Due to the impending investment of existing capital currently “sitting on the sidelines” and the subsequent necessity to replenish funds, the private equity industry will be significantly reshaped in the next two to three years, said Philip Canfield, ’96, principal at GTCR.
“Basically, everybody is going to have to raise money and there will not be enough money to go around,” Canfield said during the morning keynote at the 10th Annual Beecken Petty O’Keefe & Company Private Equity Conference, sponsored by the Polsky Center for Entrepreneurship and the student-led Private Equity Group, at the Westin Chicago River North on February 25.
This reshaping will occur as either a “muddling along” of existing firms raising less capital or a scenario in which winning firms emerge and differentiate themselves from the losers, who will “quietly disappear,” he said.
The case for “muddling along” argues that the S&P 500 rebounded strongly, firms have had some success raising funds, new sources of capital have appeared, and big firms are targeting less capital, Canfield said.
“All the firms could survive and just raise less capital,” he said. “Fund sizes would go down. There would be tremendous pressure on general partner organizations. In this scenario, it would be hard to differentiate among firms. Returns would probably rebound modestly.”
Under a scenario where the best firms are culled, returns would rebound to vintage levels of 1995–2005, but never return to the unrealistic levels of the 1980s, Canfield said. This case is more likely because, among other reasons, 45 percent of firms who have launched fundraising since 2008 have not hit their targets, he said.
“Limited partners are doing way more due diligence than ever before,” Canfield said. “There has already been pretty significant culling. The Deal Magazine has already issued a list of firms that it believes are ‘imperiled.’”
In the current environment, on the fundraising trail investors are looking for great returns, differentiated strategy, and a well-run organization, he said. In measuring returns, investors are extremely focused on evaluating drivers, Canfield said.
“They’re asking, ‘How did you get that revenue growth? What was it about your deal that allowed you to get that revenue growth? Is it replicable? Were you lucky, or was there something about your process, your strategy, your approach, or your organization that allowed you to consistently get that increase in cash flow? And how does that correlate to an increase in multiples?’” he said.
Differentiated strategy can occur by either sourcing deals through reliable brokers or by maintaining an advantage of some sort, Canfield said. “An edge or angle is something you bring to the deal that other people don’t,” he said. “You may have differentiated knowledge, such as industry expertise in technology. The other possible edge is differentiated performance, or the ability, after purchase, to do something with a company that is different from everybody else. Either way it’s pretty hard to differentiate yourself.”
In evaluating an organization, investors want to know if the most successful dealmakers are still working at the firm, how the investment process unfolds, how portfolios are managed and monitored, and which policies and procedures are in place for authorization, Canfield said.
“They want to know if everybody will have electronic access to the monitoring process,” he said. “Finally, thanks to [Bernie] Madoff, there is an incredible focus on the back office. We had investors spend an entire day with our finance and accounting team, wanting to understand the policies and procedures for everything. Now nothing is assumed.”