The Private Capital Wealth Equation, Part 1: The Controls Variable
Investment performance is assessed on a risk-adjusted basis. But with financial markets growing ever more competitive, private capital fund managers have developed tools to reduce risk while protecting or even boosting their returns.
These tools are aligned across two parameters: controls and economics. So, how do the control mechanisms function?
The reduction of investment risk through tight portfolio monitoring is a core feature of private capital. Minority shareholders of publicly listed companies can only achieve this by indirect means. Traditional asset managers have limited influence on public corporate executives. Often they have little recourse beyond nagging.
The largest asset managers — BlackRock, State Street, Vanguard, etc. — can nevertheless deploy “soft power.” Their combined ownership stakes in listed corporations often exceed 10%, and few C-suite executives can genuinely ignore their recommendations. In fact, there is some concern that the market power of these asset managers may constitute systemic risk or raise anti-trust issues.
As research by business school professors revealed, several US institutional investors hold stakes in leading public corporations that operate in the same sector. With more than $5 trillion in assets under management (AUM) in 2017, BlackRock was the largest shareholder in 33 of the FTSE 100 firms and the largest shareholder of one in three companies on the German DAX-30. With more than $4 trillion in AUM at the time, Vanguard had similarly large holdings and was growing even more quickly than BlackRock. Berkshire Hathaway, too, enjoys significant market clout. Warren Buffett’s company once invested in four major US airlines at the same time. Berkshire Hathaway might have preferred that any rivalry between, say, Delta and American Airlines be toned down. After all, a fierce price war would have hurt investment returns.
From Nagging to Bullying
Not only do global asset managers invest in multiple businesses in the same sector; they often own shares in the same public companies. “Common ownership of competitors by a small number of investment funds has become a widespread and ubiquitous pattern in public equity markets of developed economies,” business school professors José Azar and Martin C. Schmalz observed in the Journal of European Competition Law & Practice. For example, Deutsche Börse and the London Stock Exchange shared two of their top-three investors and Bayer and Monsanto shared five of their top six.
The two academics concluded that “Common ownership links can lead to a lessening of competition.” But less competition can be good news for investors. As so often happens, new strategies that are profitable in one asset class migrate to others. Amid the current unicorn bubble, these practices have emerged in private markets.
Through its Vision Fund, SoftBank has applied the betting and risk-hedging craft of “voisinage” to the world of pre-IPO, late-stage venture funding. Just as public corporations owned by the same stockholders may not compete as fiercely, private enterprises may favor collaboration, especially if their mutual owners push for a merger, as SoftBank did with Ola and Uber in India.
The Tyranny of the Intermediary
Private market fund managers have a degree of influence that public investors can only envy. Private equity (PE) and venture capital (VC) firms can intervene directly in the business: They sit on corporate boards, hold veto power beyond voting rights over critical decisions, and take advantage of anti-dilution mechanisms that protect their economic interests.
In fact, the influence of fund managers explains why, when entrepreneurs take their businesses public, they often seek to regain control through supervoting rights and by removing the preferred stock held by VC backers. The recent effort by Twitter’s management to use a poison pill provision to prevent Elon Musk’s hostile takeover bid demonstrates that executives at public corporations may act in ways contrary to shareholders’ interest — ways that PE or VC ownership would not allow.
Furthermore, robust monitoring rights do, in principle, reduce the risk of corporate misbehavior and fraud, even if recent scandals at Theranos and SoftBank-backed Greensill demonstrate that investors in young enterprises, even sizeable ones, cannot solely rely on trust in their exercise of due diligence.
Access to Deal Flow
Proprietary deal origination is another control technique to mitigate investment risk and improve returns. Over time, alternative asset managers have developed tactics to deliver superior performance by sourcing a quality deal flow.
In the unpredictable world of early stage investing, the best-performing VC firms have privileged connections with the most promising start-ups. That often means a presence in such key tech hubs as Silicon Valley in California, Zhongguancun in Beijing, and Gurgaon and Noida near Delhi. Top entrepreneurs know they must attract quality investors to maximize their chances of success. They must be prepared to move closer to tech clusters, just as Mark Zuckerberg did when he relocated to Silicon Valley from Harvard to introduce Facebook to experienced VC networks.
But with the growing influx of capital in recent decades, deal competition has intensified and it can obstruct normal market activity. At the larger end of the deal spectrum, the sole differentiator is often the price tag bidders are prepared to put on a target. This can lead to bid rigging, which reduces the risk of overpaying and contributes to better performance. Amid the 2002 to 2007 credit bubble, for example, major buyout firms allegedly colluded to tamper with deal auctions and eventually settled a class action lawsuit.
Access to Capital
To leverage deal flow, proprietary or otherwise, fund managers must first raise funds. Indeed, assembling an ever-growing pool of capital is the most visible measure of success in asset management. BlackRock and Vanguard are leading institutions because they control such large asset bases. Thanks to their firepower, Blackstone, Ares, and Sequoia have become major pillars in the PE, private debt (PD), and VC segments, respectively.
But the race for scale has translated into a cutthroat quest for capital that threatens to overwhelm supply. An ever-growing roster of private capital firms pursue the same institutional investors: banks, insurance companies, retirement plan administrators, endowment funds, sovereign wealth funds, and family offices. Just as fierce competition can invite market abuse at the deal-making phase, the same holds true at the fundraising stage.
In the aftermath of the global financial crisis, several well-known alternative managers faced accusations of bribing government officials to divert capital allocations. Two high-profile investigations in New York and California, in particular, highlighted widespread “pay-to-play” schemes to attract commitments from pension funds.
Once funds are secured — for a 10-to-20-year time horizon — managers exercise full discretion over how the funds are invested. Capital providers give alternative investment firms de facto carte blanche — within the limits of a few restrictive clauses in the limited partnership agreements.
There is an even more compelling argument in favor of private markets. In an economic dip, public investment groups, including hedge funds and traditional asset managers, usually face redemption notices from investors, whereas private capital firms do not have to return any of their clients’ commitments and can hold onto them until the market correction has run its course.
Although the lack of liquidity through multi-year commitments is a headache for LP investors, it is an advantage for fund managers: High switching costs improve customer stickiness and the visibility of fee income.
While corporate bankers can be incentivized to bring in a steady flow of transactions and many LP investors can be trusted to keep on committing capital in their search for higher yield, the real challenge to PE firms’ absolute control over their trade comes from creditors, especially if portfolio businesses find themselves in distress. But buyout fund managers have developed techniques over the years to frustrate creditors’ efforts to take over troubled assets, regardless of the borrowers’ contractual obligations. Some of these techniques were introduced through legal means, such as covenant-light, or cov-lite, instruments. Others are more brazen in their approach, as with the recent generalization of EBITDA addbacks.
But others still are outright duplicitous: Financial sponsors sometimes strip portfolio companies of their best assets to preserve partial control of the business. Apollo and TPG, for example, transferred the most promising divisions out of Caesars Entertainment in 2013 and 2014 before the casino operator filed for Chapter 11 protection. The two PE groups subsequently became the targets of numerous lawsuits.
In a market flooded with cheap credit, lenders have been unable to fight back. Whatever rights they managed to defend have proved derisory. For instance, during the COVID-19 pandemic years, a new clause was inserted in cov-lite contracts: Nowadays, often the sole means PD lenders retain to check on a borrower’s solvency is through the adoption of “springing” financial covenants that come into effect only when the borrower draws down its revolving credit facility to a certain threshold amount, thereby indicating possible financial stress.
Retaining ownership of a portfolio company in the face of hostile creditors is not just a way for PE firms to kick the can down the road and convert loans into quasi-perpetual instruments. The strategy has an economic purpose: Firms can keep charging management commissions and advisory fees related to the restructuring of the asset.
Limited Information Disclosure
Efficient markets require timely and accurate information and transparency around transactions. Public equity and bond exchanges exhibit these characteristics, but private markets do not. Private capital firms can control and contain what data are disseminated about portfolio assets. Hence, when public companies are taken off stock exchanges, they are said to “go dark.” In some cases, alternative fund managers can even shape the performance narrative by manipulating investment returns.
Looser reporting requirements in private markets help explain why such asset managers as BlackRock and State Street, with around 2.5% and less than 1% of their total AUMs, respectively, allocated to alternatives, are building private capital divisions. Full management rights and better oversight of their asset portfolios could also help them disintermediate PE and VC firms and thereby eliminate excessive fee expenses.
In private markets, the lack of transparency and liquidity, along with uninterrupted access to fresh capital and deal opportunities, are vital control mechanisms. But restraining portfolio executives, institutional investors, and lenders is only half the wealth-maximization story.
Despite their best intentions, alternative fund managers cannot guarantee their investment decisions will lead to positive outcomes. Part 2 will show how, with the principle of unconditional control in mind, they have identified levers to protect their economic imperatives, irrespective of their clients’ interests.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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