How Private Equity Firms Can Stay on Top

Continued outperformance by private equity firms has given rise not just to record levels of assets under management, but record numbers of entrants into the field — meaning managers will have to work harder to stay on top, according to a new paper from Boston Consulting Group (BCG).

Although private equity is experiencing what the Boston-based consulting firm labeled a “new golden age,” the flood of capital to the sector comes with pressure for firms to differentiate themselves and boost returns amid increasing competition for deals.

“The current conditions are favorable in so many ways, but there are also challenges looming ahead,” said Tawfik Hammoud, a senior partner at BCG and lead author of the paper, in a statement accompanying the paper. “We think top managers will use this as an opportunity — or even an imperative — to sharpen their thinking, improve their discipline, and be bold in several dimensions of their businesses.”

Private equity funds managed a record $2.49 trillion at the end of 2016, according to BCG, while 319 new firms launched last year. The industry is sitting on $900 billion in dry powder, the firm added. Just yesterday, KKR & Co. announced it raised $13.9 billion for a new fund, believed to be the largest-ever Americas-focused private-equity fund.

Among the top challenges facing managers is increasing competition, not just from other firms, but from limited partners (LPs) as well. Hammoud and his co-authors Michael Brigl, Johan Öberg, and David Bronstein wrote that LPs “now seek a more active role in the investing process.”

“After years of staying behind the scenes and watching general partners (GPs) in action, LPs are beginning to make direct investments in high-performing assets themselves or seeking co-investment opportunities with GPs,” they continued.

In a survey by private equity marketplace Palico, 90 percent of investors reported that their co-investments matched or outperformed private equity fund investments. Given that co-investing and direct investing also enable LPs to pay fewer fees, GPs are also facing pressure to offer better terms, the consultants said.

“To be clear, the best firms are still able to hold the line on fees, and smaller LPs lack the clout to refuse,” the authors wrote. “We expect to see a continued split between the top funds, which can maintain fee levels, and the laggards, which have to make concessions.”

To become or remain a “top fund,” Hammoud and his collaborators suggested three steps that private equity firms should take to improve their operations.

First, managers should “turn their operational playbooks inward,” and hold their own operating models to the same level of scrutiny as those of their portfolio companies — including investing in new technology and improving efficiency.

Additionally, the consultants said GPs need to develop a “true talent strategy” to “build teams with a wider range of experience and expertise” as well as “upgrade their approach to value creation” by moving away from “merely acting as a source of private capital and toward true strategic partnerships.”

“These are challenging times for the private equity industry,” the authors concluded. “Just as their portfolio companies must adapt to turbulence and change, so must private equity firms.”