The Economics of Buyouts

Prof. Michael: I believe scale economies will be particularly important. Roll-ups, efficiencies, and the professionalisation of small businesses  have shown strong potential in the US, and I expect these trends to become even more significant globally.

Mr. Soo Earn: For businesses in fragmented industries, roll-ups could present an excellent opportunity for growth and consolidation. Professor, you also mentioned family businesses earlier. In Asia, we are witnessing a significant wealth transition from the first generation of wealth creators to the next. Over the next 10 to 15 years, this is expected to be one of the largest transitions globally, especially in Asia and the Middle East.

Mr. Soo Earn: What advice would you give family business owners preparing for this transition, particularly those deciding between retaining the business or cashing out?

Prof. Michael: Managing wealth is very different from managing a business, and private equity can play an important role in this process. For example, I once taught a case about a restaurant chain in the US. The founder, in his 70s or 80s, had a strong vision for the business. A buyout fund acquired the company, improved its operations, and the founder was happy with the result.

Transitions can be challenging, especially if the next generation is not interested in running the business. In such cases, private equity can facilitate the transition by managing the business or helping to provide liquidity for those who prefer to exit. Each situation is unique, and planning is essential to ensure a smooth and effective transition.

Mr. Soo Earn: Succession planning is a significant challenge for this generation. Professor, what advice would you offer to business owners, particularly patriots or matriarchs, on approaching private equity when lacking a successor?

Prof. Michael: Well, if you’re a business owner without a successor and your business is viable and potentially attractive to private equity funds, here’s what I’d suggest.

What we may see more of in the future is funds being raised locally to invest within their own countries. This aligns with the fundamental purpose of buyouts: addressing financing needs for specific projects that require fund structures, which is true globally, regardless of political issues.

Private equity, as we know it, originated in the US, and for a long time, the US was the dominant market in terms of both capital and expertise. Many non-US funds were established by individuals with ties to US-based firms or MBAs from the US. However, this is changing. Now, you can get a world-class education in places like Singapore, and there’s sufficient expertise here to raise funds in local currencies and invest regionally.

This localisation trend is likely to grow. Private equity has become more accessible and less dependent on traditional centres like the US. Twenty years ago, only a few institutions taught private equity, but now, it’s part of the curriculum in universities worldwide. This has lowered barriers raising capital and starting funds outside the US, making the process much easier than it was 25 years ago. This is just my speculation, but the future of private equity seems to be heading towards more regionalisation and localisation.

Mr. Soo Earn: Regarding the sources of capital for private equity funds, particularly the role of limited partners (LPs), these have traditionally been pension funds and large insurance companies. However, smaller funds and family offices have emerged as LPs in recent years. Could you share your perspective on this shift, especially on how due diligence for LPs is handled and whether LP identities need to be disclosed to companies selling to private equity?

Prof. Michael: A few key points to consider. Firstly, the IPO market and deal activity have been quite slow recently due to factors like higher interest rates, inflation, and the after-effects of COVID-19. This slowdown in exits has impacted private equity funds because LPs typically rely on returns from these exits to reinvest in new funds. Many LPs cannot allocate fresh capital to private equity without these returns.

This has made it harder for fund managers to raise new capital, prompting them to seek alternative sources. Endowments, pension funds, and large institutional investors have historically been the primary capital providers. We’re seeing increased involvement from family offices, which have grown significantly due to substantial wealth creation in recent decades.

Another development is the entry of smaller investors into mega-funds like Blackstone, TPG, and KKR. Traditionally, these large funds required commitments of $50 to $100 million, which excluded all but the most prominent investors. To address this, they have introduced vehicles that allow smaller investors to participate. For example, they might allocate $100 million from the fund and break it into $50,000 increments, making it accessible to affluent, though not ultra-wealthy, individuals.

This innovation diversifies the LP base and enables mega-funds to grow even larger by tapping into smaller investors. It reflects the dynamic nature of the private capital market, constantly evolving to adapt to challenges and opportunities.

As for disclosure of LP identities to the companies being acquired, it’s typically not a requirement. However, private equity firms are diligent about knowing their LPs to comply with regulations and ensure alignment with their investment strategies. The focus is more on the firm’s ability to manage capital effectively than on the identities of individual LPs.

Mr. Soo Earn: What options are available for retail investors interested in participating in the private capital market?

Prof. Michael: Retail investors can participate through vehicles tied to mega funds or via smaller, community-based funds. For example, even in a city like Columbus, Ohio, which is much smaller than Singapore, funds are specialising in hotels, apartments, and venture investments. Some of these funds have lowered their minimum capital commitments to $100,000 or $200,000, which is more accessible for professionals with some accumulated wealth.

However, it’s important to understand the constraints. Once you invest, your money is tied up, and you lose direct control over it. Fund managers operate on their drawdown schedules, meaning you might receive a request to provide additional capital with little notice. Retail investors need to be prepared for these complexities while managing their portfolios.

Mr. Soo Earn: What about investing in listed private equity funds on stock exchanges, like those in the US or UK?

Prof. Michael: That’s an interesting development. For years, private equity firms emphasised the benefits of staying private, but some eventually went public to monetise stakes for their founders. Take Blackstone’s IPO, for example. It allowed Steve Schwarzman, the founder, to earn about $7 billion — essentially his share of Blackstone’s future profits.

Despite initial scepticism, public listing hasn’t hurt these firms' performance. They’ve continued to deliver strong returns, showing that being public hasn’t undermined their ability to generate value. Going public also provides retail investors a way to access private equity returns indirectly through public markets.

Audience member: I’m curious whether there are studies on how buyouts affect employees, particularly regarding employee value proposition?

Prof. Michael: Yes, there have been several studies on this. On average, employment tends to increase slightly following buyouts. Of course, this is just an average, and the effects can vary. Sometimes employment increases significantly, while in other cases, it can decrease, especially if the company sells off divisions or lays off workers.

The general aim of buyouts is to increase returns, sometimes leading to growth and job creation. However, in some instances, it can involve restructuring that reduces headcount. Increasing employment isn’t the most common result, but it tends to be the average outcome.

Also, many managers prefer working for private equity firms over public companies, as it can be more lucrative. Some workers may also prefer this, although others may not.

Mr. Soo Earn: I’d like to share an experience when I worked with one of the top five private equity firms on a buyout and privatisation of a listed company in Singapore. One of the biggest challenges during this process was change management. Ownership changes, and so does the way things are carried out.

A key process we implemented once the deal was approved was internal communication, especially regarding employee retention strategies. In a listed company, many employees have share options or performance shares, which needs to be converted during privatisation. Private equity firms often implement management equity participation schemes to incentivise and retain key personnel. Retaining these key people is crucial, especially when driving transformation and ensuring the business moves forward.

Audience member: Hi, Professor, you mentioned the traditional "two and twenty" fee structure—2% for management and 20% for performance. Do you think this fee structure needs to be adjusted to meet modern investment demands for fairness and transparency?

Prof. Michael: Well, the fee structure is quite transparent, right? Two and twenty is straightforward. It’s well-known among all participants in the transaction, though not necessarily public. One issue is that GPs (general partners) and LPs (limited partners) often don’t agree on fees. LPs want lower fees, while GPs wish to keep them high. There’s an old saying, "He who provides the gold sets the rules," and GPs usually try to maintain the two and twenty structure.

When the two and twenty model was created, it was for much smaller funds — back in the day, the largest fund in the world was $60 million. Now, funds are in the billions, so 2% of a $10 billion fund pays for a nice office, even in Singapore!

LPs have raised concerns, particularly about the management fee. They prefer that the compensation to come from carried interest rather than management fees. As a result, the typical fee structure has evolved. While people still say, “two and 20,” it’s a bit lower in many cases. For example, top venture funds often charge three and thirty. Sequoia Capital, for instance, probably charges that rate, and they could even get away with five and fifty because they are so successful. The fee structure is always a point of tension because it has a significant impact on returns. It’s transparent, but the debate over fairness continues.

Audience member: Professor, what are your views on private funds and the influence of environmental consciousness and investor activism? From the data you’ve shared regarding infrastructure and REITs, does this indicate that ESG considerations will increase the value of private fund investments?

Prof. Michael: Certainly, many investors, especially in Europe, care deeply about ESG. They avoid investments in oil and coal companies and prefer environmentally conscious businesses. I have some reservations about ESG, mainly why the Environmental, Social, and Governance (ESG) factors are grouped together. I often question whether investors care as much about the Governance aspect, though the Environmental side is certainly a major focus.

That said, investors care about ESG, and therefore, general partners (GPs) care about it too. I’ve heard GPs say they passed on potentially profitable investments, like an asphalt company because their LPs would have strongly opposed it. It does affect decisions, but only because LPs are driving this. A GP’s goal is to keep LPs happy because if you can keep them satisfied, they’ll invest in your next fund, which is how you succeed.