View from Pension Bridge

Investors and fund managers got together at The Pension Bridge’s Private Equity Exclusive conference in Chicago in July to compare notes on where to find better returns, how to manage money amid an increasingly tumultuous economic and political environment, and where GPs could find new sources of growth. Here are some takeaways from the panels and sideline chats:

Sovereign wealth and retail

Speaking in his opening keynote, Carlyle co-chief executive David Rubenstein said that sovereign wealth funds and retail investors are becoming the next big ponds in which GPs can fish for capital. 

US pensions have been the biggest source of growth for private equity firms since 1978, when the Employee Retirement Income Security Act (ERISA) relaxed its rules, allowing these pensions to invest in the asset class. 

With defined benefit pension money on the decline, managers are looking to other areas for growth. Rubenstein estimated that sovereign wealth funds will become the biggest holders of PE assets in the next five to 10 years.

He also said family offices and wealthy individuals are increasingly interested in private equity and thinks US government rules will change allowing for 401k and IRA investment in alternatives. Here’s hoping.

Fears of a frothy market

On the private equity front, there are mixed signals. Paul Yett, managing director at private markets consulting firm Hamilton Lane, said that massive funds are being raised, with private equity managers offering ever-larger funds. Meanwhile, the time between fundraises is getting smaller and leverage is creeping up – all of which looks a lot like the pre-crisis years of 2005-06. 

However, GPs seem more cautious around deployment, he added. “GPs are showing more discipline on spending money. One of the metrics for where we are in the cycle is looking at how fast managers are putting money out the door. If it’s at record speed, that’s usually the top of the market.”

He added that LPs should also be more cautious about putting money into private funds. Some do it quickly to try to reach their asset allocation targets faster, but Yett doesn’t think that’s necessarily a good idea.

“I think it’s better to under-allocate than hit the gas pedal,” he said. 

“There is always the temptation to accelerate because you need to hit your target, but that’s something you need to be cautious about.”

Hillary tipped to win

Donald Trump got dissed in his own house. The conference was held at the Trump International Hotel in Chicago, but five senior private equity executives from Adams Street Partners, Bain Capital, Hamilton Lane, the Indiana Public Retirement System and the Oregon State Treasury all said Hillary Clinton – or “Madame President” – when polled on who they think will be the next president. 

Return expectations are falling

Sam Green from the Oregon State Treasury, a moderator on the “Current State of Private Equity” discussion, asked panelists what they expect private equity funds to deliver, noting that 20 percent is unlikely these days. 

Bon French of Adams Street Partners was the most hopeful at 14 percent. Bain Capital’s John Connaughton said 13 percent, Indiana’s director of private equity Bo Ramsey offered 12 percent and Hamilton Lane’s Yett said 11 percent.  

Cutting carry can hurt you

Speakers on several panels questioned whether managers should cut their fees, given the downward pressure on returns. Management fees have been going down for certain strategies, though some speakers were not convinced that lowering carry was a good idea. 

Keirsten Lawton, co-head of private equity at Cambridge Associates, said she has seen more evidence of lower fees in credit than in private equity. Managers lowering their carry “could actually be seen as adverse selection”, she said.

Laureen Costa, managing director at JPMorgan Asset Management, agreed that “it’s a negative signal if you have to reduce your carry”.

Lawton pointed out that LPs can get lower fees through co-investments. In his opening remarks, Carlyle’s Rubenstein also pointed out that LPs are increasingly interested in co-investments.  “Investors just want to hear that something is ‘new and free’. Co-investments are new and free,” he said. 

LPs must ‘demand’ transparency

Debt managers speaking on a credit strategies panel talked of risks in the market and how they can be better managed on the LP, GP and sponsor sides.

Panel moderator Ruchit Shah, portfolio manager of alternative fixed-income and private credit at the Texas Treasury Safekeeping Trust Company, asked managers what LPs undervalue.   

Chris Flynn, co-chief executive officer at THL Credit, replied “transparency”: “Investors always say that they want transparency, but they have to demand transparency from GPs. If you’re worried about what you don't know, that creates problems.”   

Greg Robbins, managing director at Golub Capital, referred to a popular Warren Buffet quote: “Only when the tide goes out do you discover who’s been swimming naked.” 

Robbins suggested that only when the markets turn will investors appreciate who is being careful.

Shah also noted that there is often a healthy tension between equity and debt managers in deals. “But what tricks are the sponsors trying to play on you?” 

Flynn replied that it’s often in the documentation. “We can place bets at the cocktail party tonight on who has negotiated the longest definition of EBITDA versus who has actually written one,” he quipped.   

High hopes for mezzanine

Mezzanine debt has been proclaimed “dead” by many industry practitioners, although with a healthy crop of big and small managers still handling these strategies, some think the sector has merits.  

Pete Keliuotis, senior managing director at consulting firm Cliffwater, said that while his firm does not normally look for mezzanine managers specifically, he wants his clients’ private markets portfolios to be diversified, and mezzanine can usually be added to the mix to enhance returns. “Mezzanine can be a constructive part of a broader portfolio and can get you to your return objective,” he said.

Asked about projected returns in mezzanine, Whit Edwards, a partner at Five Points Capital, said he expects 13-15 percent net returns from junior debt. Keliuotis put the performance expectations in the high single digits. Some attendees later told PDI that returns in the teens seemed too ambitious and Keliuotis’s view was probably more realistic.

Erik Falk, global head of private credit at KKR, highlighted the disintermediation of banks and the death of traded high-yield. High-yield isn’t liquid anymore, he noted, and that part of the market has in some ways been replaced by private mezzanine loans.