For years, hedge funds have been turning to the private markets in search of alpha by launching hybrid funds and other vehicles. These vehicles have provided their investors with exposure to private equity (PE) and other private investments. Now that the public markets have taken a beating, having plunged more than 20% year to date, the search for alpha has become even more critical, not only for hedge funds but for all other investor types as well.
Private valuations are also tumbling, although there is more of a lag in the private markets than in the public markets. Recent analysis from Citco Waterfall found that the largest private equity firms are providing the highest returns to investors, with the average rate of carried interest paid to general partners increasing with size.
PE: a people business
Of course, PE managers’ track records play a significant role in investors’ selection process. However, the PE managers with the best track records share other important traits, which are often hidden from those outside the private equity industry. In a recent interview with ValueWalk, former Apollo partner Sachin Khajuria shares the traits all the best PE managers have in common. He founded family office Achilles and authored the book Two and Twenty: How the Masters of Private Equity Always Win.
Private equity is primarily a “people” business. With index and mutual funds investing in public securities, investors can watch fund performance in real time. Algorithms and machine-driven trading can partially drive this performance.
However, it’s different with PE. Khajuria explains that a relatively small number of people work to deploy capital per deal at private equity funds, including very large funds. He said three to five people often analyze whether each opportunity makes sense for the fund. he describes each decision as a “mini-project” involving an exchange of ideas and a debate about the deal.
“You’re relying on the judgment of those individuals to make decisions,” he explained. “Understanding what makes those people tick is important. The psychology of winning goes inside the mindset of these successful investors… There’s nothing automated about finding a target, talking to management, debating with colleagues. It’s a very people-driven business.”
The decision-makers at every private equity firm work with the management of the companies they invest in to make things happen. The discussions range from negotiating C-suite roles and compensation to discussing the company’s business plan. None of this work can be done by a computer because it relies on relationships in addition to numbers.
What to look for in a private equity manager
In conducting his research for his book, the former Apollo partner discovered that the most successful private equity managers shared several traits over and above being competent and trustworthy.
Looking beyond those factors, Sachin looks for PE managers with an ownership mindset, the mindset of being a principal, not an advisor. These PE managers structure their deals in such a way that they “eat what they cook” and act like engaged owners.
“Part of that is they have a great deal of flexibility to see how get things done, even if the world changes, Khajuria opines. “So maybe part of their investment thesis doesn’t work out because of macro changes or there was mistake in it. Maybe one part of the business performs better than another part. They should be in for the long term with the flexibility and the stamina, longevity and desire to get through the start with an ownership mentality.”
Risking it all to win big
“They need to be able to have the curiosity and stamina to run into a burning building, to go against the grain when necessary,” he added.
Khajuria also sees temperament as of paramount importance, especially when it comes to working on deals for a long time. He explained that even managers who act as engaged owners must have the flexibility to pivot if required.
“They also have the temperament for it, not getting too excitable one way or another,” he adds. “Keeping their head down, staying cool and focused on the prize. People who focus on temperament want to be at the end when it’s time to realize the gains.”
He said PE managers need to have the right team around them as well. Private equity teams do a lot of operational lifting while working with management teams. They aim to build the businesses they invest in and sometimes exit when those businesses list on a stock exchange, hopefully with a good return.
When PE sees opportunities the public markets don’t
Investing in private equity is far more complicated than buying an exchange-traded fund and holding it for 20 years. PE investors are typically very engaged and only sell to realize their return when their work is complete. On the other hand, public market investors trade in and out of positions constantly.
Chaos or dislocation can offer profits in disguise for private equity investors. He believes PE can outperform the public markets because PE investors see opportunities when others are running for the hills. He pointed to the repeated occurrences of this, like during the Great Financial Crisis, the tech bubble, the pandemic and now with what’s happening in Ukraine.
Khajuria states that it’s crucial for PE investors and fund managers to always respond instead of reacting. Further, he said no single formula works in private equity. PE investors are trying to reverse engineer their objective and reach a profitable exit point.
How likely is a recession?
Sachin believes private equity will benefit from the next recession just as it has in other economic downturns or market upheavals. He thinks the probability of a recession occurring soon is approximately one in three chances.
However, Khajuria believes that if a recession occurs, it probably won’t be like the brief COVID-induced recession that occurred in 2020. It was the shortest recession ever recorded, according to the National Bureau of Economic Research, the organization tasked with declaring whether a recession has occurred or is occurring.
Sachin points out that as inflation continues to drive up prices, he sees a significant chance of a recession, but while that could be bad news for the public markets, it might not be for private equity.
Why a recession could be good for PE
“It’s more likely to be an opportunity for private equity to buy well,” Khajuria said. “… The difference will be if a PE fund is relying on selling a lot of its assets in 2022 to demonstrate its credibility to raise funds. Now it will be tough to do such selling because valuations are challenging and because prices are lower, but, in general, I see opportunity for private equity.”
Khajuria believes private equity will lean into this year’s dislocation as PE managers did in the pandemic.
“They invested more money and found more opportunity because PE was the best game in town,” Khajuria says. “They started lending to companies that were struggling, and we’ll see that again.”
He added that the worst-case scenario would be a recession in which more companies need capital and take out loans or are bought out.
The importance of education
Khajuria wrote his book on what makes some private equity managers more successful than others because he wanted to educate investors and the general public about PE. He explained that people often think of private equity as esoteric and part of Wall Street, but it’s not. Private equity is very mainstream.
“I think greater awareness and interest in private equity, how it transforms industries, and what it means for workers in those businesses all starts with a basic understanding in clear, simple English,” he said. “… We need all the participants in this conversation. It shouldn’t just be for politicians or regulators on one hand or folks on Wall Street on the other.”
Private equity is getting bigger because of larger investments by pension funds, sovereign funds, and corporates like insurers. He believes the conversation needs to broaden and that awareness needs to increase as PE becomes responsible for more and more of society’s collective wealth. Additionally, retail investors are on the way to adding PE to their portfolios.
Why more awareness of PE is needed
“Sooner or later, if it doesn’t impact you already, it will,” Sachin declares. “It could be retail investor services or products you are offered at work. I think people don’t think about the industry enough or they think of it in a very narrow way.”
He recalled the 1980s when many investors viewed private equity as “barbarians at the gate.” Khajuria explained that this perception is quite narrow. In his view, it’s like comparing the latest iPhone to Motorola’s phones from the early 1990s.
Just as the iPhone allows users to do almost everything they can on a computer and more, he believes the private markets are “in nearly everything.” Sachin adds that many people’s perception of the private markets is a “one-trick pony,” but he hopes to raise awareness.
Michelle Jones contributed to this report.