What drives your private equity returns?

And particularly, they may simply be looking in the wrong place and at the wrong indicators for returns drivers.

Much of this mismatch of mindsets, goes the thesis, can be traced to the evolution of private equity in the US, and how this has conditioned expectations in the – relatively young – industry as it evolved. Private equity in the US got its start in the 1980s by realigning the interests of management and shareholders, which had drifted out of line, but the industry really came into its own in the 1990s as the debt capacity of companies started to rise and rise. Asset prices consequently rose in step, but against a background of falling interest rates, levered assets appeared to perform strikingly well. For private equity investors, operational improvements such as cost cutting and increasing productivity tended to focus ultimately on increasing the investee’s debt capacity, which gave the best uptick to returns.

Attribution analysis, the thesis continues, indicates that most of the returns for Western private equity investment over the past two decades can be attributed to this “balance sheet game”. Is that a problem in itself? Not to the LPs, ultimately, who enjoyed the returns. And not so long as the prevailing debt and interest rate environment stays favorable – a big question post-GFC. But it can be a problem when investors leave that situation but not its expectations.

This entire opportunity set does not exist in Asia’s most attractive markets, China and India, and the region’s other developing economies. Here, LPs and market observers have often tasked GPs with hitching a free ride on growth. This is perhaps not fundamentally different from hitching a free ride on debt – if you believe that this is what many developed-market PE firms have done.

Asia’s growth-market GPs will of course seek to outperform their peers by maximizing the returns from growth. But how they look at investing will have to be different from the Western inherited models – driving the experience curve rather than cutting costs, expanding multiples rather than focusing on debt capacity, and indeed, leaving investees free to pursue growth unsaddled by debt burdens. But the PE input has to be about facilitating growth, not “the capital structure efficiency game.” Western LPs would do well to remember that argument as they diligence their Asian GPs.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Performance
• LPs
• Funds