Lots of money

In asset management, the first lesson is staying diversified. For the average household investors, the public markets are the place to put their money to work. Equity, bonds, commodities, and, for the more adventurous, derivatives are what one finds in most individuals’ portfolios. But for institutions with hundreds of millions in cash, whether it is college endowments or insurance companies’ pooled premiums, the investment options become more colorful. Private equity, hedge funds, and real estate are three examples of alternative asset classes that institutional investors often turn to in order to complement their public market investments.

The illiquidity and large capital requirements of the alternatives make them inaccessible to the average investor, which are also big risk factors that allow those with the means to invest in them to demand return premiums. While alternative assets behave differently from public securities and derivatives, they are by no means immune to the swings of the economy. Through the course of the financial crisis, institutional investors have had to face the challenge of reevaluating the role that assets like private equity and hedge funds play in their portfolios.

The relationship between risk and reward is frequently evaluated by asset managers when they perform due diligence on potential investments. For large investors, the excess returns that come with alternatives also bring along higher risk. For the managers of private equity and hedge funds, their losses in the crisis bought them an expensive lesson in investing, but most of the surviving funds maintain their fundamental strategies. For the institutional asset managers, their losses gave them enough of a scare that they had to rethink their asset allocation targets.

In the International Monetary Fund’s (IMF) September 2011 Global Financial Stability Report, it notes that “the empirical results and survey responses indicate that asset allocation strategies of private and official institutional investors have changed since the onset of the global financial crisis. Most importantly, investors are more risk conscious, including regarding the risks associated with liquidity.” It seems only natural that this risk aversion might divert interest from the riskier alternative assets. Yet, given the need to diversify and recover losses, there has actually been new interest in alternatives. For example, pension funds surveyed by the IMF increased their allocation in these investments from 10.9% in 2006 to 15.6% in 2010.

Looking at university endowments in the U.S., the amount of money invested with alternative fund managers has actually increased during the crisis. Based on the annual study on university endowments by the National Association of College and University Business Officers, in aggregate, endowments have increased their alternatives allocation from 35% in 2006 to 52% in 2010. This rise is most dramatic for the largest endowments (with $1 billion or more), from 40% in 2006 to 60% in 2010. Smaller endowments, with more limited resources, have expectedly smaller amounts invested outside of equities and fixed income. However, it may be premature to cite this evidence that the crisis increased the demand for private equity and hedge funds. This increase may simply be due to the fact that with the size of endowments decreasing and the illiquidity of alternatives, these institutional haven’t been able to adjust their allocations quickly.

One group in particular caught the attention of the media when time came for assessing damages post-crisis: Ivy League universities. The Yale Model, named after the university, was popular among investment managers of college endowments. It called for a significant allocation to “private- equity and real- estate funds or commodity-related assets”. In the past two decades, this strategy brought great returns to these endowments, especially those of Harvard, Princeton, and Yale. Yale and Princeton allocated 70% of their endowments to these assets, while Harvard had 57% of its money committed. From 1998 to 2008, “the Yale endowment gained 16.3% annually, while Harvard rose 13.8% a year and Princeton, 14.9%. The Standard & Poor’s 500 logged an average annual increase of just 2.9% in that span.” So how did the lauded alternatives fare in the crisis? While the jury is still out as the economy recovers, evidence from the few years after the crisis shows that they endured worse losses than traditional assets. Private equity, real estate, and commodity related investments took average write downs of around 50% (exact loss is difficult to determine as the returns on these investments are realized over the long term).

If the results from the Ivy League are any indication of overall financial conditions of institutional investors, it is hard not to be pessimistic toward alternative assets. They are a source of liquidity risk, and, as the crisis has shown, are not completely uncorrelated with the public market. However, with still large amounts of cash to invest, institutions need a way to include more return drivers in their portfolios. Currently, that means looking outside of the sluggish stock market and at private equity, venture capital, real estate, and hedge funds. It is not that the wound from the crisis is not deep enough to steer the likes of Yale and Harvard away, but instead the need to reenergize investment in companies means potential future benefit for those who have the money to fill the void. Institutional investors may provide the push that the economy needs to get back on track.

With the nadir of the recession behind them, the biggest private equity (PE) firms, since early 2010, have made numerous strategic shifts in their business. Since its emergence as a high-profile asset class, private equity has evolved in direct response to discovering new means of creating value: financial engineering in the 1980s and operational enhancement in the 1990s. Today, these approaches are standard across all the best firms and no longer offer the competitive advantage they once did. Moreover, gone are the days when top tier PE firms were returning in excess of 20 percent through their traditional core business, the leveraged buyout (LBO). In fact, buyout returns are down, have been (even before the financial crisis), and seem unlikely to rebound anytime soon. Given Blackstone, KKR, and Apollo Management’s recent shift toward public ownership of their PE Firms as well as portfolio diversification away from the LBO and into credit investing, real estate, advisory services, and proprietary trading, PE firms have apparently noticed…but the question remains: What necessary innovation in private equity’s value creation model is next?

In the 1980s, private equity developed its first innovation: financial engineering, or the idea of buying companies with debt, taking them private, and then, in theory, reselling them after a few years with a rate of return enhanced by leverage. According to Henry Silverman, chief operating officer of Apollo Management, this strategy can be explained simply: “If I have 10 cents, borrow 90 cents, buy your tie for a dollar, and sell it to Joe for $1.05, I didn’t make a nickel; I made a 50 percent return on my investment.” By the 1990s, however, financial engineering had become commonplace across competent PE firms; as a result, PE firms looked for another innovation and found operational enhancement. This strategy seeks to increase the value of portfolio companies by reducing cost in any form, whether that involves process improvements, outsourcing, or restructuring.

Success in private equity hinges on a firm’s capabilities in fund raising, deal making, and adding value to its investments. These capabilities are inextricably linked such that the strength of each depends on that of the other two. That is, if a firm has more ways to add value, it will naturally discover more investment opportunities. Winning more investments means a better track record, which, in turn, helps in fund raising. As firms have matched each other’s ability to add value via the two aforementioned innovations, the question remains, “What’s next?” The answer, though seemingly apparent, will distinguish the winners from the losers in the near future: PE firms must be able to spur organic growth in their portfolio companies—that is, the ability to systematically expand or increase the revenue of companies they already own (using internal resources) through increasing their customer base, output per customer, etc. Indeed, this requires PE firms to hold a deeply rooted knowledge of the customers, their behavior, and their wants and needs per industry.

The next critical question then, is how PE firms can improve their ability to engineer organic growth without changing the firm’s structure and limiting flexibility. The answer comes in three parts: adding new growth capabilities, making growth in their portfolio companies the primary focus, and finding ways to make this growth net free.

Adding growth capabilities involves enhancing pricing ability as well as improving sales-force practices. According to the McKinsey Quarterly’s article “Freeing up the sales force for selling,” “Most sales reps spend less than half of their time actually selling.” KKR’s acquisition of Dollar General, a chain of variety stores, illustrates just how PE Firms can add these growth capabilities. When KKR helped take Dollar General private in 2007, its enterprise value stood at $7.3 billion; today, now public, Dollar General has an enterprise value in excess of $12 billion. What changed? When KKR first acquired Dollar General, its management based its decision about which products to put on shelves by simply looking at the profit margin of individual items. Although their logic aligns with common sensical thought, KKR suggested that, given Dollar General’s niche as a place to pick up a few small items (not to do major shopping), management should instead look at dollars of margin per linear foot, “a common measure in food retailing that takes into account not only how much profit a given product generates per dollar of sales, but how quickly the product sells.” This strategy prompted Dollar General to start carrying milk and other basic products as well as offering Coca-Cola in addition to the Pepsi they once were limited to. Ultimately, the “right” products maximized foot traffic among customers and increased revenue exponentially.

With constant attention to eliminating costs, how can PE firms make growth in their portfolio companies a primary focus? One way is to keep in mind the concept of “headroom” as a structure for determining available growth in a market. Headroom equals the market share that a company does NOT have minus the market share that it will NOT get. Headroom essentially outlines which customers can be targeted to switch from rival companies to their own, and what it would take to have those customers make the switch. Thinking along these lines will naturally improve coordination within the company. The last challenging aspect of this innovation involves adding growth capabilities and making growth a primary focus net free—cash invested in these initiatives must come from internal resources of the portfolio company. Doing so, will further align incentives throughout this process of spurring organic growth.

Still, as organic growth increasingly becomes important in private equity, the previous means of value creation will undoubtedly remain important. Nevertheless, as this third innovation truly makes headway, without a strategy for spurring organic growth in portfolio companies, PE firms will become less and less competitive in fund raising and deal making. Ultimately, this means returning to their role of being in the solutions business—promoting growth through real improvements in portfolio companies and increasing overall profitability in the process.