Advice for Private Equity’s Golden Age

This post originally appeared on RaudlineEtienne.com on Mar. 24, 2017.

A flood of new investors and new firms as well as record amounts of uninvested capital, or dry powder, are just a few reasons why today’s private equity sector is thriving. Both the number of firms in the industry and total assets under management are at historic highs, and according to Preqin’s 2016 Global Private Equity & Venture Capital Report, 94% of investors in private equity plan on committing at least the same amount of capital to private equity again next year.

Even amid these prosperous times, however, there are signs of disruption and challenges to the industry on the horizon, so private equity firms should take advantage of the favorable position they enjoy today to prepare themselves for future shakeups. In fact, the Boston Consulting Group (BCG) makes this argument in its recent report entitled Capitalizing on the New Golden Age in Private Equity, which asserts that private equity firms should turn operational playbooks inward, develop a true talent strategy, and upgrade their approach to value creation.

If firms want to remain on top of the private equity pyramid, then it is critical that they refine their market positions and competitive advantages. Private equity today is thriving but also crowded, so firms require stronger positions and unique advantages in order to attract new investors moving forward. In its report, BCG suggests that many firms can find these advantages through technology and new digital innovations. By digitizing certain operations, BCG posits that firms can increase efficiency and reduce costs, allowing them to invest and manage larger pools of assets–a clear competitive advantage.

Furthermore, with private equity enjoying a period of unprecedented growth and success, firms are in a position to develop new talent strategies. The hiring approach firms used prior to today’s golden age may not serve them as well in the new private equity environment where assets and investments are larger and where LPs are looking for greater flexibility, according to the BCG report. Today, teams with a wide range of experience–former executives, investment bankers, industry leaders, consultants, and individuals with digital skills experience–are particularly valuable.

Lastly, the report calls on firms to be more active in their approach to value creation. Simply trying to reduce costs and bolster revenues isn’t enough, and with disruption upending industries from retail to healthcare, funds can no longer be passively left to themselves. BCG instead recommends more interactions with teams of portfolio managers, digital-oriented strategies, focusing on freeing up working capital and other resources to facilitate turnarounds within underperforming portfolio companies, and more.

BCG’s full report is available here.

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Africa and Innovation

This post originally appeared on RaudlineEtienne.net on Mar. 24, 2017.

Home to 1.2 of the world’s seven billion people, Africa has long captured the imagination of both business and political leaders because of its massive growth potential. Until now, however, this growth has been more of a promise than reality, borne out by the fact that several of the world’s leading companies–including Coca Cola, Nestle, Barclays, and many others–have significantly scaled back or altogether withdrawn from doing business in Africa. But, according to a recent article in the Harvard Business Review written by Clayton M. Christensen, Efosa Ojomo, and Derek van Bever, new innovations may help bring the promise of Africa’s spectacular growth to fruition.

In most developing economies, investors and entrepreneurs chase after growing middle classes as the target market for their goods and services. Many leaders hoped that this would prove true in Africa and that the continent would provide a repeat of the Asian “tiger economies” of the late twentieth century, but as the authors point out, Africa’s middle class never really developed. As a result, large multinational corporations seeking to do business in Africa pinned their hopes on a demographic that simply wasn’t there, thus setting them up for inevitable losses. Aside from an anemic middle class, the authors also noted that corruption, skills shortages, and a lack of reliable infrastructure constituted other barriers to growth.

However, rather than wait for a middle class to arrive, business can succeed in Africa by looking to the needs of the “aspiring poor.” The idea that multinational corporations should practice an “inclusive capitalism” that focuses on aspiring poor communities in emerging markets rather than middle classes in established markets first appeared in C.K. Prahalad and Stuart Hart’s 2002 article, “The Fortune at the Bottom of the Pyramid.” Christensen, Ojomo, and van Bever invoke these ideas in their discussion of Africa to point out that business can focus on catering to the needs of the continent’s aspiring poor in order to create new markets instead of pursuing non-existent middle classes.

As a case study for this proposition, Christensen, Ojomo, and van Bever focus on Tolaram, an Indonesian conglomerate that operates in Nigeria and sells the wildly popular Indomie brand of instant noodles. Tolaram opted to market a product toward Nigeria’s aspiring poor through their line of low-cost noodles that are affordable, easy to make, and nutritious. In order to keep costs low, the company “internalizes the risks” of doing business in an emerging market, such as incorporating electricity and water production into its operations, buying a fleet of trucks to transport its product, and more. Today, Tolaram and its Indomie noodles are ubiquitous in Nigeria, indicating that foreign corporations can enjoy success in African markets if they introduce innovative, adaptable strategies for growth.

Of course, investment in Africa will not come without its share of costs and challenges. But as companies like Tolaram prove, for foreign entrepreneurs who are willing to focus their attention on Africa’s aspiring poor, growth and success on the continent are possible.

Impact Investing and Hedge Funds

This post originally appeared on RaudlineEtienne.com on Feb. 15, 2017.

No longer just a fad or passion project for certain members of the investment community, impact investing has become much more widespread and accepted by a wide range of investors, from wealthy individuals to corporations to institutional funds. In fact, the Global Impact Investing Network (GIIN) reported that impact investments accounted for $77.4 billion of assets under management in 2015; it also noted that private debt, private equity, and real estate held the largest percentage of these assets.

Despite the rapid growth and embrace of impact investments across the world of finance, however, they still have not gained traction among hedge funds, which held $3.2 trillion in assets under management in 2015.

Deloitte recently published a report entitled Impact Investing: A Sustainable Strategy for Hedge Funds. As the title suggests, the report outlines several factors influencing the impact investing landscape with respect to the participation of hedge funds, and it suggests that despite certain challenges, there are significant opportunities and considerable potential rewards for hedge funds that pursue impact investing.

The report points out that despite a high degree of public enthusiasm for impact investing, it remains a niche market among hedge funds; in fact, there is no existing hedge fund that is exclusively focused on impact investing. Deloitte sees this as an opportunity and mentions that the “lack of a clear hedge fund leader in impact investing suggests there may be open space for early movers to gain a competitive advantage.”

For hedge funds interested in obtaining such a competitive advantage, the report also presents a list of key considerations, including the need to standardize performance measures of impact investments, achieving comparable performance with other types of investment, maintaining fiduciary and oversight compliance, and more. While the report did take an objective look at impact investing, it did express enthusiasm as to how the trend will unfold in coming years.

“The global movement toward social finance and impact investing is becoming influential enough for hedge fund managers to thoughtfully consider their part in this next phase of evolution,” it said.

To access the full report, click here.

The Rise of Single-Family Offices

This post originally appeared on RaudlineEtienne.net on Feb. 14, 2017.

For the past several years, the rise of single-family offices has been one of the fastest-growing trends in asset management for the wealthy. According to Forbessingle-family offices are both growing in number and also in terms of how much wealth individual offices manage on behalf of their clients. There are several reasons behind this development: First, the ranks of the wealthy are expanding, which means there is simply more capital to manage, and these wealthy families enjoy the discretion, direct relationships, and personalized services that are possible through a single-family office.

“Single-family offices are very appealing because they can provide tight oversight of the professionals employed, and they often provide expanded access to business opportunities and economies of scale,” Richard Flynn, managing principal of the family office practice at Rothstein Kass PC, explained to Forbes. “Single-family offices can also be instrumental in ensuring confidentiality for the family.”

While there are some common characteristics to single-family offices, one of the advantages is that its organization and structure can be customized to meet the needs and interests of the family that it serves. This means that there are a wide range of options available at single-family offices, but at the same time, this makes it hard to define what constitutes a single-family office and how to count how many exist.

For professionals in the private equity sphere, Forbes also traces how single-family offices have been increasingly turning to private equity as well as hedge funds for recruitment in order to hire successful proven investors. Private equity professionals are often excited to join these offices, Forbes notes, because families are often more inclined to look at the long-term than other funds and because many single-family offices adopt participatory compensation models. Under such a compensation plan, wealth managers have a stake in the family’s overall portfolio or particular investments, which means they also get to enjoy in the success of the family’s investments.

“In our compensation studies, what we’ve found very interesting about the participatory compensation model is that while some investment professionals can earn many millions of dollars in a year others can earn nothing at all,” Usha Bhate, executive director of Institutional Investortold Forbes. “The participatory compensation model usually has a number of failsafe mechanisms built in. For example, payouts, while guaranteed, tend to be stretched over a number of years, ensuring the investment professionals are not taking undue risks.”

Exploring Behavioral Finance

This post originally appeared on RaudlineEtienne.com on Jan. 25, 2017.

Today, some funds are beginning to integrate psychological and neuroscientific knowledge with economics, creating a system known as behavioral finance.

While few would dispute the assertion that investors don’t always make rational decisions, most of us like to think that we’re better than that. Michael Ervolini, the co-founder of Boston-based Cabot Research—a firm that’s using the latest behavioral finance research to advise portfolio managers—says that’s exactly the type of problem behavioral finance can help solve.

“People may have a suspicion that they aren’t perfect, but they view behavioral tendencies as happening to someone else.”

One of Cabot’s clients, Principle Global Equities, has been rolling out a system to leverage market volatility using behavioral finance insights. According to Jeff Schwarte, a portfolio manager at Principle, “Volatility can be an entry point, but if a portfolio manager is worried about the next quarter, for instance, that volatility will make them question their investment savvy.”

This is only one example of the uses of behavioral finance, but it’s easy to see the promise of it. If investors can be made aware of their own biases and potential for irrational decision-making, poor and ill-considered choices could be made far less often.

Yet if behavioral finance is to make a significant impact in the investing and financial world, it needs to go beyond portfolio managers just trying to remind themselves to be more rational.

J.P. Morgan Asset Management has funds that are based entirely around behavioral finance insights, and one of their primary concerns is formalizing and institutionalizing the decision-making process. A good example they note is always recording the rationale for an investment choice, as well as the conditions under which it should be sold.

Another example, this one going back to Principle, is to ask “portfolio managers if they would buy an existing holding today.” Naturally, if they determine that they would not, they encouraged to quickly move the money elsewhere. This might seem like an obvious technique, but we know from psychology that we are disposed to a powerful bias for the status quo.

It’s doubtless too early to make sweeping pronouncements about the impact of behavioral finance on investing and the financial industry at large, but it is an interesting topic to speculate.

The Importance of Strategic Edge in Private Equity

This post originally appeared on RaudlineEtienne.net on Jan. 12, 2017.

The private equity (PE) asset class has prospered in recent years, but as Bain & Company notes in its 2016 Global Private Equity Report, this may not be the case for long. In light of decreasing GDP growth around the world as well as other factors, investors anticipate that the double-digit gains that have become familiar over the course of the last four years may become a thing of the past. In fact, Bain predicts that the industry will settle at a “new normal” marked by positive cash flows but returns that are less stellar than those of the recent past.

If these claims are true and the industry is about to return to a resting point, then PE firms need to devote renewed attention to strategy. Fund managers should develop ways that their firm can remain successful and competitive in the changing PE landscape, Bain argues, by emphasizing their ambitions and strengths to create a “repeatable model” for strong investment. And since it takes time to implement a successful strategy, PE firms need to start now.

According to Bain, PE strategy should begin with a firm’s stated ambitions or visions of future successes. The next layer of strategy is to develop concrete goals and action items that allow firms to realize their ambitions. Lastly, a firm should look to hire a talented team of professionals to put this strategy in motion. In the report, Bain suggests three areas where a firm can hone its strategic investments: taking advantage of its “investment sweet spot,” identifying thematic insights, and mobilizing talent and resources.

Bain also asserts that PE firms’ strategies should emphasize repeatable results. As the PE environment continues to change in response to new trends, such as a preference for larger firms by investors, strategies need to be able to adapt and ensure steady, consistent returns even as the market evolves. Firms will need to be able to communicate the repeatable nature of their strategy to potential investors, so in addition to being ambition-oriented and repeatable, PE firms’ strategies should also be easy to articulate to clients.

To read Bain’s full report, click here.

Should Private Equity Firms Integrate ESG?

This post originally appeared on RaudlineEtienne.net on Dec. 13, 2016.

A recent Forbes article explored the opportunities that private equity (PE) firms could take advantage of by integrating environmental, social, and governance issues (ESG integration).

Considering the ideal position of PE firms to improve the world around us, it’s certainly an interesting suggestion that the writer makes about the role PE firms can take in developing ESG initiatives within the firm’s portfolio.

To explain how ESG integration could benefit PE firms, Forbes presents a compelling outline of the many social and financial boosts that could potentially happen. And there’s other research that suggests a similar positive influence.

According to this report, the PE industry possesses huge assets, somewhere around $2.4 trillion. Because of the size of the industry, it indicates the stage is set for PE firms to take a huge leadership role in ESG integration. Another reason PE firms are in such a good position to improve ESG integration is the most recent holding period for those companies in a PE firm’s portfolio. The holding period of a company’s stocks for a PE firm in 2015 was 5.5 years, while on Wall Street, it’s a mere 8.3 months. That short time period is not nearly long enough for a company to properly conduct ESG integration because it’s necessary to have a longer period of time to see concrete results.

Another possible benefit for PE firms? These entities are not held to many of the same regulations as listed companies, so PE firms can more freely check up on a portfolio company to ensure it’s being properly managed. In the case of evaluating ESG integration, this could mean determining how much value the company is creating, which could in turn influence future investment decisions.

Notably, a recent survey cited that businesses say risk management is their largest reason to begin ESG integration. Some experts argue that integrating ESG values is a first step to mitigating risk and helping companies appeal to their shareholders and potential investors who need greater assurances.

European PE firms are also honing their focus on ESG investments. In the last month, Invest Europe–a trade association for European PE, venture capital, and investors–published a due diligence questionnaire for private equity firms interested in ESG so that the firms can better assess potential ESG investments. That questionnaire is available here.