From buyouts to asset managers

Is it better to perfect one investment strategy and stick to it or carry your brand name into multiple areas and try to carve out a larger foothold? This question has long preoccupied the global private equity industry. For every Hellman & Friedman targeting a narrow range of industries or Cinven focusing on a particular geographical region, there is a Blackstone, Carlyle or KKR seemingly trying to do it all.

As the global buyout firms augment corporate private equity offerings with the likes of real estate and infrastructure, hedge funds, structured credit and fund-of-funds, their strategies are often defined as those of public traded entities seeking to please investors. There is an element of truth to this: Quarterly financial reports rely on stable and diversified cash flows rather than volatile carried interest payments.

Another explanation is that the traditional buyout model is no longer serves its purpose. "These organizations want growth and if a product no longer has potential then you look elsewhere," says Thomas Kubr, managing director and CEO of Capital Dynamics. "We have clearly tested the maximum size of buyouts in the last cycle."

Joe Bae, managing partner of KKR Asia, takes this a step further: buyouts no longer meet the needs of the market. "A buyout, or even a minority private equity investment, is not what every company needs in order to grow," he says. "To meet the needs of companies across the world and investors around the world, we needed a more diversified platform."

For example, a mid-market company in India, unable to a bank loan and uncomfortable at the prospect of handing over equity to third-party investors, might prefer a structured finance option. Or a US pension fund might want to back an Asia special situations vehicle rather than the standard pan-Asian buyout option.

Geographic considerations

Factor in the geographical as well as the asset class diversification being employed by the buyout firms and the role of emerging markets, driven by Asia, is writ large.

"As funds spread out from advanced industrial economies in which target companies looked largely the same from a financial analysis point of view, the risk profile has changed enormously," says David Patrick Eich, head of Kirkland & Ellis' global private equity practice in Asia. "That results in pressure to diversify. It can be hard to pool all of these interests in a way that makes sense."

KKR and TPG Capital are both preparing new $5 billion-plus pan-Asia funds, their first large-scale regional vehicles since before the global financial crisis, but in the interim both have launched dedicated China funds. The Carlyle Group, meanwhile, is the poster child of geographical diversification, having set up 11 funds across five categories in the region in the space of 12 years.

Bae explains that KKR's approach to Asia is grounded in the belief that there is no one-size-fits-all approach, given the wide variations in incomes and growth between different countries. A pan-Asian pool of capital is established and particular local strategies, involving everything from credit to infrastructure.

Few private equity players have the resources to pursue such a multifaceted approach and Eich sees a rough-hewn division among the global players into broad-service asset managers and sector or geographic specialists as a natural response to changing industry dynamics. He compares it to gradual emergence of a secondaries market in Asia - something that only happens once a certain stage of maturity in the private equity market is reached. "We've gone beyond the beta version," he says.

There is, of course, no guarantee that buyout firms' wider reach will prove sustainable in the long term. It's likely that approaches to different asset classes will be modified and perhaps even completely jettisoned much as Goldman Sachs reviews and revises its business lines.

Asked what the buyout firms might ultimately resemble - Fidelity, Goldman or Partners Group - one industry participant's response was "a bit like each of them but not like any of them." Business units that operate much like the listed mutual funds, with more of a retail angle, are not beyond the realm of possibility, however.

Effective development

It all depends on how effectively the development process is managed. Several industry participants contrast Carlyle and Blackstone in this respect. Blackstone is described as a veteran in asset class diversification that has established itself - often organically - as a leading player in areas such as real estate, hedge fund-of-funds and credit. Private equity only accounted for $65 million, or 15%, of net fee related earnings in 2010; real estate and hedge funds were the major contributors, with $147 million and $124 million, respectively, for a combined share of 61%.

Carlyle, meanwhile, is seen as relatively new to asset class diversification, having purchased asset manager Emerging Sovereign Group, credit hedge fund Claren Road Asset Management and fund-of-funds AlpInvest Partners within the last 18 months or so. Private equity was still responsible for about one third of fee related earnings as of June 2011. There is no reason why Carlyle can't redress the balance but a couple of LPs express disquiet with the hit-and-miss nature of its geographic diversification efforts.

On a general level, other obstacles remain. Capital Dynamics' Kubr is skeptical about the public ownership model in private equity, arguing that GPs will struggle to meet the expectations of both investors in the management unit and LPs in the funds. He is also unconvinced by the buyout firms' cross-selling ambitions, saying he has seen nothing to suggest that a US pension fund that is an existing investor in a buyout fund would look any more favorably on an infrastructure vehicle from the same GP. High net worth individuals and family offices are thought to be a better bet.

But most of this is forgotten if strategies are a success. "If you are able to get ¬the best people for a particular region or in a particular asset class and are able to deliver returns, that's all that matters," says one New York-based LP.

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• Apollo Global Management
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