Last week I had the pleasure of attending this year’s Private Equity Forum in Chicago, which brought together prominent investors, fund managers and advisers to discuss the state of the private equity (PE) industry and investment opportunities both in the U.S. and globally. Here are my takeaways.
Compliance and operations: finding the ‘why’ for expansion
While a firm may have ambitious growth goals, PE managers considering the expansion of their platform should first ask themselves “why?” to help navigate potential issues relating to two core sets of considerations: (1) legal, regulatory and compliance, and (2) operational and practical.
Pertinent supporting questions include:
- Do our documents allow us to do this?
- Do we have the infrastructure to support a new line of business or product offering?
The SEC will always look at whether the firm has adequate investor relations, finance, legal and compliance infrastructure to support the expanding platform(s). They will also examine whether risks and conflicts have been identified and managed.
The first thing they’ll ask, though: what is really new in the business, and what is in fact old?
Top tip: Firms should loop in their Chief Compliance Officer (CCO) at the beginning of any discussions around new products or platform expansion. It’s also highly beneficial to involve LPAC; let them help justify the why. They are experienced and will pressure-test reasons.
What else is the SEC focusing on?
The SEC will look at – and test – the process for how and to whom co-investment opportunities are offered. They’re also interested in conflicts of interest associated with offering opportunities that have limited capacity.
Other SEC exam priorities include:
- Post-commitment management fee calculations, including write-downs, write-offs and partial dispositions
- Fee offsets
- Fees associated with operating partners and passing through salaries of in-house professionals
- Conflicts of interest associated with GP restructurings, annex funds and continuation funds; valuation and what options were offered to the LPs
- Conflicts of interest associated with having investors in different layers of the same company’s capital structure
- Using affiliated service providers: fund should get market rates or better
Top tip: When the SEC issues exam priorities and risk alerts, CCOs should bring the whole firm into reviewing them, assessing their policies and procedures, and identifying business changes and risks. Most compliance problems come down to a lack of communication, either internally or externally to LPs.
Deal sourcing in today’s environment
Heightened geopolitical risk and sanctions activity are also contributing to greater regulatory focus on investments. In terms of due diligence, it’s no longer sufficient to “know your client”; you also have to know your portfolio companies. Sensitizing deal teams on the issues and risks is critical.
And on the topic of deals: don’t wait for them to be brought to you. In the current environment, there’s a lot of pressure to close, so PE managers have to be active and think thematically – as in, “where do we have expertise and advantage over others so we can get in early?” Firms must be ready to pay fair value, close promptly, and work harder than everyone else.
Top tip: Look at the resilience of a business over a cycle; don’t judge based solely on 2021 performance. Thanks to the global pandemic, 2021 was not a normal year and it must not be looked at as a baseline.
Private equity is seeing a flight to quality
This was the overarching theme of the day. Although fundraising and deal activity have slowed down overall, focus is on high-quality assets. The best managers are still competing for the best companies, while lower quality assets are receiving virtually no bids.
With this intensified competition, firms must be willing to pay market value and offer a transformative value creation plan.
The flight to quality is also giving rise to a couple of notable trends:
- Separately managed accounts – This approach enables managers to obtain a pool of capital from investors ahead of possible deals so they can then act quickly when a good deal comes along
- Use of secondaries and continuation vehicles – This allows managers to double down on their best companies and give new investors access
The only constant is change
In discussing the management of PE assets in today’s economic environment, CCMP’s Timothy Walsh aptly commented: “One of the great things about private equity is that change is what we do for a living.”
While you can certainly learn from prior downturns and recessions, it’s crucial to apply these learnings to the current world. Circumstances are always different and the successful PE players are those who act on this basis.
