How we all became invested in private equity

There is more to the rise of private markets than fund performance alone


In 30 seconds...

  • Why private markets are such a dynamic and interesting sector.
  • Professors Eli Talmor and Florin Vasvari discuss private markets’ increasingly significant role in the global economy and reflect on the last decade of study in the field.
  • The story of the expansion and democratisation of private equity.

Are you invested in private equity? If the answer is ‘no’, then you are probably forgetting about your life savings.

Quietly, private equity has spent 40 years transforming from the corporate raider image, embodied by the fictional Gordon Gekko into a trusted longterm investment manager, attracting sovereign wealth funds and pension money. Today, pension funds are among the leading investors in privately-owned companies. A trend dubbed the democratisation of private equity – we are all invested now.

Since the 1980s the number of publicly listed companies has decreased by half, while the number of private privately-owned companies have increased dramatically, overtaking listed in 2007.

This is because many executives opt to avoid the arduous and expensive task of running a publicly listed company. Companies these days also spend far longer growing before they list. For example, before Google listed on the public market back in 2004, it received just US$40 million (£31.2 million) from venture funds and other private backers. In contrast, today, companies like Airbnb and Uber receive billions of dollars from these private markets before listing. 

Eli Talmor, Professor of Accounting and founder of Private Equity at LBS, (main image, left) has had a ringside seat during the growth and professionalisation of private equity. He sees the subject area as a complete business education, that draws together a number of core skills combined with active leadership and deal making.

Together with Florin Vasvari, (main image, right) Professor of Accounting and Chair of the Accounting Faculty, they have condensed their wisdom on this central tale of capitalism into Private Capital – Private Equity and Beyond. Under the banner of ‘Private Capital’ they have drawn together all the ways a company can find private backing before it goes public including angel investing and crowd funding.

They spoke to Think at London Business School about how the industry has evolved and what they hope to achieve with the new double volume.

Is the story of private capital all about superior fund performance?

Florin Vasvari (FV): I think it is both performance and diversification. Certainly performance historically has been superior, but when people are looking at their portfolio it is not just about performance, but also diversification. The extent to which the returns on private equity investments are correlated or not to the returns of other asset classes is as important.

Eli Talmor (ET): Private capital is about tapping the private sector - the biggest part of the universe. Private capital is about diversification, performance in contrarian times and it is about better governance. So, the arguments are, actually, way beyond fund performance.

How have private markets grown?

FV: Private equity has two beginnings. One was the venture capital industry that created Silicon Valley, and the other branch, which was born on Wall Street. This was the opportunistic branch that started, in the early 80s, to take over companies using a lot of debt that was available. That's why the buyout side of the industry had earned a bad reputation by the late 80s. They were the Barbarians at the Gate that made excessive use of debt to acquire companies. 

They called it multiple arbitrage, buy low, sell high. There was a lot of excess, but lenders are much more regulated now. You won’t see structures where 90% is financed with debt and the rest is from a buyout fund. Today it is usually 50:50, if not less, in fact, in emerging markets few use debt at all.

how we all became invested body image

Asset managers are expected to diversify their capital across many asset classes. Private capital is one of those asset classes and private capital provides many sub-strategies. It’s private equity, it's real estate, it's infrastructure. So, there are many ways of diversifying even within the private capital market.

At the very basic level, if you are a big manager investing a pension, you want exposure to public markets, but also to the private economy, and sometimes the only way you can achieve that is by investing in private capital funds.

Private equity funds, in particular, have become so big and so influential, that they had been delaying the listing of a lot of companies. These funds allow the entrepreneurs to stay private and not worry about compliance risks, liability risks, analyst expectations and short term expectations. This is a massive trend, not just in the US, but globally.

Having said that it is important to put private capital in perspective. BlackRock is the largest asset manager in the world. At the moment, they manage close to US$7.2 trillion. Now, if you look at private equity, which is within the private capital market, it manages just US$3.6 trillion. The entire global private equity industry, including its dry powder (unallocated cash),  is half the size of the largest public fund manager in the world.

Should the public care about what goes on in private markets?

ET: We are all exposed to private capital. If you have a pension or life insurance, you are exposed. Some call it the democratisation of private capital. 

FV: The biggest investors in private capital funds or global alternative asset managers as they are now known are the pension funds and sovereign wealth funds, and this is a change which has come about in the past 10 years.

Instead of buying mature companies via private equity funds, they started to (1) buy real estate and infrastructure assets via dedicated private capital funds that focus on these types of assets or (2)lend to private companies via private debt funds. So we have infrastructure private equity funds, real estate private equity funds, natural resource funds as well as credit funds. The common denominator in all of these private capital funds is that they are closed-end funds that lock investors’ capital for long periods of time, usually 10 years.

How much has changed because of the 2008 crisis?

FV: On the private credit market side, everything. Private debt funds have grown three times since the credit crisis, because they have been replacing the banks. Banks are not incentivised to lend to private companies anymore due to regulatory pressures. If a small private company takes a loan of US$100 from a bank, then the bank needs to set aside reserve capital for that loan in case it underperforms. Therefore, bank lending locks in a lot of capital,making it unprofitable to lend to small companies. 

“2008 was a pivotal moment. The financial crisis set up a generation of abnormal performance”

Instead the market has seen the emergence of private debt funds that provide debt solutions to private companies. Many banks prefer to lend to these private debt funds which in turn lend to these companies, if that makes sense. Banks are thus protected as fund managers would need to lose the entire fund before banks can incur a loss. Banks of course like it because they don't need to set aside so much regulatory capital.

ET: During the crisis, there was such a cry for someone to ‘save the world,’ because all the banks went under. If they didn't fail, it was because the US Government saved them. 

At the time, there were only two sources of hope, of money. One was private equity and the other one was the sovereign wealth funds. The reason being, that private equity raises money in advance, so they had a lot of cash and they were able to invest in opportunities at a time when nobody else had money.

So that's been part of the change in attitude among regulators, media, unions, and others who were sceptical about private equity before 2008. They realised what an important role they can play. 

2008 was a critical moment. The financial crisis set up a generation of abnormal performance. And through the bad times after 2008 it was private equity that was the closest to the management of private companies. They were in the trenches turning things around.

What else has changed?

ET: Operational engagement has been become widespread. Ten years ago, I would have to go to Bain Capital and a couple of others as examples of funds really engaging with the firms they invest in. Now, everybody has operational partners. This is a no brainer. These used to be people like lawyers and bankers, who came to the industry to focus on the transactions. Today, it's not just the bread of the sandwich, it is the sandwich itself.

The other big change is minority investments. Ten years ago, nearly all the deals done in Western Europe and the US were 100% buyouts. Now that’s no longer the case. 

The trend started with emerging markets because there were very few cases where a family was interested in an outright sale of their business. Also, private equity fund managers need to have a local partner in order to operate the business efficiently in the developing world.

So private funds many now buy say 30% of a business as opposed to 100% and that's sometimes the only way of securing deals because a lot of families don't want to give up control. The expectation now is that when the private equity investors come in, they provide a lot of added value to the owners of the business, not just capital.

Does private equity do anything apart from make money?

FV: The private equity industry has the potential to have huge impact on Environmental, Social and Governmental (ESG) targets. This is because of the governance model that is employed in private equity.

They control these companies and they can push for changes almost instantly. Blackstone, for example, will be much more effective in ensuring certain principles are implemented, than say Fidelity, because Fidelity is investing in thousands of companies in the public market with minority stakes. Fidelity investment professionals therefore never sit on any boards unlike Blackstone’s professionals, who take a much more active board role in the businesses they invest in.

“When you look at private equity from an operational perspective and really distil it down, you end up with better type of corporate governance”

Private equity also cares about impact investing because it makes economic sense. These are long-term investors and they are actually already making money using ESG principles. Private equity fund managers usually trade on long-term trends. Why buy a company that is destroying the environment now, expecting to sell it seven years later when the public awareness will be even higher than it is today?

So, managers are already looking ahead. When they invest, they need to anticipate where future buyers’ expectations will be seven years ahead, and the trend is very much towards sustainability.

Private equity limited partners were the first in private equity not to invest in the tobacco industry and military equipment. Some of them don't invest in casinos; a few of them are Sharia-compliant meaning that they prefer limited to no leverage in private equity transactions.

Contrast that with the situation of stock market investors. They may decide not to invest in a given company or area, but without engagement at a board level there is no impact on the grey areas of sustainability.

ET: Private equity has been embraced in emerging markets. Before private equity, a few families in emerging economies dominated private markets, much as the Carnegies and the Rockefellers did in the US 150 years ago. These families were ruthless and often abusive. Private equity has brought transparency, professionalism and good governance.

Consider Brazil, for instance, where more than half of the M&A deals are driven by private equity funds. They don’t even blink. It is just how business is done.

FV: Probably the best example is China. Ten-twelve years ago, China was not even on the private equity map.Today it is the second largest market in the world for private equity funds. China is one of those examples where the government has embraced the industry and various governmental agencies and entities in China are significant investors in private equity funds. The simple idea is that private equity fund managers are better at allocating investments in the economy than government employees.

What do you want to achieve with your book?

FV: A decade ago, we were trying to explain what private equity is and justifying its existence. Today, we don't need to do that. Today everybody knows what the private equity industry is about. Today it is all about ‘how can private equity become more professional?’ ‘How can it become more responsible?’ ‘How can it employ better practices?’ These are kinds of questions we deal with in the book because nobody questions the existence of the industry anymore.

This is a book for practitioners. It is about best practices such as fund reporting, administration, governance or risk management. It is also about screening deals, valuing private businesses, managing a portfolio company’s operations or implementing an optimal post investment exit strategy. In our previous book, International Private Equity, the exit chapter was primarily about citing performance in exits and classifying investments based on the academic literature. Now we are talking about how one would actually manage the process of exiting a deal. The focus is totally different, because we know more but also because the industry has evolved over the last ten years.It is as simple as that.

ET: We hope that our students and alumni will benefit from the insights that we provide.

We believe the operational angle of private equity is best practice. When you look at it from an operational perspective and distil it down, as we have in the book, you end up with a better type of management that have a wider relevance that extends to companies that are not owned by private equity funds. We believe that family businesses, for example, could benefit a lot especially on the operations side. 

As a subject, it is very hands on and it's very comprehensive, and that’s why we love it.

Discover more about London Business School’s private equity executive education in London and Singapore.

‘Private Markets: Private Equity and beyond’ has been endorsedas the ultimate authority in the field by:

Henry Kravis, Co-Chairman and Co-CEO, Kohlberg, Kravis Roberts;

Stephen Schwarzman, Co-Founder, Chairman and CEO of The Blackstone Group;

and David Rubenstein, Co-Founder; and Co-Executive Chairman of The Carlyle Group