Welcome to the 79th Pari Passu Newsletter,

After a restructuring write-up last week, we are back with a generalist investing lesson today: the rise of permanent capital vehicles.

At a high level, investing roles entail deploying the limited partners’ capital into the opportunity that offers the highest risk-adjusted return. Behind this apparently simple description, there are a myriad of technicalities that enable a check to be wired in exchange for an ownership stake (both in the public and private markets).

Today, we are diving into the evolving relationship between the limited and general partners and the shift toward permanent capital vehicles.

But first, a message from Piece of Cake Moving & Storage

Make your next moving day a Piece of Cake, with America's most loved mover Piece of Cake Moving & Storage. Use the promo code IGFAMILY for a 10% discount off your next local move, or a 5% discount off your next out-of-state long distance move.

This moving promo code never expires and can be used for all your upcoming moving days! Whether you're moving locally or out of State, Piece of Cake Moving offers extensive moving day services including; White Glove Packing & Unpacking, Short and Long Terms Storage, as well as Moving Box Bundles, and a convenient Plastic Bin Rental Service. 

Get a Free Flat Fee Moving Quote and use the code IGFAMILY.

Introduction

When one of the most successful financial products ever, the leveraged buyout (LBO), was initially pioneered by Henry Kravis and Teddy Forstmann in the 1970s, it was initially a burdensome process. Raising money from investors to finance the equity portion of an LBO was conducted on a deal-by-deal process, requiring additional time and energy for each deal. As LBO specialists grew and evolved into powerful firms such as KKR and Forstmann Little & Company, they established longer-term investment structures to secure capital commitments from Limited Partners (LPs), such as endowments, pension funds, and sovereign wealth funds, to finance the equity portions of LBOs. These structures, which are technically known as blind pools, allow a limited partnership to raise funds without telling investors where the money will be specifically allocated. Blind pools, referred to publicly by their individual vintage fund name (e.g., KKR Flagship Fund XIII), typically retain secured capital commitments for ten years. This additional firepower gave these firms a competitive advantage, allowing them to react rapidly to business developments without needing to go out and raise new capital. For example, it allowed Kravis and Forstmann to continue raising the price offered to management during the famous 1988 bidding process for RJR Nabisco. In addition to speed, this ten-year structure also theoretically gives the private equity firm, or General Partner (GP), the time to comfortably source, study, and invest in companies it decides are good investments at the time it deems ideal for maximizing returns, with the confidence that capital is lined up [2].

While vintage funds have been wildly successful and remain the standard fund structure, there have been several developments that have led private equity firms to look elsewhere. The first of these was the Great Financial Crisis (GFC), which led to the extinction of a quarter of buyout firms post-2008. Massive investments made pre-2008 at expensive multiples significantly underperformed, a major blow to an industry that had been given an increasingly large share of global capital without question. This made it much more difficult for firms to raise subsequent funds post-2008. Even leading megafunds such as TPG Capital had a difficult time fundraising. It took TPG eight years to close a new flagship fund, on the back of underperforming transactions such as the buyouts of Harrah’s Entertainment (alongside Apollo), TXU, and Washington Mutual. A trend echoed across the industry: when TPG finally raised its $10.5bn 2016 vintage, it was about half the size of its 2008 vintage, TPG VI [2]. 

Another major development was the commoditization and saturation of the industry over the past decade in a low-interest environment. With private equity firms raising increasingly larger funds with less time between raises, competition for LP dollars became even more intense, with more time and resources allocated to fundraising. With the further standardization of investment techniques, from covenant-light financing to vendor due diligence, equity returns have constrained and LBOs have become more accessible to generalists. Many LPs have themselves elected to make direct investments rather than relying upon the private equity firms (the general partners, or GPs). Part of the reason for the power shift from GPs to LPs has also been that the majority of GPs do not return LP commitments within the contractual ten years. Additionally, as time has passed, firms that have had a long history of top quartile funds have eventually had misses, leading to decreased LP interest. While a handful of firms with immaculate track records or unique investment edges still have the ability to dictate terms with LPs and charge fees above-standard fees, the majority have experienced more difficulty in differentiating themselves to LPs [2].

The final critical development encouraging private equity firms to look beyond the vintage fund structure has been the IPOs of many leading firms. Following Blackstone’s IPO in 2007, a number of firms have followed, most notably Apollo, Ares, Carlyle, KKR, and TPG.  While private equity firms were previously incentivized to raise larger and larger funds that achieved high rates of returns in order to be compensated through their share of the growing returns, known as carried interest, or “carry,” the IPOs changed this. Instead, management of the private equity firms could be compensated through stock in the publicly listed firm. Additionally, beyond the interests of LPs, firms now had to consider the interests of the public shareholders. Due to the variability of fundraising and investment performance through the vintage model, public shareholders have awarded higher multiples to PE firms not based on the carry generated by investments, but instead on management fees charged to LPs for the assets managed on their behalf. As a result, the management of publicly traded PE firms are incentivized to increase the scope and duration of the assets they manage in order to charge these consistent, growing management fees, de-emphasizing the former importance of the traditional vintage fund model [2, 6, 8].

Growth in PCVs

Subscribe to Pari Passu Premium to read the rest.