Podcast transcript: Why PE must aspire to long-term value
15 min approx | 22 January 2021
I’m really pleased to welcome back to the show Andres Saenz, EY Global Private Equity Leader. Andres, thanks for joining me today.
Thanks for having me.
Now Andres, I know this is going to sound a little bit bizarre, but in honor of our first anniversary, I thought it was about time that we explain to our listeners what exactly NextWave Private Equity means.
NextWave Private Equity: NextWave, broadly, is EY’s point of view on where an industry is headed, in this case, private equity. And not just like where its headed next year or the next couple of years, but really, 3, 5, 10 years out, with a goal of understanding if that’s where the industry is headed, what needs to happen now to enable success in 5 years.
And I think for PE if you have megatrends, like demographics and technology and globalization, etc., but these specifically, it’s an industry that’s growing up. It’s still young, but it’s had great success, great growth; it’s gotten more sophisticated, and we think it’s really at an inflection point where it has matured and is entering a level where a lot of the things that were the challenges of the last 5 to 10 years are different than what they’re going to experience on a go-forward basis.
And this is in the context, by the way, of pretty significant growth that they’re still going to expect going forward. Preqin has a 15% KGR over the next five years in terms of AUM, so it’s a really interesting point in the industry’s maturation.
Why do we think that this is so important then to highlight as NextWave?
Because it forces the industry’s hand in terms of having to change and adapt. Within this context, individual private equity firms have to decide: how are we going to compete; how are we going to win; are we going to be broad vs. specialized; specialized based on what? Like, what’s our strategy?
And I think there are a few areas that have been in the top of the house conversation but just haven’t been that important, and I think now they’re going to become absolutely critical to success. Things like: what is your purpose and how transparent are you about that purpose, digital transformation, the importance of an innovative, diverse workforce.
I mean, I think those have been sort of part of the conversation, but I think as the industry matures, they take on an outsized importance in the industry having to figure it out.
I know many of our listeners have been wondering about our namesake, so this has been great to help clear it up and really set the scene. Now Andres, when you were on the show about, I think it was six months ago, you spoke about the trends that were accelerating in private equity. Now, would you mind just quickly revisiting these and perhaps sharing really briefly where you think these trends are currently standing?
The first one is ESG and purpose broadly. With COVID-19, I think there’s an increased recognition of the role of companies and the well-being of society. As PE has matured, the expectations on them, as well, have increased. And, in general, he has lagged larger corporations than this department and so really, really important for them now.
Secondly, related to some degree, but separately — talent. Again, if you look at COVID, the emphasis on workforce well-being, the issues around income equality, related issues around D&I and some of the events last year around Black Lives Matter, etc., there’s an increased focus on the talent agenda from the leaders all the way down to the full workforce. So there’s recruiting and training and engagement; but at the PE firm at the portfolio level, it’s become critically important in a way that maybe it wasn’t as much in years past.
And then the third one is digital. Go back to the year that we’ve had: COVID, not only the continued tech advances and the role of digital, but how you manage the fund, how you manage your workforce, how you think about origination and diligence and the portfolio — all these things are getting accelerated.
For today’s podcast though, I was thinking we could pivot our conversation to focus on two perhaps more aspirational topics: long-term value and its impact on shaping the sector, and, secondly, I’m going to call it the “art of possible.” So let’s start with long-term value; perhaps you can outline some of the basics. What’s driving the shift for PE to focus on long-term value?
You’re getting incentives and pressure from a lot of different places. First and foremost, the investors — the LPs. They’re absolutely demanding that the private equity firms track and communicate what they’re doing from a long-term value perspective — so, again, from not only the financial but customer set broadly and the societal value that they’re adding. So that’s obviously a critical one, but then you have other stakeholders — regulators: when you think about entrepreneurs and the importance of origination, when you think about recruiting and the importance of talent and people wanting to be associated with companies that are creating long-term value.
It’s as much, I think, about the industry’s ability to operate as it is about finding a way to compete and thrive by being able to articulate what you’re doing as a private equity firm, and why that matters, and why you should be connected to all these stakeholders.
And philosophically, it’s really a shift from the historical view of what we contribute to society because we are successful and that we give back to society: really to a much more holistically integrated philosophy that says we are successful because we create shared value with society.
It’s easy to say and we can comprehend it, but I think to actually embed this type of a long-term value strategy in organizations is tricky. And, I guess to make it trickier, whether you’re a corporate or a PE, there’s no one size fits all and everyone is grappling with how to implement it.
And everyone’s at different levels of maturity in their implementation. Having said that, based on what you are seeing in the marketplace, can you walk us through some of the typical stages that we’re seeing companies live through in their journey to long-term value?
If you start at the bare minimum, it’s compliance: to some degree, staying within the bounds of the law and the next stage, risk management more broadly, managing not only legal risks but broadly other risks, financial and nonfinancial. The spectrum starts to turn on the next stage where it’s more opportunity seeking.
And you say: well, there are opportunities for value creation related to long-term value and value creation that’s beyond sort of the financial one. And then you move from that into impact focus. You certainly have a lot of funds out there that have impact-specific funds or they may have certain investments that have that orientation, but you’re really now thinking of a world where there are superior returns based on an impact focus beyond just specific opportunities here and there. And I think, ultimately, the holy grail is long-term value.
By creating shared value, you measure meaningful ways of creating value across financial and nonfinancial metrics as part of your core strategy.
Obtaining this long-term value point is kind of utopia right? Because then you’re creating not only financial value but you’re also creating an intangible value where you’re giving back to society.
Where would you say most PE firms are right now?
They’re, to some degree, along the spectrum. I think a few of them are still in compliance mode. I think there’s more of them that have the ability to institute a risk management approach and the sort of protocols that are driven by LTV and ESG. I do think some of them are moving into opportunity seeking and trying to figure out ways of using a purpose transparency ESG in a way of sourcing better deals, creating value within the deal time frame, etc.
Many do have impact funds (certainly not widespread, but certainly the bigger funds do). I don’t think anyone is at the long-term value level, where it’s part and parcel with its core strategy, but I have seen, really over the last year, leaders at the top firms asking themselves the question: how are we going to incorporate this — how are we migrating in this direction? And I think it will take some time, but it’s been interesting to see them wrestle with the question.
What makes it even harder is that there is, as you said, there’s no magic long-term value formula that needs to be followed, and everyone’s evolving and thinking about how it applies to them and the values that they want to embed in their business differently.
In fact, you and I have been involved in a number of discussions recently with our private equity clients around D&I, around sustainability, and how they think about these questions, and how they bring them to life within their own organizations. I see that as the building blocks of their broader, long-term value agenda or strategy. Have you had other examples that you can share with us around how you’re seeing the long-term value strategy evolve within the PE complexes?
It’s been interesting how they translate these broader, existential questions and mission-driven questions to specific initiatives. We’ve seen people, for example in Europe, very focused on climate change regulations and what that means for their portfolio, what that means for even how they do diligence on a company, and how they think about that: institutionalizing a consistent approach, not just to minimize risk, but, really, to find opportunities.
On the D&I side, we’ve seen a whole host of different initiatives around recruiting and training of the employee base, and even thinking beyond just their specific footprint into their supply chains, and the D&I element of that, and how you monitor and report that all the way up to the portfolio company boards, and the influence that the private equity firm can have on that — so putting specific initiatives in place across some of these things that make it more tangible, but that absolutely start to move the private equity firms in this direction of having a more aligned set of goals, and being able to measure those and then, ideally, being able to communicate those to a broader stakeholder set.
And how high do you think the stakes are for those PE firms who don’t start buying into and building their long-term value strategy? Do you think they’ll pay a price?
Yes, I think it’s non-optional, and I think they recognize it on a couple different angles. One is the more, on its face, scary version of it, which is regulatory scrutiny that, in some ways, threatens PE’s license to operate. When we talk about the industry maturing, these firms are very large, they have a very large footprint, and regulators are going to care that these firms have the right set of incentives. Some of those are going to be financial, and some of those are going to be nonfinancial. So just with the industry’s ability to continue to operate, that becomes very important.
The other one is around the basis of competition going forward. Having a proper LTV strategy is going to be absolutely critical to how private equity firms compete across many dimensions:
- Competition for capital: as we talked about, LPs (which are private equity’s customers) are demanding a commitment to ESG and LTV and will allocate capital accordingly.
- Competition for deals: I think, more and more so, entrepreneurs want to be associated with firms that not only have capital and know-how but have aligned values; that may be the difference between being able to sign up a deal and losing it to some other private equity firm.
- Competition for talent: you see this across the talent pool, but I think it’s probably particularly pronounced with millennials and their desire to work at a place that is aligned with their core values.
And so it’s just simply not optional to not have an LTV strategy and just keep on their merry way, business as usual, because I think these issues are becoming critically important to all the stakeholders.
Completely agree, and how the executives and how PE complexes deal with these issues, and address them and build their long-term value strategy, is really going to shape the future of private equity and, in fact, will ultimately dictate what they stand for as an organization in the long term and, to your point, will be dictating how successful they’re going to be.