In Patient Capital (2019), Harvard Business School professors Victoria Ivashina and Josh Lerner explore the challenges facing long-term investors—including pensions, sovereign wealth funds, university endowments, and family offices—who are searching for investments that have the potential to deliver greater long-run returns than those in the public markets.
But performance in such private investments has moderated in recent years for a number of reasons, including ever larger private equity fund sizes and increasing competition in the upper middle market, persistently low interest rates across the globe, and longer holding periods—not to mention the internal structure of private equity fund managers, which sometimes results in the wrong incentives and a lack of long-term planning. At the same time, the rise of private equity investing has had an outsized influence on both the way portfolio companies are managed and how they are valued.
In an interview with the KPMG Board Leadership Center (BLC), Dr. Ivashina discussed the challenges facing private equity investing today as well as the impact that private equity firms have on the management and oversight of portfolio companies. Following are edited excerpts from that conversation.
BLC: What do you see as the biggest challenge for private equity firms today?
Ivashina: For more than 30 years, the private equity industry has been characterized by fast growth and high returns (albeit, with some cyclicality, which is an intrinsic part of the industry). The central question is whether the industry can sustain this healthy profile in the future. In large measure, the answer to this question depends on governance, incentives, and measurement of long-term performance—by both the private equity firm and its portfolio companies—which need to be approached in a systematic and transparent way that is indicative of a mature industry. For example, the training of board members on the portfolio company side should be a high priority to help ensure that the portfolio company and the private equity firm understand and are aligned on investment horizons, risks, expertise, and incentives. To achieve this, there must be robust and clear communications between the portfolio company and the private equity firm.
It is encouraging to see signs of structural flexibility starting to propagate throughout the private equity industry, with the introduction of longer-lived funds and more robust development of a secondary market for institutional investor interests. While fund structure and finite fund life play an important governance role and simplify the incentive problem, the prevalence of multiples of 5—i.e.,10-year fund, 5-year investment horizon, 5-year holding period—is not the best way to approach long-term investments.
BLC: From the point of view of a director or executive of a portfolio company, what do you think most differentiates the investing approaches of private equity firms and institutional investors making direct investments?
Ivashina: Private equity firms and institutional investors investing directly seldom compete head to head, but when they do, it is vital for target companies to understand the scope of what the investor can offer outside of capital. Most institutional investors do not have the capacity to pursue hands-on operational turnarounds, which is a major focus of private equity firms. But the differences go deeper than that, as those institutional investors traditionally face multiple internal constraints. For example, private investments typically are only a fraction of an institutional investor’s overall portfolio, and, as a result, there is often limited opportunity for a hands-on approach. Scale is another important factor, as it may be a challenge for an institutional investor to build adequate internal infrastructure for deal sourcing and due diligence. It can also be difficult to incentivize and retain the investment professionals making direct investments on behalf of the institutional investor. Even the most sophisticated institutions are likely to feel constrained by some of these challenges. That said, with the proper scale, governance, horizons, and incentives, there could be market segments where institutional investors have a competitive edge. Flexibility in the investment horizon, comfort with passive strategies, and differentiated risk and return profiles can give an edge to a large institution committed to direct investing, and there are successful examples of it.
BLC: What is your outlook for private capital markets—for private equity firms and institutional investors—in light of the challenges presented by COVID-19?
Ivashina: The economic consequences of COVID-19 are unprecedented in scale, scope, and speed. Not surprisingly, there are multiple ways in which private equity is affected. For example, we are already seeing that many institutional investors were unprepared for the “denominator effect.” As public and private valuations move at very different paces, a sharp drop in public valuations makes an institutional investor’s exposure to private investments look large. Not having proper governance to handle this dislocation, many institutional investors are finding themselves selling their stakes or defaulting on commitments.
For private equity firms, there are both pressures and opportunities. Needless to say, the exits will have to wait (and so will the capital distributions). But the immediate difficulties for portfolio companies relate to a very high and widespread level of corporate leverage. Most portfolio companies are currently under immense pressure to raise liquidity. For highly leveraged companies, this is an especially difficult problem. For private equity, how to get portfolio companies through this crisis, with traditional sources of debt capital in disarray, will be a central development to follow. And the effectiveness of the portfolio companies’ boards will be important for timely and disciplined financial decisions, particularly as distress investors—who have been sitting idle with substantial capital in recent years—begin to put proposals on the table.
BLC: What do executives or independent directors of private equity portfolio companies—primarily target companies—need to know about the private equity firm to determine whether there is a “fit”?
Ivashina: It is crucial for existing managers and directors of portfolio companies and targets to understand that a controlling or influential shareholder could significantly drive company decisions in critical moments. For a board member of a private equity portfolio company, it is important to understand the private equity firm’s business model and priorities. The strategy and reputation of the firm, past performance, composition of the limited partner base, fundraising history, stage and performance of the current fund to date, track record of the senior partners on the deal, and investment committee processes—all of these elements should inform the portfolio company board about critical alignments, particularly incentives. Much of this information can be found through public sources, but understanding the asset class and what to look for is imperative. Indeed, past individual deals are unlikely to prepare you for the idiosyncrasies of your own company; therefore, understanding the governance and discipline of the private equity fund itself will be most critical.
Still, the management and board of the portfolio company are central even in the case of buyouts. An intrinsic feature of a private equity investment is that it has a finite horizon; there has to be an exit. So, having a strong and experienced management team is a core component for a successful exit.
BLC: Will the expectations of institutional investors regarding the management of ESG and sustainability risks and opportunities influence how private equity firms prioritize these issues?
Ivashina: I am personally very enthusiastic about the increasing attention to environmental, social, and governance (ESG) factors by private equity firms and their portfolio companies, both on their own and as a result of increased attention by institutional investors. To be clear, ESG is a complicated concept. Its definition is still evolving, and it is likely to continue changing over time. I am glad to see broad attention to it, and now several data and analytics firms are looking to grow their ESG footprints, making the emerging ESG rating segment a competitive field. In my view, the main force that drives ESG is not specific to private or public markets. Because of the intermediated nature of private investments, ESG tracking is slower to spread in this area of investing. On the one hand, most of the private equity firms have some sort of tracking of ESG metrics, but very few can give concrete examples of foregone profitable investments or operational initiatives that were driven by ESG awareness. The change is certainly happening, and the public market is the leading indicator of this change.