Funds Are Not Enough: The Newest Trend In Private Equity Is Buying Companies Directly

Hedge Funds & Private Equity Funds Are Not Enough: The Newest Trend In Private Equity Is Buying Companies Directly Antoine Drean Contributor Opinions expressed by Forbes Contributors are their own. Founder of fund advisory Triago and Online PE fund marketplace Palico New! Follow this author to improve your content experience. Got it! Jul 19, 2022, 09:31am EDT | New! Click on the conversation bubble to join the conversation Got it! Share to Facebook Share to Twitter Share to Linkedin Traditional private equity fund investing is still hugely popular, with a whole new class of individual investors joining the institutional investors who’ve dominated the asset category for decades.

Evidence suggests private equity’s control-driven, activist style of investment leads to higher, more predictable returns than passive public market investment, so no surprise there. But rapidly growing economic uncertainty initiated by the pandemic, now compounded by rising inflation, war in Ukraine, and darkening geopolitics, is changing the way people invest in private equity. Traditional, diversified funds are still hot, but investing directly in individual companies is even hotter.

That dynamic is unlikely to change and it’s one with major implications for how mergers and acquisitions are practiced, how companies are financed, and for the popularity of management buyouts. Investors are progressively directing a greater portion of their private equity commitments to identifiable assets and risks. They are putting relatively less in traditional funds, which are typically blind pools – i.

e. with no investments yet targeted – that draw investor cash based on the historic track record of the manager. Single-asset investment, made without third parties or, increasingly, with so-called “fundless” managers who propose investments exclusively on a deal-by-deal basis, is capturing a growing share of private equity capital.

This makes sense at a time of heightened economic uncertainty. Investing in specifically identified companies, rather than in blind pools that hand all discretionary power to managers, allows investors to vet investments for a range of specific problems ahead of committing capital, something that’s impossible to do in a classic fund. Last year, some $179 billion, or an amount equal to a record 17 percent of the capital committed to blind-pool fundraising, was devoted to direct investment, according to the latest figures from Triago , the private equity fund advisory I founded 30 years ago.

That’s up from $93 billion five years earlier – equal to only about 11 percent of commitments to blind pool fundraisings that year. And there’s every reason to believe that direct investment will continue to grow in importance in comparison to the sums devoted to classic funds. One of the most striking examples of the rise of targeted investment is the late January decision of the California State Teacher’s Retirement System to nearly double the size of its single-asset investment program over the next five years.

Only some $1. 2 billion in 2017, CalSTRS will increase targeted investment to $15 billion by 2027, up from $8. 4 billion currently.

As the second largest pension fund in the U. S. , CalSTRS’ commitment to targeted investment will prove a catalyst for similar moves.

Direct investing can be appealing to investors for a reason other than today’s growing economic uncertainty and that is so-called portfolio management bias. While the best managers don’t succumb to this temptation (a reason to continue investing with them!), a wide range of investors have come to believe that once some managers have achieved their targeted returns and the profit sharing it triggers (typically 20 percent of appreciation), instead of maximizing value at unsold portfolio companies, the tendency of many is to focus on quick sales of those firms, initiating the next fundraise and another, quick 20 percent of profit – and the higher annual fees associated with private equity funds in their early stage. MORE FOR YOU The $30 Billion Kitty: Meet The Investor Who Made A Fortune On Pet Food Chairman Xi, China’s Looming Crisis, And The Myth Of Infallibility Meet Private Equity’s Quiet Corporate Turnaround Artist The growth of direct investing is also eating into the mergers and acquisitions business of investment banks.

The growing class of deal-by-deal managers that has evolved to meet investor demand for direct investment opportunities is finding capital for these deals by turning to classic private equity fund advisors who are tied into networks of private equity investors. Deal-by-deal managers, and traditional private equity fund investors who opt for direct investing and link with syndicates of the like-minded, are eschewing advice from traditional investment banks that emphasize access to strategic buyers and fund managers (but tend to be weak when it comes to accessing capital from pension funds, foundations and family offices). Worried investment banks are already trying to remedy this situation by hiring veteran fund advisors.

Finally, this new source of capital for mergers and acquisitions holds the seeds for a new type of financing for management buyouts; at Triago we’re witnessing the beginnings of it. Increasingly, corporate managements approach us about direct partnerships with private equity fund investors, or with the growing cadre of deal-by-deal managers who intermediate for those investors. They’re looking to finance deals where management ultimately holds significant equity stakes – usually minority positions, but there’s no reason why they can’t be in the majority.

I am convinced that this trend has the potential to provide a much more stable financing mechanism than the junk bond revolution of the ‘80s – with the potential to be just as big. Antoine Drean Editorial Standards Print Reprints & Permissions.