David Solomon is the recipient of the 2016 Peter Hilton Founder’s Award
We’ve seen over the past five years a protracted influx of family offices and also direct investing and then also a lot of regulatory pressure on the private equity industry. From your perspective as an investment banker, how has this really changed and evolved the private equity landscape over the past, let’s call it, 5 to 15 years?
Family offices have become much more important in direct investing in private companies. This was an evolutionary process that started with family offices investing in alternatives (private companies) through private equity funds, either in fund-of-funds or directly as limited partners of specific funds.
Then, as they became more comfortable with the asset class, they realized there are some disconnects with their own objectives: First, fund structures stipulate an equity kicker, called ‘a promote, for the general partner who is the fund manager. However this promote is achieved only when they generate outsized returns beyond a preferred return to the limiteds. So the private equity fund has to produce outsized returns consistently by using high leverage and shooting for the moon with acquisitions and EBITDA growth, raising the risk profile. Whereas families are more into wealth preservation – they are happy to get a 10% or 15% yield and don’t have to go for that 20%, 25% IRR.
The second disconnect is that the private equity fee structure is expensive. For example, what starts out at 22% gross yield becomes 15% net yield, after a layer cake of fees. Therefore, as a result of both cost and risk profile, big family offices have begun to consider developing the team and sustaining the high overhead of doing direct investing.
However, the catalyst in the last 8 years has been the emergence of private equity professionals of great stature being hired into family offices. For example, you have Paul Carbone from Baird Capital being hired by Pritzker Group (J.B. and Tony Pritzker’s family private equity fund) and there are many other examples. Furthermore, there has been a key change in the private equity community in terms of top quartile funds growing larger and crowding out many lower quartile funds, which has released a lot of professional talent in the street.
What we’ve also seen in the private equity world is that there’s not a lot of room at the top of these funds. Some of the old timers continue to hold their outsized piece of the ownership of the fund and, therefore, young and upcoming professionals get frustrated and decide to do something on their own. They either start first time funds or join a family office with similar compensation to a traditional fund.
Therefore, we’ve seen these larger families like Pritzker, Crown, and Roberts (the list is extensive) which have moved decisively into direct investing. So what’s been the impact on M&A? M&A professionals including Lazard have started thinking about family offices as a separate buyer class which appeals to our seller clients. Families have a longer hold period, which is delightful for sellers and managers who remain with the business: managers don’t want to go through yet another sale process in three or four years. Families typically use less debt, and it is delightful not to deal with five- or six-times EBITDA in debt and accept a little lower yield. It’s still very smart money, still looking for great performance, but not the higher risk profile that you might see in a private equity leverage environment.
So our selling clients are telling us they would love to find a family office buyer. As a result we’re treating families as a separate category from private equity and we’re redoubling our efforts to make those connections when we sell a company.
In many cases with family offices, it seems the decision making is sort of rolled up to the patriarch or matriarch and that doesn’t always necessarily mean the same timeline in the auction process. There seems to be a bit of disconnect when working with a family office and their time horizon. So how do you look at that as a banker where your role is to really get that valuation maximized for your client? Is it having an impact on the way you’re bringing companies to market at Lazard?
At Lazard, our view of the middle market auction has changed significantly. In the 1990s, middle market auctions were a very mechanical process in which 200-300 buyers were contacted, a hundred books were distributed, and the banker would accumulate 25 indications of interest. This worked in the 90s because there was a broad community of generalist private equity groups who would bid on almost anything you put in front of them. The result was a broad distribution of valuations allowing the banker to select the top bidders with whom to engage.
We have evolved since then, becoming more targeted and efficient. Private equity valuations are tighter and it’s not as difficult to predict where a company should trade. Therefore, auctions can be more targeted. Also, the buyers are now more focused by sector, and we can reach out to fewer buyers because we know exactly who they are.
At Lazard we put a lot of effort into developing strategic buyers and family buyers. Strategic buyers are the slowest, and international strategic buyers even slower. We have a great network throughout all the major capitals around the world to access those buyers – our Tokyo office is a large group and the Japanese strategics are very active. Our offices in Beijing and Hong Kong have become very important with the increase in outbound investment from China. European interest in U.S. assets has also grown, and we have teams in every Western financial center.
However, our response to this global interest in U.S. companies and a broader set of non-traditional financial buyers has been to slow down the front end of the process and approach strategic and family offices early. This allows time early in the process for the senior leadership at the buyers to evaluate strategic fit long before we call the question on price. Years ago, we used to do price discovery early in the auction by sending out the book, getting indications of interest and then narrowing the field. However, that had many problems with it. If you call for pricing too early, you then force yourself to react to that price. If a buyer has only read the book and is low on value, you can’t then say “come on in, we’d like you to meet management and think about whether this is a good strategic fit” because they’re already on record at a price that’s too low. So now you’re pushing people out of the process even before they know what the company is and whether it’s an interesting fit. So now we’re often trying to get some early high-touch interaction with a focused group of buyers prior to the lock-step of an auction process and before we start talking about valuation.
In the context of what you are talking about in terms of new bankers and people entering the field to both focus on not just the technical skills but the relationship-building skills, I’d love to hear your reaction to that value proposition as it stands today and what that really means for associations like ACG and the importance of them looking forward in shaping some of these emerging leaders in the deal-making community.
I think the most interesting aspect of networking is how to connect the right people efficiently with a high level of relevance. In this age of Facebook and LinkedIn, ACG offers a people-to people network that can be of increasing value if certain changes can be made to adapt to this changing environment of social media. I would like to see more senior managers from operating companies and private equity where I could develop deeper, more substantive interconnections beyond a quick hello.
I need to consider where I spend my time, to have a good ROI on time invested. I would love to meet with the CEO of a business that could be relevant as a seller or buyer and talk in small groups about strategy and economic change as we’re talking about today. Those types of events are always very, very helpful. I think it’s that sharing of content with people who are relevant to you that will make ACG more powerful in the future.