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Private equity can be a wonderful thing.The combination of capital and expertise provided by private equity investors can help companies to grow and create jobs. This is particularly true for smaller and mid-sized companies which tend to be engines of job growth.
But at the same time, traditional private equity structures have contributed to wealth inequality. Not just for executives of the portfolio companies, but for their employees and the communities they operate in.
On this episode of the Impact Investing Podcast, we caught up with Delilah Rothenberg, Founder and Executive Director of The Predistribution Initiative. The Predistribution Initiative is a multi-stakeholder project designed to co-create improved investment structures, particularly for mainstream markets.
Their goal is to share more wealth with workers and communities, incentivize investment teams for environmental, social, and governance (ESG) integration, and ultimately make sure that systemic risks - like income inequality and climate change - are addressed.
Although The Predistribution Initiative does not focus solely on private markets, the growth of private equity has introduced issues that are relevant in public markets, too. Here are 7 of the most pressing private equity challenges and how public and private market investors can work to solve them.
But first, how does private equity work?
Let’s start with the basics. Private equity funds typically have institutional investors, like pension funds, insurance companies, and sovereign wealth funds. These investors are called Limited Partners (LPs) because they pour large amounts of capital into the fund and then sit back as the fund manager, or General Partner (GP), does the heavy lifting.
The GP will invest the LP’s money into portfolio companies. Then, they’ll help those companies grow and generate profits. The goal is to eventually sell the portfolio companies and give the LPs their money back (plus returns, of course).
Sounds easy enough, right? But with the flow of capital from top to bottom and then back to the top, influence and incentives can create a number of opportunities for inequality.
1. Higher valuations, lower returns
Over the past few decades, investors have found private equity to be an attractive asset class. But with so much money flooding one asset, valuations become higher and returns are harder to come by.
This puts pressure on large fund managers to cut costs and layer on debt to maximize returns. This can ultimately lead to poorer compensation, benefits, and working conditions for staff and increase the financial risk to the business.
Delilah says to start alleviating these pressures, large institutional investors need to take a step back and reconsider their asset allocation.
“It might not be performing the way it used to. So where else can we get the returns that we need across asset classes?”
2. Outsized influence
Private equity firms typically work with smaller companies. This gives them a more meaningful position within that company and an outsized influence over governance and capital structure.
When this influence is misused, investors can push the company to take steps that will increase returns. For example, cutting benefits and pensions, laying people off, or taking on more debt. In the long run, this can harm the company, its community, and its financial resilience.
But if used correctly, Delilah says private equity governance can be a positive thing.
“If that opportunity of influence is used for regenerative investment structures and to have elements of multi-stakeholder governance, then that is an incredible opportunity for broader societies and economies.”
3. Debt, debt and more debt
As we know, taking on debt can help a company boost returns for its private investors. But there are more ways that debt comes into play to fuel inequality.
When private equity firms take on a majority stake to acquire companies, they can use less of their equity and rely on debt. The only problem? This debt is at the portfolio company level, not at the fund level. That means it’s the portfolio company’s responsibility to repay and service the debt.
Plus, some private equity funds use a practice called dividend recapitalization. This is when the fund manager, who has governance influence over the company, decides to pay themselves and their LPs dividends by placing more debt on the company.
To stop the reliance on debt and the constant pressure for returns, Delilah says LPs and other investment professionals need to be more reasonable with their expectations.
“I think it’s really important for us all to take a step back and say, what kinds of returns are reasonable from this particular style of private equity given the environment we’re in today, and how can we sustainably generate returns?”
4. Inequitable compensation structures
GPs receive two types of compensation: a base management fee and a performance fee. The base rate is generally a 2% annual fee on the assets in the fund, which the GP gets regardless of how the fund performs. The performance fee is typically a fee equal to 20% of the returns a fund generates over and above some sort of hurdle rate (e.g. 8%).
This structure can lead to unintended consequences (e.g. increase a GP’s desire to take on risk in order to exceed the hurdle rate) and inequitable outcomes (private equity managers can capture a disproportionate amount of the value that is created by all parties in the process). Delilah says restructuring this management fee is a potential solution to help distribute wealth more evenly.
“As GPs start to market themselves as ESG and impact investors, we hope that this will give the LPs additional winds at their sails to say, are you really practicing what you preach if you're paying yourself so much?”
5. Inequitable profit distribution
In addition to fund manager compensation, we also need to look at how profits at the portfolio company level are being divided. In traditional capital structures, workers and community members are often excluded from private equity profit distribution. Through its work, The Predistribution Initiative is exploring whether the profits from portfolio companies could be shared with workers and communities.
“Regardless of what happens, there needs to be a narrowing of compensation ratios between the executives of the fund manager and the workers and beneficiaries of the portfolio companies.”
Check out episode 25 with Jon Shell where we discuss the Leveraged Employee Buyout concept being pioneered by Social Value Partners
6. Barriers to entry
LPs typically require GPs to put their own investment into the fund as a percentage of the total capital. While this helps align the incentives of these two parties, it creates a huge barrier to entry for those who want to become fund managers but haven’t generated enough wealth to make that kind of investment, especially for historically excluded or marginalized groups.
Another barrier for underrepresented fund managers is that it’s simply easier and safer for LPs to go with a fund manager they already know. There's more career risk associated with giving someone new a shot. Besides, going with someone new requires more time and effort conducting due diligence from scratch.
Adding to the problem is that are concentration limits to limit how much capital an LP will put into a single fund (e.g. their ownership cannot exceed 10% of the fund). The trouble for first-time managers (who tend to raise smaller funds) is that these limits make it difficult to raise capital from large investors. For instance, a 10% concentration limit works out to a max investment of $10M on a $100M fund. While $10M may sound like a lot of money, it's peanuts for institutional investors. So new investors are stuck fishing in smaller ponds.
The net effect, it's hard for newcomers to enter the space.
“There's a huge consolidation of capital among the largest managers, which then flows down to result in consolidation of capital among corporations and it's really not healthy for the economy.”
To solve this problem, Delilah says the industry needs to completely rethink its investment structures. Instead of focusing solely on where they can make money, LPs must get creative with their investments, take risks, and consider how they can share the wealth.
7. Long-term market instability
Communities and other stakeholders aren’t the only ones negatively impacted by these dynamics. Weak capital structures, income inequality, and secular stagnation can all expose LPs to long-term risk.
“In the long run, this really erodes the stability of financial markets and boomerangs back to the LPs.”
Delilah says avoiding these risks requires LPs to adjust their investment structures to be more long-term. For example, an evergreen fund that remains open so that GPs aren’t pressured to exit an investment quickly and generate returns. Or more niche strategies, like revenue-based financing or equity redemptions.
And ultimately, The Predistribution Initiative is working towards a holistic change to the entire investment system. From education in schools to legislation, Delilah says we need to start redefining success in private markets and looking more closely at the role of the fund manager.
“If we really want to change capitalism, we can’t just look at the portfolio company level as we have been for the past 10 years or so. We have to look at what’s going on at the fund manager level as well.”
Want to learn more about how The Predistribution Initiative is helping? Find them at www.predistributioninitiative.org and sign up for their newsletter to stay up-to-date on new projects and impact investing workshops.
Listen to the full podcast episode here and don’t forget to leave a 5-star review on Apple Podcasts.