For reference, here is the high-level explanation of the “Bullwhip Effect”

The bullwhip effect is a supply chain phenomenon where orders to suppliers tend to have a larger variability than sales to buyers, which results in an amplified demand variability upstream. In part, this results in increasing swings in inventory in response to shifts in consumer demand.

For illustrative purposes, see the below image that reflects the lag-time and (duration imbalance) between supply and demand. Imagine the GP as the one cracking the whip. The closer to the GP, the shorter the interval.

In a prior post, I referenced the evolution of private equity as an asset class. The key takeaway relevant to this post is that a previously illiquid, partnership equity interest, has now become a highly-valued asset. The value of this asset is primarily driven by recurring management fees, which itself is related to capital deployment, and somewhat misaligned with customers (limited partners), as the primary goal has shifted away from performance incentives (carried interest) and returns (a lagging indicator). As Charlie Munger once said, “Show me the incentive, and I'll show you the outcome.”

Can you guess how GPs responded to this shift in the market?

They deployed capital faster than ever before, quickly hitting the minimum deployment thresholds to go out and raise another committed pool of capital. Successor funds were often much larger than the size of prior funds, even with very little liquidity provided from exiting portfolio companies. While the funds had strong “paper” returns from markups, they did not provide incremental liquidity to their LPs. Further exacerbating the “liquidity” issue was the introduction of “Continuation Funds,” which allowed traditional private equity investors with target hold periods of five years or less, the ability to extend the duration of the management fees. The below chart is from the 2023 Bain Private Equity Report, which is appropriately titled,

“The Anatomy of a Slowdown”

At that moment in time, the introduction of GP stake sales coincided with the increased allocation from pensions and endowments to alternative asset classes. What was the basis for these valuations? Recurring, management fees.

Unfortunately, the rate of deployment (two to three years) far outpaced the ability of GPs to exit investments and return capital to LPs (five years). At the same time, interest rates have risen steadily and public markets have fallen precipitously. As a result, interest expenses for highly leveraged companies have increased, and both private market lenders and leveraged loan issuances have decreased, making it tougher to transact in the “Slightly” Leveraged Buyout game. Pensions are over-committed to illiquid, alternative assets - and many are seeking to increase their allocations.

In the current state of play, valuations for PE portfolio companies are down. Public comps are trading at heavy discounts to what they were in the past two years. The cost of capital is at an all-time high, thus decreasing the net present value of future cash flows (DCFs). The paper gains are mostly gone and every manager is debating whether or not to exit an investment early, at a discount to holding value, to provide liquidity to LPs and live to fight another day. I learned more than a decade ago - the best way to fundraise is to mail a distribution check, including a return envelope and subscription docs for the next fund. That’s what everyone is hoping for now. It’s not coming. The tide is going out on GPs, and we’ll soon know who has generated value for the pension plans of many hard-working Americans, and who has lost retirement savings of the teachers, police officers, and firefighters that are critical to our society.

GPs and LPs are slowly realizing that the value of their investments is nowhere near what they were on paper in 2021. The only issue - there are not many forced sellers - and that’s not going to change. An old fund I worked at held a $150+mm equity check for 20+ years to avoid a clawback - they still haven’t exited. I will remind you - incentives drive outcomes. In reality, a number of GPs are contemplating closing up shop and converting to a family office. They would rather pull the fundraise, take all of the economics, and run the cash cow out than pay to live and fight for another day. Think about it - if that $150mm equity check is a 4x three years from now, versus a 2.5x today, it’s ~$45mm in carried interest. If you’ve sold a secondary stake, taken the cash, and you’re maximizing your economics in your last ride, what do you think the outcome is? Not everyone is in this for their legacy.

It’s time we all admit what has driven PE returns over the last decade, and it wasn’t the 2+2=5 calculus from the all-time classic, Barbarians at The Gate, that introduced many of us to the industry. It was three primary factors:

• low-interest rates

• increasing allocations from under-funded pension funds, losing yield from fixed-income investments

• the vast majority of exits were to other private equity funds, leading to a self-fulfilling prophecy and recycling of portfolio companies at higher multiples (multiple expansion drove more than 50% of historical returns).

As in any investment strategy, historical drivers of returns cannot be relied upon to create future returns. This will certainly be the case in the years to come.

The three prior points are very much intertwined. Low-interest rates decreased returns from fixed-income, which led underfunded pensions to look for higher-yield asset classes, such as private equity. The increase in capital allocations led to the expansion of the industry, which increased competition for deals, driving up purchase price multiples. At some point, the music will stop. Once, institutional allocators tap out on alternative asset allocations - the secondaries industry (funded by the same bucket of capital) won’t be able to help provide incremental liquidity. The below is an egregious chart crime - but it’s the best I can do. We’re at the end of the loop, hoping that a lower interest rate environment is on the other side, but it is most likely not. We may see a long-term elevated rate environment that would cause irreparable damage to the industry.

It’ll be interesting to see what happens in the next few years. Endowment bias (pun intended) is real and not everyone is going to survive. The wolfpack will get smaller, but the funds that remain will have true, sustainable competitive advantages. The last hope for the industry will be the penetration of the largest untapped investor segment, HNW individuals, a customer base that is unallocated to private equity and alternative assets. While this is a heavily fragmented market, tech-enabled platforms (e.g., CAIS, Moonfare, etc.) will be the most likely distribution points for this segment.

Where will the money go? Who stands the right to win these customers?

Institutional, brand-name funds can provide reduced fees to offset the double-layering that comes from the feeder fund structure. The publicly traded GPs have a competitive advantage to lower their biggest cash costs with Stock-Based Compensation, and it’s something they actively use now. They also have a broad product offering to be able to provide a bundled solution, without the extra layer of fees of a fund of funds, while also providing asset diversification.

Fee sensitivity is a high-ranking concern for the customer base, and safety in brand names will help RIAs and PWMs retain their customers while providing the key benefits of the asset class, diversification and access to “slightly” levered assets.

These GPs will use the added dry powder to ease the impact of the bullwhip effect (forcing early exits at discounts) on their institutional LPs. This will have a positive impact on returns and thus allow the cycle to permeate. In summary, capital will continue to flow to the largest GPs in the coming years. As a smart LP once told me, you can’t feed your family with paper IRRs, but you can with DVPI.

Buyers and Investors beware.

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I want you to re-frame PE funds as small and medium-sized businesses that provide a service (returns) to their customers (investors). The vast majority of PE Funds had one strategy (product). This product concentration also had key-person risk and cycle risk. Combine all of this with the term “leveraged buy-out” and you have a high-risk / high-reward investment strategy.

GPs and LPs were aligned - carried interest - is the carrot. Low equity contributions (<25%) and high corporate tax rates made it feasible to take on onerous amounts of debt. An unregulated debt market (re: junk-bond boom) combined with lower multiples also contributed to the highly-leveraged buyout. For example, the take-private of Jerrico (owner of the franchisor, Long John Silver’s) for $620 million in 1989 requires less than 5% equity contribution.

Now, back to the entrepreneurial founders of PE funds. While they were focused on investing in growing businesses with structural barriers to competition, most were not looking in the mirror. The funds mostly took a generalist approach, with few specialists - they were relatively undifferentiated.

The founders of these funds built a strong business that generated extensive wealth for all of their partners. However, the names on the door held onto most of the carry pool, and talent spun out in search of greener pastures. The firms did not have much “value" if they were put up for sale by an investment bank, and thus “partner” buy-outs and generational succession plans become increasingly important. These pure capitalists, while motivated by legacy, still wanted to hold onto economics, despite no longer being in “the game”.

While many firms faced this conundrum, some decided to minimize “key-person risk” and “product concentration” by expanding and diversifying their fund strategies into adjacent areas and services. For larger funds, it was often creating a middle-market strategy, filling the void where the firm had historical success. Larger funds expanded into new geographies (e.g., Europe, Asia, Australia). Funds also created credit vehicles (e.g., BDCs, Mezz Funds, CLOs), while some moved into entirely different asset classes (e.g., Real Estate, Commodities, Hedge Funds). This had the benefit of increasing the number of revenue-generating products for GPs, mitigated strategy risk, and enabled cross-sell of an existing customer base (institutional LPs).

By transitioning their single-strategy funds into institutional firms, these SMBs began to scale into real businesses (asset managers). The primary risk at this point shifted to their ability to generate returns - the cost of failure became high. As a result, GPs began to shift away from maximizing leverage in deals, as the cost of failure became high. This allowed them to over-equitize deals, deploy capital more quickly, and raise funds over shorter time frames.

The impact on the investment approach is reflected in the current state of the market. Instead of buying low-growth businesses with perceived moats by maximizing leverage, asset managers transitioned into acquiring high-growth businesses with large addressable markets. While this strategy reduced risk, it allowed management fees to balloon. Per BCG’s Global Asset Management Report (2021), alternatives represented ~15% of AUM but generated ~42% of revenue, not inclusive of performance fees. As of 2003, those numbers were ~9% and ~27%, respectively.

The customer base (LPs) for alternatives can be summarized into Pension Funds, Non-Profits, Retirement Plans, Family Offices, and High Net Worth Individuals. Pensions are the largest investor pool - and their need to shift towards alternatives has been driven by a funding deficit and the need for higher returns. A good amount of these customers, including pensions, use third-party consulting firms and RIAs for asset allocation and manager recommendations. Now, put yourself in the shoes of a third party recommending one of your biggest clients to allocate capital on behalf of firefighters and schoolteachers. Are you going to recommend the established incumbent or the unproven upstart? The cost of failure to back an upstart is not worth it - you’d recommend the incumbent. This dynamic has only served to multiply the capital base of large asset managers.

As the industry transitioned from a fund approach focused on “hunting” companies to acquire to asset “gathering,” the focus became more on generating management fees than carry. When you think of management fees, they are an extremely attractive revenue stream. First, they have long-term visibility (five-plus years). Second, capital scales, and there is a high degree of operating leverage as successor funds increase in size. Think of another industry with high-recurring revenue, operating leverage, strong unit economics, and a massive, underpenetrated TAM - software.

In the next newsletter, we’ll dig deeper into the SaaS comparison. In subsequent versions of The Evolution of An Asset Class, we will cover other instruments that helped create and push forward the asset class as it continues to mature. These topics include secondary markets for LP interests, fund of fund, GP seeding, GP staking, and single-asset continuation vehicles.

Once we’ve covered the past, we will begin to look forward. If you are familiar with the term “solo-capitalists,” which was coined by Nikhil Basu Trivedi, and the current trends in the SMB PE market - the lower middle market of private equity is poised for disruption.

Please share this post with anyone you think may be interested. Thanks for reading.

VAC

PE Evolution: Why it’s creating The Golden Era of SMB.

It’s a pretty well-known phenomena: LPs have increased capital allocation into private equity, rotating out of assets with lower returns. Dry powder has continued to build, peaking in 2019 at $750 billion.

Due to increased asset allocations to private equity, we’ve increasingly seen more (and more… and more…) competition for deals. Alongside other factors (e.g, interest rates, new GPs, etc.) purchase price multiples are increasing - supply (committed capital) continues to outpace demand (quality companies for sale).

The data supports this – median Enterprise Value to EBITDA multiples increased more than 50% (9.2x in 2011 to 14.6x in 2019). Private credit markets allocations have increased as well, as lower corporate tax rates and interest rates have improved cash-conversion profiles. While maybe not 100% causality, it’s hard not to see the correlation with a substantial increase in total leverage at close (4.6x in 2011 to 7.5x in 2021).

Given the increase in multiples, firms have achieved a reasonable amount of their returns from multiple expansion. I know what you’re thinking - Is this sustainable?

Over the long-term, probably not. However, as markets (and managers) are prone to doing, they evolved. While roll-up strategies are nothing new, the market has shifted to heavy add-on strategies, where platforms are the “best-buyer,” capable of paying a higher price. This results in multiple arbitrage as sub-scale assets, which typically trade at discounted multiple, can be bolted onto an existing platform that has a relatively, higher value due to scale. According to Pitchbook, add-ons represented approximately 56% of PE transactions in 2011, growing to represent approximately 75% of PE transactions in the first half of 2021.

While the market is still in the early innings of the add-on frenzy, the increased competition for smaller deals has led to higher multiples for smaller businesses. The primary beneficiaries of this are small and medium-sized business owners, who have struggled to hand down their blue-collar empires to the next generation.

Where’s it happening?

While the add-on frenzy continues, it will lead to an increase in purchase price multiples for SMB opportunities. The sectors that benefit the most from these consolidation strategies have a few characteristics:

1. Large, heavily fragmented markets

2. Recurring, recession-resistant demand drivers

3. High barriers and benefits to scale

One of the key areas of PE interest in the past few years has been regionally-focused service businesses in large MSAs. Over time, this has led into secondary and tertiary markets, as the search for more scale moves into smaller markets with less desirable growth characteristics. A few examples of services that PE funds have focused on:

With all this in mind, I’m calling this the Golden Era for SMB in America, as private equity firms continue to consolidate these markets. The consolidation cycle is in the early innings and the spread between platforms and add-ons is wide. I’ve seen multiple HVACR and EMS platforms trade at >20x LTM EBITDA and add-ons still trading for around ~5x EBITDA (pre-synergies) in some instances. Such a gap will not persist in perpetuity but will shrink in the coming years.

I plan to go into the synergies components in subsequent posts, but in the interim, I recommend you read Apax Partners’ post on density-driven business models.

I hope you enjoyed the introduction. Please subscribe and lookout for the first memo.

@ValueAddCapital