Over the past several years, valuations have gone through the roof, which is good if you’re selling a business. This will inevitably hurt private equity firms deploying capital (unless valuations remain at these high levels for several more years). At the same time, LPs are more concerned with the fees being charged by GPs. Funds that have not performed in the top quartile will most likely face two scenarios: raising a smaller fund or reducing their fees (many are shifting toward 1.5/15 model). If GPs are really struggling to raise money, they may need to both cut fees and raise a smaller round.
How did this happen?
There are several reasons for the push toward lower fees. One reason is the performance of the stock market. Since 2013, the Dow has gained nearly 60%, making exposure to the public markets more attractive and potentially less expensive. Additionally, public markets provide the liquidity that private equity funds cannot. In private equity funds have a fixed term of 10 years.
So why is future of private equity so bright?
Well, unlike picking stocks, private equity’s long-term future is not under threat from algorithmic trading. It is not hard to imagine a future in which hedge funds and stock pickers are only able to differentiate based on the algorithms they use. Even then, over time technological parity will compress returns and the overall market for these alternative investment vehicles will shrink. Since private equity relies on many intangible aspects to evaluate investments, pure technological methods won’t exist in the industry.
Discussing a company’s future or market trends with management team can tell you a lot about a company’s prospects.
Similarly, walking a manufacturing floor, you can boost your productivity by identifying inefficient production methods (something you can’t find on a spreadsheet). Another component is pursuing a roll-up strategy in a fragmented market where execution risk would is set to lesser operators. These examples highlight some of the limitations of technology within private equity investing. Thus, there will be less long term parity in the industry which will ultimately benefit better investors/operators.
While the private equity industry has come under pressure recently from LPs to reduce fees, the long-term prospects remain strong. It is an industry where the best investors long term, not the best technology, will win the day.