Modern private equity (PE) can trace its roots to the early years following WW2. The first PE funds were focused on venture capital providing startup capital to newly emerging companies with the eventual hope of taking them public through an initial public offering (IPO). Well-known names such as Apple, Fed Ex, and Genetech were initially funded by VC funds and led to successful IPOs during the 1980s. The PE industry later introduced leveraged buyout (LBO) funds with the development of the junk bond market. A famous LBO transaction in 1989 was the acquisition of RJR Nabisco by the buyout firm KKR. The PE industry suffered a setback during the tech bubble in the early 2000s but later recovered and continued growing and evolving. Today, the PE industry has a series of buyout funds, VC funds, mezzanine and credit funds, real estate PE funds, natural resources, and infrastructure funds. The PE industry, like its cousin in the hedge fund space, has been constantly developing new structures for institutional and retail clients around the world. Assets under management in the PE industry are estimated to be in excess of $3 trillion.
While many large and successful PE firms, such as Blackstone, Carlyle, and KKR have gone public and generated huge wealth windfalls for the owners, an increasing number industrial companies have been viewing the PE success with awe and envy. In fact, successful PE firms were often created by teams that were once employed at the very same industrial companies. Some companies even attempted to create internal PE funds but failed due to significant cultural differences and insurmountable conflicts of interest. However, those that were able to focus and develop internal PE funds were able to transform their companies. One such example is the Canadian company Brascan, which originally focused on electric power generation in Canada and Brazil. Today Brascan is Brookfield Asset Management and is a highly successful diversified alternative investment manager with $250 billion in assets and 70,000 employees in 30 countries.
The success of some of these industrial companies is a realization that they possess a competitive advantage over many traditional PE firms in managing projects in areas where they have historically been present. Not only would this operating expertise give companies an efficiency advantage but also significant credibility with investors interested in the field where they operate. In addition, internal PE funds would also give companies important additional sources of capital to further increase corporate profitability. Despite this potential, most industrial companies have not developed internal PE funds. One needs to ask why?
Large successful industrial companies typically have long histories of growth and development. In turn, this often creates inflexible corporate identities and rigid organizational structures. A new PE fund, by definition, must be innovative, flexible and nimble. Many companies may have problems with this. Let’s explore three main potential conflicts that may arise when an industrial company attempts to create an internal private equity fund within its organization. Internal conflicts of interest arising from the formation of an internal PE fund can be put into three broad categories: fund strategy, fund autonomy, and fund team. Let’s analyze each one.
Fund strategy is the investment focus that the PE team will follow for the benefit of the fund investors (the Limited Partners). But will the fund have to follow the strategy(ies) of the parent company? Will a fund with a parent company focused on electrical power generation be limited to only invest in power generation? Should the fund be able to decide an investment strategy to focus only on renewable clean energy while the parent pursues operations with natural gas and coal? While it would make sense for the fund to leverage the technical and operating expertise of the parent, the question remains. Who decides the fund’s investment strategy? In addition, should the fund invest in geographic areas where the parent is not present? The basic investment strategy decisions can be further complicated by large bureaucracies present in industrial corporations with little flexibility and strong cultural identities.
Fund autonomy follows from fund strategy. How much decision-making ability should the fund team have in approving investment decisions? Corporate oversight in the areas of environmental, social and governance (ESG), compliance, fiduciary responsibility, and finance are all important and being part of a corporate structure favors the adherence to established policies and procedures. However, should the fund team be able to approve investment decisions it views as in the interest of the fund investors, even if at odds with the parent company? For example, should the fund team have the autonomy to decide not to purchase a project from the parent that it is interested in selling to the fund? Who will make the decision and what valuation procedure would they follow? Should the fund team have the autonomy to decide to use a third-party valuation expert? What happens if the fund sees an opportunity to sell a project while the parent does not want that to happen? These are issues that can create internal tensions between to fund structure and the corporate parent.
Finally, there is the question of the fund team. Who will be in the fund’s investment management team? Should they be veterans of the company (internal hires) or should they be hired from the marketplace? What about the compensation schedules? Often, investment teams in PE funds get very attractive compensation packages, including a portion of the carried interest. Carried interest is generally 20% of the profits generated from the management of the PE fund after fund investors recover their initial investment. Limited Partners often want the fund team to get an important share of the carried interest as a means of securing an alignment of interests. That way, fund investors will know that the fund team will earn more if the fund is well managed and generates strong returns in the long run. However, this compensation structure is almost always at odds with the established corporate compensation policies and can create very important tensions within the company. Who decides what the right compensation schedule needs to be?
An internal private equity fund can be an important tool that can revolutionize and rejuvenate an industrial company. However, there are many potential conflicts of interest that can prevent the successful formation of a PE fund. Corporate management interested in this potentially transformative tool should be prepared to confront a series of potential conflicts of interest with an open mind to resolve and overcome these hurdles.
Eddie Deschapelles is an Adjunct Faculty member of the Karl F Ladegger Program in International Business Diplomacy at the Walsh School of Foreign Service in Georgetown University. He teaches an honors course on alternative investments covering hedge funds, private equity, real assets, commodities and structured products. He has had a 35 year career in asset management and investment banking, having held senior positions at BAML, Citigroup, Aspect Capital and the Permal Group where his responsibilities included product development, business development and business strategy. Eddie is currently creating an infrastructure private equity fund within a large industrial company. He graduated from Georgetown University with a BSFS degree, cum laude, and from Harvard University with an MBA degree