The cover story in the most current issue of Business Week may shed some light on a potentially new era for private equity. (For purposes of this discussion, let’s think about private equity more broadly than just buyout financing and also include venture capital and other forms of deal-related institutional fund management in the mix.) In this profile piece about KKR and the buyout fund’s recent strategy, we begin to see an operating model take shape that increasingly crosses the line from pure private equity investing into merchant banking. And it makes perfect sense.
Of particular note among the private equity firm’s initiatives – some of these also described in a video interview with Henry Kravis in the online edition – is an in-house investment bank dedicated to capital raising for KKR backed companies, and a public KKR listing on the NYSE. According to Kravis, access to public capital is meant to enhance the partnership’s equity base with a level of “permanent” funding, which, taken together with a captive banking operation is indicative of KKR’s drive to increase the flexibility of its investment approach. Accordingly, the firm plans to be more accepting of minority rather than control positions, and to loosen its liquidity event time-horizons that are mainly dictated by a finite-term limited partnership structure.
The headline, maybe in order to attract the attention of a newsstand readership on “Main Street”, makes reference to Warren Buffett as the model which KKR now seeks to emulate; and perhaps there is some element of Buffett-style investing to what KKR seems intent to pursue. There is, however, a much more interesting capital markets (“Wall Street”) motif in KKR’s activities and goals, which has to do with efficient intermediation, expansion of funding options, and what could prove to become a new merchant banking model for a new era.
Before continuing with this thought, let’s first clear up a point that is often confused. The “principals” of a private equity firm are really not principals at all but, more precisely, “agents.” The capital that is invested by any such funds – private equity, venture capital, what have you – is raised from a variety of outside funding sources (limited partners) by whom the fund managers (general partners) are with greater or lesser latitude entrusted. For this trust and the associated service, the fund’s general partners are compensated with a management fee and a carried interest in the investment return – the equivalent of an agent’s retainer and commission. The main difference, in this sense, between, say, a VC and a placement agent, is one of relative control over investment capital: emphasis on relative is added because both agent and VC have selling to do, and the eventual compensation of each depends on the success of such selling. Some would argue that the nature of an agent’s transaction fee – paid from investment proceeds – is a further difference, but this view is deceptive and overly simplistic: The fund manager’s economics (and not only the equity carry but the management fee itself) also diminish transaction proceeds, if less directly or immediately.
Now, getting back to KKR and what this all means… As we consider the investment firm’s stated strategy in the context of the agency function described, we can see KKR’s access to public markets and its proprietary capital raising operation as means by which the firm is diversifying the resources for the investments it pursues, diminishing its reliance on any one. With an ability to tap into financing beyond the resources of its exclusive base of limited partners, the group can thus be more responsive to more opportunities more efficiently, and Henry Kravis’s discussion about a more flexible investment profile and horizon becomes much more meaningful.
By way of contrast, when it was widely rumored earlier this year that the limited partners of venture capital funds were asking managers to cease and desist from pursuing new deals, and when venture capital activity has accordingly fallen as if off a cliff, this tells us a lot – not only about the “principal” non-status of VCs, for example – but about the limited efficiency that such a fund model ultimately demonstrates.
And so, perhaps, there is a lesson from the venture capital experience of 2009 and KKR’s new strategy (which, not coincidentally, was taking shape at the same time): As Main Street (industry) and Wall Street (finance) both evolve, traditional capital markets structures must evolve accordingly. In certain sectors especially, (e.g., media and technology – segments particularly rapid in their evolution), the ability of capital sources to keep pace with immediate needs of investment targets takes on special importance. In such an environment, the rigid GP/LP structure of investment funds may prove to be a constraining and antiquated model… and the much more pertinent resource becomes industry expertise, flexibility, execution efficiency, and capital access, wherever this may be.
