Incremental changes in private equity market forces over time may have set the stage for profound evolution in the structure of the industry.

In the wake of the "Great Recession," several trends have become evident. Many smaller investors-high net-worth individuals and small family offices-are less inclined to lock up money in long-term "blind pool" partnership structures, in part due to recurring market volatility. But many larger family offices and institutional investors, while aggressively seeking PE, have a new interest in funding transactions on a deal-by-deal basis, retaining investment discretion and control over their overall exposure.

The rigid structure of a typical private equity fund does not support one-off transactions. As the private equity industry evolves to accommodate these investor preferences, more-efficient market mechanisms for matching capital with investment opportunities will develop.

A market-based scheme for underwriting private equity deals could be an attractive alternative to the current model.

In recent years, performance correlations between private equity and the public markets have been increasingly close, with recent numbers showing private equity actually underperforming the public markets, according to Bain & Co.'s 2014 Global Private Equity Report. Closer correlations make investors less tolerant of the inherent inflexibility and illiquidity of private equity. At the same time that correlations have increased, extreme volatility in the financial markets has made long-term, inflexible private equity commitments more problematic for many investors, because they limit the investors' ability to react quickly to dramatic changes in economic circumstances.

Compounding these trends is the reality that middle-market companies are now almost always sold in highly competitive processes.

The well-connected sponsor who could source truly proprietary deals is largely a thing of the past. Today, established sponsors just hope their industry networks can help them win ties. In a world where M&A investment bankers make sure that everyone sees and competes for every deal, PE firms can no longer argue credibly that they are providing unique access to deals.

This has set up an emerging trend by some institutional investors and family offices, who often have the same access to deal flow as established sponsors, to bypass committed funds and invest directly on a deal-by-deal basis.

Also breaking the traditional private equity mold are new, unregulated investment funds that tout their ability to underwrite the entire balance sheet, potentially making traditional assumptions about private equity funding obsolete. These are seismic shifts in the industry and could presage a new business paradigm.

In recent years, private equity has failed to outperform the public markets-not surprising, given the growth of PE assets. Assets under management in private equity are approximately five times what they were in 2000. As private equity has become a much larger percentage of the overall equity market, one expects to see higher correlations as the asset class increasingly becomes the market.

This has led to the perception by some investors that, notwithstanding long-term historical results, they may not be adequately compensated for the inherent disadvantages of the PE model in the future. Given the recent correlation statistics and the overabundance of private equity "dry powder" of approximately $1 trillion worldwide, these investors are justifiably concerned that private equity will underperform public equities. This critical reexamination of PE may be further exacerbated by recent volatility in the financial markets. In uncertain times, liquidity and flexibility become more important.

There are likely many investors who would value the ability to achieve targeted PE exposure without the illiquidity and long-term lockups of a traditional fund. However, only a small percentage of these investors have the capacity to manage a full-blown in-house PE effort.

Is there a way of providing these investors the ability to make discrete investment decisions on a deal-by-deal basis, see a large volume of deals, and leverage the experience, deal flow, investment acumen, and portfolio management expertise of quality sponsors? Can this be done in a way that frees sponsors from the need to fundraise constantly? A private equity marketplace may present a solution.

An underwritten PE marketplace could address these emerging investor demands efficiently. This same business model could free sponsors from the persistent distractions of fundraising, which often consume 40 percent or more of senior partner time, while giving them on-demand access to a reliable market for equity capital.

This approach is not new-it would rely on the same market-making activities that exist in the initial public offering market, the bank syndications market and the junk bond market. The envisioned model would involve an underwritten market for private equity capital in support of qualified sponsors on a deal-by-deal basis. The underwriter would, in effect, guarantee the required equity funding, in support of a sponsor, and syndicate the investment among institutional investors.

The key components of the private equity marketplace would be the:

1. Underwriter. Establishing an underwriting intermediary with the reputation, market presence and capital to speak credibly for a deal - essentially guaranteeing the equity funding - is central to the model. The underwriter would distribute the equity to syndicates of investors seeking exposure on a deal-by-deal basis. The underwriting process would parallel analogous processes for funding other elements of the capital structure.

2. Qualified sponsors. This model would not disintermediate private equity sponsors. Sponsors act on behalf of investors as owners and provide corporate governance services, including strategic planning, financial oversight, compliance and investor reporting. In the new paradigm, sponsors would continue to play their traditional roles. However, they would no longer need to raise money in long-term blind pools, but rather could capitalize transactions on a deal-by-deal basis through an organized clearinghouse, or marketplace.

3. Institutional investors: Underwriters would assemble flexible syndicates of institutional investors seeking private equity exposure outside the constraints of long-term, committed blind-pool structures. These investors would have a significantly better ability to manage their private equity exposures through changing economic circumstances. They would also be able to manage sector exposures more closely and protect against "style drift" on the part of sponsors.

Underwriters would benefit from being at the center of a high-margin underwriting business with tremendous proprietary information advantages and ancillary business opportunities.

It is hard to predict how the private equity industry will evolve in the face of changing market forces, but the marketplace model has the potential to transform private equity into a more attractive, efficient and flexible asset class with much broader appeal.


John Mueller is the founder and manager partner of Partners Private Equity, a Cleveland-based investment firm.

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