Investment performance is evaluated based on risk-adjusted returns. However, as financial markets become more competitive, private capital fund managers have developed methods to reduce risk while maintaining or enhancing their returns.
These methods are categorized into two main parameters: controls and economics. So, how do these control mechanisms work?
Portfolio Oversight
Tightly monitoring portfolios to reduce investment risk is a key feature of private capital. Minority shareholders of publicly listed companies can only achieve this indirectly. Traditional asset managers have limited influence on public corporate executives. Often they have little recourse beyond nagging.
The largest asset managers — BlackRock, State Street, Vanguard, etc. — can still exert “soft power.” Their combined ownership stakes in listed corporations often exceed 10%, and their recommendations cannot be easily ignored by C-suite executives. However, concerns have been raised about the market power of these asset managers, which could potentially pose systemic risks or raise anti-trust issues.
Research by business school professors has shown that several US institutional investors hold stakes in leading public corporations operating in the same sector. In 2017, BlackRock, with over $5 trillion in assets under management (AUM), was the largest shareholder in 33 FTSE 100 firms and the largest shareholder in one-third of companies on the German DAX-30. Vanguard, with over $4 trillion in AUM at the time, also had significant holdings. Warren Buffett’s Berkshire Hathaway has also enjoyed significant market clout, as evidenced by its investments in four major US airlines simultaneously. Berkshire Hathaway would have preferred to avoid rivalry between competing airlines, as it would have negatively impacted investment returns.
From Nagging to Bullying
Not only do global asset managers invest in multiple businesses in the same sector, but they also often own shares in the same public companies. According to business school professors José Azar and Martin C. Schmalz, “Common ownership of competitors by a small number of investment funds has become a widespread and ubiquitous pattern in public equity markets of developed economies.” For example, Deutsche Börse and the London Stock Exchange shared two of their top-three investors, and Bayer and Monsanto shared five of their top six investors.
These patterns of common ownership can lead to reduced competition. However, less competition can be advantageous for investors. These practices have also emerged in private markets, particularly in the world of pre-IPO, late-stage venture funding. Companies owned by the same shareholders may prefer collaboration, especially if their mutual owners push for a merger.
The Tyranny of the Intermediary
Private market fund managers have a level of influence that public investors can only envy. Private equity (PE) and venture capital (VC) firms can directly intervene in businesses by sitting on corporate boards, wielding veto power over critical decisions, and utilizing anti-dilution mechanisms to protect their economic interests.
This level of influence explains why entrepreneurs often seek to regain control when taking their businesses public by obtaining supervoting rights and removing preferred stock held by VC backers. Recent events, such as Twitter’s management efforts to prevent Elon Musk’s hostile takeover bid, demonstrate that executives at public corporations may act in ways contrary to shareholders’ interests, actions that would not be allowed under PE or VC ownership.
In theory, robust monitoring rights can reduce the risk of corporate misbehavior and fraud. However, recent scandals at companies like Theranos and SoftBank-backed Greensill show that investors in young enterprises cannot solely rely on trust in the exercise of due diligence.
Access to Deal Flow
Sourcing a quality deal flow through proprietary deal origination is another control technique used to mitigate investment risk and improve returns. Top-performing venture capital firms, for example, have privileged connections in key tech hubs where the most promising start-ups are located. These firms know the importance of attracting quality investors to maximize their chances of success.
Increased capital influx in recent decades has intensified deal competition, which, in turn, can hinder normal market activity. At the larger end of the deal spectrum, the differentiating factor often becomes the price tag bidders are willing to pay. This can lead to bid rigging, reducing the risk of overpaying and contributing to better performance. Collusion among major buyout firms during the credit bubble of 2002 to 2007, for instance, led to tampering with deal auctions.
Access to Capital
Fund managers must raise funds to leverage deal flow, whether proprietary or otherwise. Assembling a large pool of capital is a visible measure of success in asset management. Leading institutions like BlackRock and Vanguard have gained recognition due to their large asset bases. This has allowed firms like Blackstone, Ares, and Sequoia to become prominent players in the private equity (PE), private debt (PD), and venture capital (VC) segments. However, the pursuit of scale has sparked a cutthroat competition for capital that threatens to exceed supply. Many private capital firms target the same institutional investors such as banks, insurance companies, endowment funds, and family offices.
Accusations of bribery in diverting capital allocations have been leveled against well-known alternative managers in the aftermath of the global financial crisis. Investigations in locations like New York and California have shed light on widespread “pay-to-play” schemes aimed at attracting commitments from pension funds.
Once funds are secured for a long-term horizon, fund managers have full discretion in their investment decisions. Capital providers give alternative investment firms significant leeway within the confines of limited partnership agreements.
Private market investments have an advantage over public investments during economic downturns. Public investment groups typically face redemption notices from investors, whereas private capital firms do not have to return any of their clients’ commitments and can hold onto them until the market correction has passed.
While this lack of liquidity can be a headache for limited partner (LP) investors, it is an advantage for fund managers. High switching costs increase customer stickiness and the visibility of fee income.
Frustrating Creditors
Creditors pose a challenge to private equity (PE) firms’ absolute control over their trades, especially when portfolio businesses face distress. Over the years, buyout fund managers have developed techniques to frustrate creditors’ attempts to take over troubled assets, disregarding contractual obligations. Some techniques are legal, such as the use of covenant-light instruments. Others are more questionable, like stripping portfolio companies of their best assets to retain partial control. These actions can lead to legal disputes and lawsuits against PE groups.
In a market flooded with cheap credit, lenders have been unable to effectively counter these strategies. Whatever rights they manage to defend tend to be minimal. For instance, during the COVID-19 pandemic, new clauses were added to covenant-lite contracts, providing limited ways for lenders to check a borrower’s solvency.
Retaining ownership of a portfolio company in the face of hostile creditors allows PE firms to continue earning management commissions and advisory fees related to restructuring the asset.
Limited Information Disclosure
Efficient markets require timely and accurate information, as well as transparency in transactions. While public equity and bond exchanges meet these criteria, private markets do not. Private capital firms have control over the dissemination of data about their portfolio assets. When public companies are taken off stock exchanges, they are said to “go dark.” Looser reporting requirements in private markets explain why asset managers like BlackRock and State Street are building private capital divisions. They aim to achieve better oversight of their asset portfolios and disintermediate private equity (PE) and venture capital (VC) firms, thereby reducing excessive fee expenses.
In private markets, the lack of transparency and liquidity, along with sustained access to fresh capital and deal opportunities, play essential roles as control mechanisms. However, restraining portfolio executives, institutional investors, and lenders is only part of the wealth-maximization story.
Although alternative fund managers have good intentions, they cannot guarantee positive investment outcomes. Part 2 will explore how they have identified levers to protect their economic interests, regardless of their clients’ interests.
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All posts reflect the opinion of the author and do not constitute investment advice. The opinions expressed in this article do not necessarily reflect the views of pankajsihag.com or the author’s employer.
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