Shifting Sands

07 January, 2010

Limited partners’ view on the future of private equity.

The private equity (PE) industry has undergone a dramatic change compared to two years ago. To gain a deeper understanding of the change and the future of PE, it’s critical to understand the perspective of Limited Partners (LPs), who invest in PE funds, and their view on the future of private equity.

LPs feel that the PE model is sound and continues to be a fundamentally attractive asset class that can offer above-average returns. The PE industry in India will continue to grow though the past year was an anomalous blip in its growth trend. At the same time, LPs have strongly suggested that the PE model will need to change to deal with the issues, challenges and opportunities that have emerged in the past two years.

Further, LPs also believe that General Partners (GPs), who manage PE funds, need to adapt to the challenges in the market. They feel that those GPs who form a strong relationship with LPs are likely to survive in the “shake-up” of the PE industry. It can be achieved by focussing on the business growth of portfolio companies, implementing robust risk management functions, utilizing the industry knowledge, sector expertise amongst other practices.   

At Ernst & Young, we conducted a global study with Limited Partners to understand their views on the future of private equity. The report is titled Shifting Sands and through this article, I’d like to share some of our key findings.

Focus on business basics (and not financial engineering) to drive growth

As per the research findings, LPs feel that there is a need to return to the fundamentals of the PE industry; that reliance on leverage from cheap credit, multiple arbitrage and continuing macroeconomic growth, which characterized the industry in the years up to the financial crisis, will not work now. According to the LPs, greater emphasis needs to be laid on operational effectiveness and performance improvement to create value.

This value creation can be achievable if PE investments are based on the strategy to grow the businesses acquired. Further, GPs should consistently persist with their organic revenue growth initiatives to drive profit growth among their PE investments. In fact, another recent study conducted by Ernst & Young has revealed that PE-backed European businesses have outperformed their public counterparts and showed an average per annum growth of 15% in profits, 5% in employment and 9% in productivity from the time of acquisition to exit. The primary reason for this was that 62% of PE investments were based on the strategy to grow the businesses acquired. Another important factor was that the bulk of the growth in profits under PE ownership was the result of implementation of specific growth initiatives, particularly those that drove organic revenue growth as well as acquisitions.

Risk management and governance to be implemented in substance

According to LPs, GPs should focus on entering the right deals with high-quality assets by utilizing robust risk management functions at the right time. It will be essential to ensure that all acquisitions are supported by a clear investment rationale that identifies value-creation opportunities, and also that all investments are aligned with the overall strategy of the GPs. Further, as per the study, LPs strongly recommend a robust due diligence process while evaluating any PE investment decision.

In other words, LPs do not want the GPs to dilute their focus and neglect the importance of an overall investment strategy. LPs expect GPs to have a keen sense of where investments fit into their overall investment plans and have a strong understanding of the sector and the risks associated with it. Hence, further emphasizing the role of risk management processes followed by GPs.

Inculcate operating and industry expertise

The importance of having in-depth understanding of the inherent risks and opportunities associated with the industry sectors and sub-sectors in which GPs invest, cannot be ignored. According to LPs, the GP should focus on understanding the growth drivers of business and performance improvement that are most relevant to its current portfolio companies. Further, LPs are of the opinion that if needed, experienced GPs can join the portfolio companies’ boards of directors to improve their portfolio performance.

In fact, this trend is picking up in India. Several global PE firms in the country have recruited Indian industry experts as GPs or as part of their PE investment teams.

GP track record critical to subsequent fund raises – first timers may find the going difficult

Another interesting finding of this report is that LPs are becoming increasingly selective and are partnering with more exclusive GPs with proven operational capabilities and strong investment strategies. They are attracted to GPs with proven operational capabilities and a track record of generating above-average returns, independent of improving markets, particularly during difficult cycles.

We see this trend gaining ground in India, with several well-known PE veterans leaving their respective firms and starting out on their own, having raised or being in the process of raising sizeable funds from LPs. In such a challenging fund-raising scenario, this highlights the fact that there is an exclusive group of GPs that have implemented or are implementing, strong investment strategies. (PE fund-raising in India declined significantly to $2,383 million in January–September 2009 from $6,396 million and $8,140 million in 2007 and 2008, respectively.

Enhanced transparency in reporting back to LPs

LPs also expect GPs to build relationships on enhanced information flow and transparency. The former require increased communication and detailed information to monitor their portfolio performance. LPs seeking increased communication is a reflection of their desire for enhanced transparency and a closer alignment of objectives with GPs.

There is no doubt that LPs have adopted a cautious approach and are strongly focusing on quality. Key indicators of this trend are the quantum of fund-raising and deal-making activities that have taken place this year. Nevertheless, India (on the back of its strong underlying fundamentals) is the preferred destination for several LPs. Going forward, increasing domestic consumption, due to a burgeoning middle class and a growing population, is expected to drive cross-sector growth rates in the country. This is likely to, in turn, give rise to a growing economy with companies ensuring strong returns, and thereby boosting the PE investment outlook on the country.

To sum up, LPs believe that PE continues to be a fundamentally attractive asset class that can offer above-average returns. Not to forget the significant opportunities for success in India’s growing economy. However, for GPs to continue to maintain their status they must continue to adapt some best practices. These include focus on the fundamentals of the PE industry by placing greater emphasis on business growth, investing with a clear strategic vision supported by strong due diligence, applying robust risk management functions and demonstrating strong industry knowledge and sector expertise.


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