The Year of ‘Re’

Across private capital markets, the key trends of 2011 will have been informed by an intense rethinking of the investment norms forged during the prior decade.

Let’s not get into a debate about when the current decade began. Whether January 1, 2010 felt more like the start of the new decade than did last Saturday is less important than the feeling that we are closer to creation than to destruction.

I would argue that the whole of 2009 and 2010 was an era unto itself, during which investors stumbled around in the dark, tried to stay warm by burning the furniture and did inventive things with the detritus of the prior dispensation to stay sharp.

The stumbling and scrambling seems to have taken on some rhythm here at the beginning of 2011, and this has been aided by enhanced visibility in the mergers and acquisitions and capital-raising markets. To turn a Bob Dylan lyric positively on its ear, it’s not light yet, but it’s gettin’ there.

The next year will see the reemergence of a private capital investment market that is refashioned by mistakes made in the past and repurposed for the enormous opportunity that lies ahead. In fact, across private equity, venture capital, real estate, infrastructure, real assets, secondaries, distressed assets and other long-term illiquid strategies, there will be heavy usage of words that start with “re”in describing the differences from the prior cycle. Some of my predictions are below:

Strategies redefined: It has always been difficult to neatly segregate the different types of private investment strategies. But just when the private investment market thought it understood roughly what terms like “buyouts,” “value-added real estate” and “distressed” meant, an economic earthquake caused these strategy buckets to slosh all over the floor. Institutional investors are now seeking better ways to understand, define and manage their large portfolios of private partnerships, and the old labels will not do. The California Public Employees’ Retirement System (CalPERS), for example, has thrown its private equity allocation into a “growth” category along with public equities, arguing that these two classes of securities actually have similar risk characteristics that should be jointly monitored. CalPERS’ infrastructure and real estate assets will go in a “real” group, and commodity-linked assets will go under “inflation.” Even within the traditional parameters of “alternative assets,” the lines between strategies are blurring. For a number of reasons, buyout firms are finding excuses to put one foot in the “growth” bucket. Not only has leverage been lacking lately, but many of the most exciting investment opportunities are companies with disruptive business models and technologies in need of big dollops of straight equity. In real estate, firms that once proudly called themselves “opportunity” investors, at the riskiest end of the risk/return spectrum, are now crazy for “core,” proclaiming this supposedly safer strategy to be the hot new opportunity. Investors will need to look through these labels into the underlying assets and the investment managers who claim to know how to extract value from them.

Resources redeployed: I have long observed that it is hard to kill a bad private equity firm, or any other firm that manages long-term, illiquid funds. Before it is clear that a firm has no talent for investment, the next fund has already been raised. Today, however, the demand side of the private investment market has undergone a sea change, and the limited partners are eager to fall out of love with as many general partners as possible in an effort to concentrate capital with only the best managers. Because of this, many firms are going to experience franchise atrophy. This will play out over several more years thanks to fund extensions and other delay tactics. But this slow-motion shakeout will be very good for the private funds industry, allowing capital to be redeployed into more deserving franchises and freeing up ambitious talent to move to new firms or launch innovative investment management franchises of their own.

Business revolutionized: The first big private investment story of 2011 was Goldman Sachs’s $450 million investment in Facebook. Expect more deals like this throughout the year. Firms will be attracted to opportunities like Facebook (and Groupon) in part because they have revolutionized their respective industries, and in part because they require nice, big equity checks. The largest venture capital firms have always sought out such companies, but firms that in the prior decade focused on leveraging up traditional companies will now be more inclined to invest in companies that could eat the lunch of traditional companies. These bets will be seen in alternative energy, media, finance, education, health care and anywhere else a slug of equity might help push the new, new thing past a tipping point.

Fundamentals returned to: After the capitulation of Bear Stearns, but before the true extent of the financial mess had manifested itself, Stephen Schwarzman, CEO of The Blackstone Group, succinctly described the spreading woe as “American SARS.” And yet as the epidemic continues to morph, it has been striking to see how the original “hot zone” has become the number one focus of investment, especially for non-U.S. institutions. These investors are interested in returning to the fundamental, underlying assets that will be essential once the American economy is humming again. Particularly hot is U.S. commercial real estate in “24-hour cities,” like New York and Washington. There is also an eagerness to own U.S. infrastructure, as evidenced, for example, by South Korea’s National Pension Service joining Kohlberg Kravis Roberts to purchase a stake in Colonial Pipeline, which pipes refined petroleum from the Gulf of Mexico to New Jersey. The outlook that these non-U.S. investors have for the U.S. economy dovetails with that of Warren Buffett, whose company, Berkshire Hathaway, made what he called an “all-in wager on the economic future of the United States” through a $26 billion investment in a railroad. Investment managers that present attractive ways for investors to return to basic assets like railroads and core real estate will win big in 2011.

‘Emerging’ reconsidered: It is hard to know to what extent semantics have played a role in preventing Western investment institutions from fully exploring opportunities in the so-called BRICs. But if anyone has been hesitant to have a good look at “emerging” markets, they should know that the man who has done the most to make them famous in recent years believes the term is bunk. Not only does Goldman Sachs’ Jim O’Neill believe Brazil, Russia, India and China should be labeled “growth markets” instead of “emerging markets,” he would now like to add South Korea, Turkey, Mexico and Indonesia to the grouping. Throughout 2011, news of deals, fund formations and exits in these eight markets will reconfirm the findings of a growing number of Western institutions, which is that the failure to allocate to these markets is a failure diligently seek growth. The inevitable sad stories out of these markets will confirm something institutional investors already know, which is that you need to expend tremendous energy picking good managers in any market or your capital will become submerged.

Allocations replicated: Nearly everyone ended up looking and feeling bad in the wake of the Great Recession, and while the private investment world was no exception, it would appear that as a mode of investment, private investment partnerships did not look as bad as the others. Investors were disappointed with specific investments and manager decisions, but looking ahead, most of them want even more “alternatives,” defined broadly. This means that in the United States, which has the longest history of institutional investment in alternatives, most allocations will hold steady (although there will be a redefinition of the strategy buckets, as described above). But throughout 2011, enthusiasm for private capital investing will be seen most startlingly in the huge population of non-U.S. investing institutions that are beginning to unveil ambitious new allocation goals. Across East Asia, the Middle East and even Latin America, sovereign wealth funds, retirement systems and insurance companies are being given the fiduciary and regulatory go-ahead to allocate significant percentages to private equity, real estate, infrastructure and similar private, illiquid strategies. These allocations are based on careful studies of the way that alternatives have performed for Western institutions over the years. Investors new to these asset classes want a more investor-friendly form of participation in private partnerships, but they are impressed with the effect that alternatives have generally had on overall portfolio performance.

Interests realigned: It is generally agreed that long-term private partnerships can be the most powerful way to make bets on the future. There is less agreement on the exact terms and conditions of these partnerships, but these details are now being debated. Investors looking back at their participation in alternative investment funds during the 1990s and 2000s believe that in too many cases, they allowed investment managers to effectively enjoy all the upside and feel no pain on the downside. There is today a massive focus on alignment of interests between general and limited partners, and this is coming in the form of lower and more appropriate fees and greater general partner “skin in the game.” There has also been a huge focus on investors “doing it for themselves” through direct investment in assets. This is rarely done without the sponsorship of an investment manager with which investors already have a relationship, and so a key theme of 2011 will be not only getting right the terms of traditional limited partnerships but also fine-tuning the economics and controls around co-investment opportunities. This second challenge is going to be harder than many investors realize. Take note of the experience of the South Carolina Retirement Systems, which launched a direct investment initiative only to shelve it late last year, once the political and financial complexities of such an undertaking became clearer. That said, institutional investors in Canada, Singapore, China, Abu Dhabi and elsewhere are becoming heavy hitters in direct private capital deals, and it is unlikely that these groups will soon revert to being “just another limited partner.”

Attractiveness recapitulated: The world has changed, and as a result, investors are re-examining everything in their portfolios. When not pulling their hair out over stocks and bonds, the largest investors are coming across huge portfolios of private partnerships and rightly asking, “Are these good or evil?” It is easy for veterans of private equity, real estate and the like to forget that even the most sophisticated fiduciaries need frequent refresher courses in the strange behavior of long-term private partnerships and their potential benefits and hazards. These reviews need to be done in compelling, non-cheesy ways, devoid of marketing pablum and filled with facts that help investment boards understand not only their alternative allocations, but also the exposures of their broader portfolio. In 2011, there will be a lot of ‘splaining to do, and those general partners who fail to do so risk being ignored the next time they need to raise capital.