You can read about it all over the news: family offices are the new force in private markets, private equity fee-gouging is leading pension funds to reconsider allocations, deal-by-deal co-investing is surging, proprietary deal flow is on its deathbed, and on and on.
What is really going on here? The mega-trend in motion is the grand unbundling of the private equity fund model, transitioning from the committed capital 2 and 20 model to a more flexible deal-by-deal model.
Of course, a core group of top-tier committed capital private equity funds will continue to leverage their brands, their scale, and their performance records to preserve the current committed capital business model. The rest of the market will largely unbundle, with capital, deal sponsors, and deals connecting on a deal-by-deal basis. And with the unbundling, the 2 and 20 standard private equity fee economics will proliferate into a range of lower and less standardized fee structures.
There are three powerful and secular forces combining to create this perfect storm that is re-organizing private equity:
- Information abundance and transparency on private companies is reducing the deal-sourcing advantages of the incumbents
- Turnkey access to direct private capital is reducing the advantages of the committed capital PE fund over its deal by deal competitors
- Broad-based investor fatigue with the opacity and fee drag of the 2 and 20 model is leading to new fee structures
Let’s look at each of these forces and the flywheel that collectively has begun to spin.
Force #1 – Information abundance and transparency on private companies
Information availability on private companies is at an all-time high and is accelerating. Web-based services that capture private company hiring and employee data (LinkedIn), private company traffic data (ComScore), and private company transaction data (Pitchbook), along with online deal networks (Axial, CircleUp, AngelList), are leveling the deal sourcing playing field.
Access to this information isn’t predicated on a KKR or Goldman Sachs pedigree or budget, nor is it tied to being a member of the right golf clubs or some other velvet rope. This information is accessible to anyone with an internet connection and a few thousand bucks. This new abundance is enabling a new class of deal-by-deal equity sponsors to emerge, most frequently in the form of the “seasoned operators” or the “up and coming dealmakers,” who decide to leave their linear career paths and boot up their own private equity operation.
Force #2 – Turnkey access to direct private capital
There is a rapidly growing class of private company buyer, the “independent sponsor,” that does not have committed capital funds behind them. This has historically hamstrung them in winning deals as i-bankers and entrepreneurs have lacked confidence that they can actually fund the deal on closing day. This has changed with the arrival of online deal networks like Axial, where a mix of software tools and a private curated network of family offices, independent sponsors, and private equity firms connect easily and efficiently in real-time to source deals and co-investment capital to fund transactions. Examples of this in the American private equity middle market include White Wolf’s investment in Technicut, Gibson’s acquisition of IQ Logic, and Elm Creek’s acquisition of The Care Group. These transactions, wherein deals are sourced by independent sponsors and capital is subsequently sourced on-demand to fund those specific deals, give LPs the flexibility to pick and choose the deals they fund.
Force #3 – Broad-based investor “fee fatigue” with the private equity 2 and 20 model
The aforementioned technology-enabled trends are gathering steam against a backdrop of severe investor/LP fatigue with the blind pool structure and its famed 2 and 20 model.
Collectively, these three forces are bringing the world’s family offices out of the shadows, emboldening endowments to set up their own direct investment operations, and allowing a whole new class of operators and mid-career private equity professionals to establish their own deal-by-deal private equity outfits and skip the blind pool fundraising process altogether.
If this is true, what does it all mean?
Most importantly, this unbundling of private equity is a boon for America’s entrepreneurs. They will be empowered in unprecedented ways, enjoying access to lower costs of debt and equity capital and greater capital partner choices, whether for business expansion or an exit.
In this new landscape, investment bankers responsible for delivering great outcomes to their business owner clientele will need to develop new playbooks to stay on top of all the emerging capital sources — the proliferating family offices, the independent sponsors, the seasoned operator who’s now running his own private equity outfit. Those that do will deliver exceptional service and outcomes to their clients by reaching beyond the predictable strategic buyer and PE buyers when they take companies to market.
For private equity professionals, the availability of deal-by-deal capital will enable them to compete with committed capital incumbent GPs more effectively than ever. The source of competitive advantage for private equity professionals will shift to their industry expertise, their reputation as a partner to CEOs, and their ability to align their deal-sourcing efforts against their points of differentiation. Many mid-level private equity professionals will leave the nest between now and 2020 to chart their own private equity path.
This information-enabled transformation of private capital markets is very much in keeping with American ideals of competition, meritocracy, and free choice. While its arrival will shake out the marginal participants in America’s private equity and investment banking industries, these forces will create far more value than destruction by further cementing America (and not just Silicon Valley) as the best place on earth to take risk, strike out on your own, and be an entrepreneur.