Saturday, January 28, 2006

What is the role of a 'philosophy' in private equity?

In looking at business, I have not seen the role of 'philosophy' more pronounced than in private equity. PE firms have have a view on investment opportunities - some rely on leverage, others on macro-economic drivers, still others on specific operational value-add - a view (mostly) sustained through the life of a fund. This contrasts with the usual corporation, which can (and must!) change focus, markets, sometimes even sectors to deliver returns to investors.

There may be a curious contrast here. PE investments (by LPs) are illiquid, and therefore non-diversifiable in a continuous, non-discrete sense. On the other hand, public markets are liquid, so investments in the public markets are truly diversifiable on a continuous basis. Yet, investors lock themselves into a philosophy.

The answer may lie in portfolio theory. A philosophy defines an "asset class" - a security with an expected IRR and risk profile. So, a firm with a unique philosophy gets the attention of LPs, and potentially offers financing for situations that other funds would not touch. Therefore, there are few "me too" funds left (many were formed in the late 90s). This is more true in mature markets (like the US), where efficient markets direct capital to the best deployment opportunities.
Finally, it's worth considering another indicator of how important a 'view' or philosophy is, seen in recent club deals. The Sunguard deal began with a group of investors, but some dropped out while others joined in as the bidding process continued. Clearly, for some firms, "in their view", Sunguard did not provide value at the price in question. As an LP, this is exactly what I hope for when I invest in funds A and B, so I know I am really getting two securities and not the same one. Thoughts?

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