Q&A: Hamilton Lane's Hartley Rogers

Q: With some private equity firms raising ever larger pools of capital, what does that tell us about the fundraising environment?

A: The global private equity market is much larger today than at any time in the past. It’s not just the amount of money being raised, but also the number of deals available in different sectors. Private equity has become a more important part of the global financial landscape. As the US economy and stock market capitalization continue to grow, large public companies like Apple, Google, and Facebook have come to represent a significant share of overall public equity market capitalization. Once you get below the top 50-100 companies, the rest of the public company universe is dramatically smaller – both in terms of the overall population of companies and their sizes. For investors who want to invest in small cap companies, private equity is becoming an attractive alternative to public markets investing since, by their very nature, PE-owned companies are generally not listed.

Furthermore, when you look at aggregate fundraising in private equity and compare it to the total size of the public capital markets, it’s still small – PE fundraising has averaged 1.6% of the MSCI world market capitalization over the past 11 years. Another concern that we often hear is that there is too much dry powder in private equity right now. Maybe, but if you divide the private equity dry powder by the current investment rate in the industry, the current dry powder would be used up in about three years. That’s in the normal range based on the history of the industry. It supports the point that the private equity business overall has grown, including the deal flow. There may be extra dry powder, but in terms of the capacity of the market to absorb that dry powder right now, it still looks okay.

Q: To what extent can parallels be drawn between now and the pre-global financial crisis (GFC) years, based on the amount of dry powder, valuation multiples, and leverage levels?

A: The business is much larger today in terms of the number of private equity firms and the number of deals. The fundraising level is about the same level as it was at the peak, but if you look at the capacity of the market to absorb the dry powder, we’re at a lower level today than we were pre-GFC. Valuations are high today. However, in terms of leverage, it doesn’t feel like the risk presented by leverage is so substantial because interests rates are much lower today than pre-GFC. Companies are not using as much of their cash flow to service their debts as they were before, and that means the equitization of private equity portfolio companies is higher than before.

Back in the early days of the private equity industry, companies had more debt in their capital structures relative to equity, so the return for private equity would largely be a large function of the leverage and paying down the debt. Today, that’s not what is really driving many sectors in which private equity is involved. It’s more about growth in EBITDA and earnings and operational improvements. Strong private equity firms should be able to drive this growth organically by finding ways to increase revenue, cut costs and manage companies more efficiently, or by building platforms and making add-on acquisitions of other companies. 

Q: What trends do you see in the amount of capital entering different asset classes? 

A: The key thing in the business today from the standpoint of a sophisticated client – whether they are an institution or a high-net-worth individual – is they don’t want to give all their money to one GP and concentrate the risk. What investors are looking for from us is an appropriate risk-return profile and it gets to a very interesting point because our business has really changed. If you go back 15-20 years, private equity investing was all about picking the best manager, that’s what all fund-of-funds did.

Today, it is one of multiple skills that must be mastered. Another major skill is portfolio construction. The private equity business has grown, to the point that “private markets” is a better term to describe it. LPs look at it as an illiquid sector – it’s hard to get out once they get in and they need to get an extra return to pay for that illiquidity. It’s true not only of buyouts, but of a whole range of different alternative asset classes including credit, real estate, infrastructure, and other real assets. There are many different sub-sectors of alternatives that for an LP to invest in, so the ability to use analytical tools and data to construct a portfolio with adequate overall risk and return parameters is very, very important.

Large GPs, which are also offering different products, are seeing the same thing – they know LPs are fine-tuning their portfolios and looking for diversification in alternatives. They want to keep these clients, so they want to show them not just the main fund they offer, but also real estate funds, credit funds or Asia-focused funds. 

Q: Given the increases in fund size among the larger pan-Asian PE players, is the fundraising pattern in Asia the same as the pattern globally?

A: We see that Asia follows a more global pattern. In terms of investment opportunities, Asia is maturing as a market, and it no longer has a pure emerging market label. When we look at different geographies, we have North America, Europe, Asia and then the rest of the world. Asia has its own place now because it is maturing and growing. Many fund managers here have credibility and long track records, and their teams include people from established firms. Our feeling is that Asia is getting more active, whether it is the significant venture capital investment in many parts of the region or the beginnings of increased buyout activity in Japan.

Q: How significant are Asian LPs becoming for managers based outside of Asia?

A: Very significant. Asia has very large sovereign wealth funds and pension funds. Asian investment in private equity globally has increased a lot since the GFC. In Japan, investors were very comfortable with hedge funds for a long time because they felt like they had no liquidity and no transparency in private equity. Today, Japanese LPs are realizing the value of private equity.

The GPs in Japan are growing and doing more deals. Private equity is becoming more legitimate as well. As Japanese institutions get more comfortable with that, they are increasing their allocations globally. Other Asian investors are getting increasingly sophisticated, there is a lot of learning about the asset class. They are doing a lot of portfolio construction, using firms like Hamilton Lane to build out of these portfolios for them.

Q: How will the industry develop globally, given many large LPs say they want to consolidate GP relationships and do more co-investments?

A: As the asset class has grown, global LPs are embracing the idea of portfolio construction rather than just a series of fund investments. In the old days, they might have invested in 30 funds through fund-of-funds. If each those 30 funds had 25 portfolio companies, the LP would wind up with 750 portfolio companies. As a result, LPs became over-diversified, which led to average or index-type returns.

Today, investors realize that there was too much diversification, and so, instead of investing in a large number of funds in each separate sub-asset class, they are looking for optimal portfolio construction. For example, if an LP wants exposure to US mid-market buyouts, it would know that the optimal size portfolio in that sub-asset class is something like 10-15 names, not 40 names. For some investors it might still be too high and they would be happy with only five.

When you look at portfolios that were built out over a long period of time, many had far more funds than the optimal amount. These investors would therefore rather concentrate their resources because they feel they already have enough diversification. If they focus on fewer funds, they would expect to be more important to those funds and get better access and information.  

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• Topics
• LPs
• Fundraising
• Asia
• Japan
• Hamilton Lane
• GPs