Under the private equity fundraising model, every few years fund managers secure capital commitments with a 10-year duration and charge management and advisory fees during the lock-up period. While longer-dated products have emerged over time, the basic pattern has remained essentially unchanged.
Unfortunately, fundraising is cyclical. Downturns require patience: Fund managers must wait until the green shoots of recovery appear before going back to market for a new vintage.
Clearing the Fundraising Hurdle
Economic slowdowns affect the credit supply, capital availability, and the health of portfolio assets. In the wake of the global financial crisis (GFC), even large firms like UK-based Terra Firma couldn’t close a fresh vintage, while others — BC Partners, for example — barely survived, maintaining their asset bases but never truly expanding again.
Global operators, too, struggled to get back on the growth path. Some, such as TPG and Providence Equity, had difficulty attracting fresh commitments and raised far less than they had for their pre-GFC vehicles. KKR took eight years to close a new flagship buyout fund, collecting $9 billion in 2014, barely half the $17.6 billion it had generated for its previous vintage.
While small fund managers were stuck with the legacy model, the largest players looked elsewhere for solutions. Vertical integration was one path forward: For example, Carlyle acquired fund of funds manager Alpinvest from pension funds APG and PGGM in 2011.
Warren Buffett’s Berkshire Hathaway offered PE firms a new template. Thanks to the float of its car insurance unit, GEICO, the company has permanent access to a perennial pool of capital. Apollo, Blackstone, and KKR, among others, all acquired insurance businesses over the past decade to harvest a similar fount of capital and leverage a perpetual source of fees.
Indecent Exposure
But there is a snag. Insurance is sensitive to random variables: Rampant inflation, for example, leads to higher claims costs and lower profits, especially for property-liability insurers. Sudden interest rate movements or, in the case of life insurers, unexpectedly high mortality rates (e.g., due to a pandemic) can have outsized effects on the bottom line.
The Financial Stability Board (FSB) in the United States suspended the global systemically important insurer (GSII) designation two years ago, acknowledging that the insurance industry, unlike its banking counterpart, does not present a systemic risk. But the macroeconomic backdrop is much harder to control than corporate matters and can hinder cash flows.
As such, the failure of an individual insurer might not have a domino effect, but it could be precipitated by a severe lack of liquidity. That outcome is more likely when the insurer is exposed to illiquid private markets. So, a sustained economic crisis could impede a PE-owned insurer’s ability to underwrite policies, issue annuities, or settle claims.
Insurers have a public mission to cover the health or property of their various policyholders. PE firms, on the other hand, have a primary fiduciary duty to institutional investors. Indeed, unlike private capital, the insurance industry is highly regulated with strict legal obligations. This has critical implications. For example, past customer service and corporate governance issues at life insurers Athene and Global Atlantic, today owned respectively by Apollo and KKR, resulted in heavy fines. Such incidents can expose private capital to public scrutiny and make the trade more unpredictable, especially when insurance activities account for much of the business. Last year, for instance, Athene represented 30% of Apollo’s revenue.
Alternatives Supermarkets
Another solution to the PE fundraising dilemma was asset diversification, a blueprint first implemented by commercial banks in the late 1990s and early 2000s.
Citi and the Royal Bank of Scotland (RBS) acquired or established capital market units and insurance activities to give clients a one-stop shop. Cross-selling has the dual advantage of making each account more profitable and increasing customer stickiness.
Blackstone, Apollo, Carlyle, and KKR (BACK) built similar platforms to help yield-seeking LP investors diversify across the alternative asset class. They now offer single-digit-yielding products like credit alongside riskier higher-return leverage buyout solutions as well as longer-dated but low-yielding infrastructure and real asset investments.
By raising funds for separate and independent asset classes, BACK firms shield themselves from a potential capital market shutdown. While debt markets suffered during the GFC, for example, infrastructure showed remarkable resilience.
Still, such innovations have drawbacks. “Universal” banks underperformed their smaller and more tightly managed rivals. Opportunistic deal-doing betrayed a lack of focus. For instance, RBS acquired used-car dealership Dixon Motors in 2002 despite little evidence of potential synergies. In addition, a pathological obsession with return on equity (ROE) failed to account for the declining quality of the underlying assets. Moreover, retail bankers frequently proved to be mediocre traders, M&A brokers, corporate lenders, and insurers.
Early indications suggest that multi-product platforms like BACK may not be able to produce the best results across the full spectrum of private markets. Carlyle’s mortgage-bond fund operations and its activities in Central Europe, Eastern Europe, and Africa as well as KKR’s European buyout unit all failed or struggled in the past, which demonstrates the challenge of monitoring and maintaining performance across the board while running a financial conglomerate. Murky product-bundling may further hamper returns at these world-straddling alternative asset supermarkets.
A Performance Conundrum
That diversification decreases risk while lowering expected returns is one of economic theory’s bedrock principles. Yet, in 2008, diversification at “universal” banks showed how risk can be mispriced when the performance correlation between products is underestimated. Risk can increase when all-out growth strategies are not accompanied by adequate checks and balances. The quasi-exclusive emphasis on capital accumulation and fee-related earnings by publicly listed alternative fund managers may come at the expense of future returns.
This is one lesson of Berkshire Hathaway’s business model that the new breed of PE firms may not recognize. Achieving unconditional access to a capital pool is one thing; putting that capital to work is quite another. The cash surplus from the insurance float — over $100 billion as of 30 June –has made it virtually impossible for Berkshire Hathaway to beat public benchmarks, especially when negative real interest rates encourage competition through unrestrained credit creation and asset inflation.
PE firms amassing funds to expand beyond their core competency will face similar headwinds. Perpetual capital has become the alt specialist’s most critical division. Blackstone’s grew 110% year-over-year (YoY) in the quarter ending 30 June to reach $356 billion, or 38% of its total asset pool, while Apollo’s $299 billion perpetual capital base climbed to 58% of assets under management (AUM). Blackstone sat on $170 billion of undrawn capital at the end of June, while Apollo had $50 billion to play with. That’s a lot of dry powder to put to work, which could only drag returns down.
A permanent and diversified capital base may soothe PE’s fundraising hunger pangs, but the associated insurance activities and multi-asset strategies could cause a full-on case of investment performance indigestion.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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