In a recent Forbes article, Ronald J. Sylvestri, Jr. discussed the waning viability of the traditional private equity fund. As a possible alternative, he made mention of holding companies: “Private equity people are now looking to buy operating businesses and run them, and use the subsequent cash flows to buy other businesses.”
While Sylvestri’s suggestion — much akin to Buffett’s Berkshire Hathaway – is certainly worth consideration, there are significant hurdles to a wide-spread adoption of a holding model, especially in the middle market. Though a few select middle market investors may be able to make the transition, there are several fundamental requirements that many will be unable to meet.
One of the few investors to operate as a middle-market holding company is Markel Ventures, a wholly owned investment subsidiary of Markel Corporation (NYSE: MKL). Similar to Berkshire Hathaway or Teledyne, Markel Ventures is uniquely positioned to reinvest its insurance profits to acquire and help grow non-core businesses. Their model is based on a permanent capital, no debt approach, in which the investment is held for life.
Because of their rare arrangement, Bill Weirich, Managing Director of Markel Ventures, and Andrew Crowley, Manager of Markel Ventures, were able to speak to some of the fundamental issues a private equity firm would need to address before even contemplating a holding model.
1) The Need for a Large Permanent Capital Base
According to Weirich and Crowley, the biggest hurdle to establishing a permanent capital fund is finding the right investors. Crowley explained, “If you were to adopt a permanent capital model, you would need a capital base with a long-term outlook to get off the ground.” He continued, “Most LPs prefer good returns in the 5-7 year window, rather than potentially great returns in a 20-25 year window.”
While there may be means to assuage investor concerns — harkening back to the old days of conglomerates paying investors with dividends — Crowley does not believe LPs would be interested. “While it is theoretically possible for a traditional PE shop to adopt the model with dividend payouts, it would be very difficult to find investors who are patient enough.” He continued, “Most other middle market investors operate with a short-term focus, feeling the pressure to take fleeting money and provide their LPs with immediate returns when possible.”
While the immediate returns are appealing, the risks and costs associated with long-term investments can be significant hurdles for any LP to overcome, particularly if they are accustomed to the shorter time frame.
2) Patient and Diligent Investing
Even if an ex-PE shop were able to acquire patient, long-term investors, a behavioral shift would need to accompany the structural shift. To successfully adopt a permanent capital model, it would be necessary to disregard the existing 5-7 year time frame. By opportunistically selling, or trying to cash out too early, you miss out on the compounding of the asset — especially if you cannot immediately find a new investment. Instead, investments must be long-term exercises of patience and discipline.
Crowley explained, “Logistically, one of the biggest challenges to the model is the level of discipline and control required to realize long-term, compounded results.” He continued, “Many folks are tempted by easy returns and try to jump start the engine right away.”
“To realize the greatest benefits, it is important for us to be extremely patient and disciplined with our investments,” said Crowley. “If you are an opportunistic seller, or succumb to the appeals of a leveraged environment, permanent capital is probably not a system you should adopt.”
Markel Venture’s dedication to their model has been tested numerous times. “We will always receive offers for our companies, many of which would yield a remarkable short-term return,” says Weirich. Whether they made the right choice, only time will tell.
3) Avoidance of Fad Industries
If investments are expected to endure for decades, a re-evaluation of investment criteria would be required as well, most notably industries or companies that could have an expiration date.
Crowley explained, “…we avoid investing in industries subject to overnight evolution or fads. For example, Markel’s public company equity portfolio did not participate in the dot com bubble in the late 1990s and today we remain cautious of the technology sector. Such businesses are great investments for buyers with a unique angle and a shorter time horizon, but they do not fit our Markel Ventures long-term model.”
Crowley continued, making mention of health care and other carefully managed industries, “While we are not averse to participating in highly regulated industries, which can also be prone to major changes, we are very careful to participate in safer niches.” He added, “If one stroke of pen from Congress can wipe out our business, we will pass.”
The cautious model leaves some major industry gaps. If there were a shift towards holding companies, which firms would invest in the “fad” industries? Or what if a new business was not short-lived and faddish, but endured? Maybe the venture capital/private equity dynamic would shift along industry lines rather than seed stage.