the perspective of the GPs, longer-duration capital provides their firms the flexibility to hold onto companies for longer periods which allows them to create value in these businesses over a more realistic time period. In these situations, sponsors can maximize the value of the outsized winners in their portfolios instead of giving away so much upside. As an example, private equity firms that implement a buy-and-build strategy often struggle with the “5 and 5” structure because buy and build strategies by their nature involve a larger number of acquisitions that all require time-consuming integrations before a successful exit can be achieved.
Many sponsors also speak of the challenges of riding out cyclicality in the markets or in their industries of focus when placed under the time pressures traditional private equity structures. Sponsors can be pushed by LPs to either buy companies at market high’s or exit companies at market low’s as a result of artificial fund terms. In fact, they can often find themselves in a lose-lose scenario because if they acquiesce to the demands of LPs it can lead to underperformance with companies that they have strong conviction will deliver superior returns with a little more time. If they don’t put money to work fast enough (deal pacing) or exit companies fast enough (liquidity) then they frequently are penalized on a go-forward basis with respect to fundraising.
As these fundraising woes have spread throughout the private equity community it has led to more groups thinking that the current fund model is broken or at least in need of updating: “permanent capital” is viewed as part of this solution oriented world view. While many endowments, pensions, insurance companies, etc. have specific liquidity needs that prohibit them from investing for periods beyond 10 years, we are in fact seeing a growing number of LPs in these categories and others express an interest in “tailored solutions” that include 20 year terms or even evergreen structures with proper exit ramps along the way. I have debated the scalability of this opportunity set with my partners and team but through a series of iterative discussions with LPs and GPs alike – and some recent mandates in the space – I am convinced that the window for permanent capital is now open. The key metrics for success remain team and strategy, so a: (i) highly focused strategy targeting a single industry vertical (ii) coupled with a strong, outsized GP commitment from a proven and experienced team, is a fundraising dynamic built for success. In an environment where many GPs are actively thinking about how to grow and diversify – permanent capital should be near the top of your list of considerations. Timing is everything and the market opportunity is now ripe. If you would like to learn more, we would be happy to share our thoughts and experiences.
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