Tereza Tykvová penned a paper, almost two years ago, entitled “How Do Investment Patterns of Independent and Captive Private Equity Funds Differ? Evidence from Germany”. It presents and discusses empirical evidence of performance differentiation between independent and captive funds (in Germany). A captive fund, according to Alt Assets, is:
A private equity firm that is tied to a larger organisation, typically a bank, insurance company or corporate.
There’s been a long-standing debate about the viability, attractiveness, performance and conflicts of captive funds. In theory, they’re setup like traditional private equity funds, but in practice, they lack theje ne sais quoi that gives private equity its mystique and appeal. It’s a similar argument to whether listed private equity defeats the purpose (and circumvents the value-add) of traditional private equity.
Anyway, Tykvová postulated and confirmed that independent funds perform better. In the broad strokes, his thesis is that the peculiarities of captive funds directly suppress performance. That is, the principal-agent problem is more at work than in a traditional fund. I’ve written previously about the principal-agent problem and specifically that private equity goes a long way to circumvent the problem. Well, captive funds go some way to undo the circumvention of the principal-agent problem because often the edicts from a captive fund’s parent (often a bank) conflict with the value-add of private equity. Rather than harp on about my biases either way, here’s a list of captive characteristics (as usual though, the list isn’t exhaustive):
- Capital flow: when a fund invests directly from the balance sheet of a large corporate, it doesn’t have all of the issues associated with raising a new fund. This is particularly attractive to private equity teams when capital is tight, like right now. Most of the time though, the parent will still require some external fund raising to complement its committed investment.
- Deal flow: if the parent is a bank, accounting firm, advisory firm, etc., then the team has access to deals from within the greater group. This can mean thousands of warm leads into businesses deemed fit by other departments within the greater group. At times, I would give my left… ummm… arm for access to potential investees like that.
- Carry: I’ve written previously about how private equity teams are precious about their carry and how various external parties can have a stake in the carry. Well, it’s not unusual for parents to take 5-10% of out-performance, meaning 25-50% of the total carry. Is that worth the additional capital and deal flow? Maybe in times like this, but it still tests the relationship. For the parent, this portion of the carry determines whether the private equity business group is profitable, so it is basically the fund’s life-line. Don’t deliver profits and you’ll have the board barking down the phone and analysts questioning your existence.
- Reporting: if there’s anything that goes against private equity, it is reporting on a regular short-term basis (often quarterly) to a manager, a board, or even worse, the public. Exposure to quarterly reporting conflicts directly with the theory of private equity; that is, building great global companies over a medium term. Public markets, public investors and the J-curve definitely don’t mix.
- Deal competition: this is a pro or a con; personally I see it as a pro. If your parent is a bank or advisory firm, then other banks and advisories won’t bring you deals, unless they’re of inferior quality. If I had to choose between having access to an intra-company database of thousands of potential investees and getting regular calls from pesky investment bankers, I wouldn’t exactly be torn.
- Interference: private equity teams love autonomy and flexibility; nothing’s going to kill the vibe more than a corporate dictator trying to flex his bureaucratic muscle. Captive funds often have to deal with an executive from the parent on their investment committee who can’t help but toe the company line. This can be a constant distraction. Other edicts from the top may include exiting investments at certain times to satisfy analysts and to bolster quarterly reports.
- People: private equity is as much an art as a science (cliché police?) and the art is based on people and culture. The private equity culture is the engine of the private equity machine; the flexibility, autonomy, creativity, diversity, energy and opacity make private equity what it is. You add some bad voodoo into the mix (read: bureaucratic bullshit) and all of a sudden you’ve upset the equilibrium. I see this as the biggest problem with captive funds.
Truth is, I don’t think captive funds can compete with independent funds. The empirical work supports this thesis, the industry trends support this thesis (captive fund numbers are on a downward spiral) and the anecdotes support this thesis.