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ECONOMIC OUTLOOK Longer Duration Funds: The Next Step in Private Markets’ Evolution

MAY 2018

THE CARLYLE GROUP | 1001 PENNSYLVANIA AVENUE, NW | WASHINGTON, DC 20004-2505 | 202-729-5626 | WWW.CARLYLE.COM

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Longer Duration Funds: The Next Step in Private Markets’ EvolutionBy Jason M. Thomas and Peter Cornelius

Not long ago, when a company with a market value in excess of $500 million needed capital to scale operations, it had virtually no choice but to pursue an initial public of-fering (IPO). Management teams would go on road shows with their investment banks to visit prospective investors, research analysts would learn about the company and its future prospects, and the resulting demand for shares would determine the quantum of capital the company could secure to invest in its future or provide liquidity to existing owners.

Today, a public listing is no longer an inevitable stage of a growing company’s lifecycle. IPOs still occur, but their fre-quency has declined steadily over the past twenty years as companies turn increasingly to private markets for capital. The growth of private equity funds, increase in familiarity with, and efficiency of, private transactions, and rising fric-tional costs associated with public listings have combined to make private equity ownership one of the preferred organi-zational forms for a large and growing share of businesses across the U.S. and global economies.1

Unfortunately, the private market’s development in terms of depth, breadth, and pricing efficiency has not been matched across an equally important dimension: duration. There are more funds and larger funds, but their contractual life has remained the same. As a consequence, private equity funds can accommodate most businesses’ capital and liquidity needs but only for a three-to-six-year investment period. At that point, investors expect to be repaid (hopefully at a price that compensates them for their cost of capital). If an IPO is no more attractive to the company’s residual owners and management at the end of the holding period than it was at its beginning, the process repeats itself, with a new source of private capital replacing the old.

The next step in the private market’s evolution should be the widespread adoption of longer-duration private equity funds. For a large share of businesses, three-to-six years of private equity ownership may be the optimal time for the company to expand its geographic footprint, enter new markets, reorient its strategic direction, or consolidate oper-ations. Likewise, a three-year effective duration—a five-year average holding period with interim cash flows—may be precisely the cash flow profile sought by a large share of private equity investors (limited partners or LPs). However, longer-duration private equity funds are badly needed to provide more permanent homes for the large and growing share of businesses that would prefer to remain private.2 Such funds would also allow institutional investors with longer investment horizons to fund companies with lon-ger-term value creation plans, reduce reinvestment risk,

1 “The Fuel Powering Corporate America: $2.4 Trillion in Private Fundraising,” April 3, 2018, Wall Street Journal 2 “Where Have All the Public Companies Gone?,” November 16, 2017, Wall Street Journal

better match assets to liabilities, and potentially benefit from longer-term compounding of invested capital.

The Decline in Public Companies and OfferingsOver the past 20 years, the number of public companies in the U.S. has declined by half, with similar declines observed in other economies (Table 1). The Wilshire 5000 broad U.S. stock market index has not had 5,000 constituents in over a decade and only 3,458 companies currently merit inclu-sion.3 The main driver of the decline in stocks has been an even larger drop in the number of IPOs. In the late 1990s, roughly 500 IPOs occurred each year, on average. Over the past five years, the average has been 130—a decline of nearly 75% (Figure 1).

The decline in public listings has many origins. First, private transactions have a number of built-in advantages. Relative to IPOs, private equity offers price certainty, faster execution, more upfront liquidity, and active ownership, which gener-ally includes CEO networks and value-creation platforms to improve longer-term business performance (rather than a focus on quarterly earnings). Private equity transactions also allow founders or management teams to pick their own partners rather than have their (sometimes hostile) partners picked for them in the public markets. The 27% annualized growth in global private equity assets under management (AUM) over the past 20 years has allowed more companies to avail themselves of private capital.4

TABLE 1

Decline in the Number of Public Companies Across Geographies5

Peak End of 2016 Decline

Netherlands 392 103 -73.7%

Mexico 390 137 -64.9%

South Africa 754 303 -59.8%

France 1185 485 -59.1%

United States 7322 3671 -49.9%

Brazil 592 338 -42.9%

UK 2913 1858 -36.2%

Israel 664 427 -35.7%

Germany 761 531 -30.2%

Switzerland 289 227 -21.5%

Norway 214 171 -20.1%

3 Wilshire 5000, Total Market Index, Fact Sheet, March 31, 2018.4 Preqin, 2017.5 Source: WDI Database September 2017; Mauboussin, Michael J., Dan Callahan, CFA, and Darius Majd. The Incredible Shrinking Universe of Stocks: The Causes and Consequences of Fewer US Equities. Report. Global Financial Strategies, Credit Suisse. March 22, 2017

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FIGURE 1

75% Decline in U.S. IPOs6

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Second, the frictional costs associated with public listings have increased over the past twenty years.7 The Sarbanes-Ox-ley Act of 2002 introduced regulations that dramatically increased the costs of going and staying public.8 Increased regulation has done little to dint the rise of shareholder lawsuits, which ensnared 2.75x more public companies in 2016 than a decade prior.9 Over the same period, there has been a similar increase in the number of companies subject to the demands of activist shareholders.10 As the costs and distractions associated with being public accumulate, public companies become less able to compete with their relatively unburdened private rivals.

New regulations have not only added direct costs for public registrants, but also eviscerated the old “ecosystem” of un-derwriters and research analysts that marketed public com-panies’ prospects to the stock investing public. Evidence of widespread conflicts of interest inside investment banks led to the Global Analyst Research Settlement, Sarbanes-Oxley Act, and Regulation Fair Disclosure (Reg FD). Spending on stock market research has fallen by more than 50% since the early 2000s, as banks cut back on staff and compen-sation in the face of these new restrictions and declining brokerage commission revenues.11 The decline in research spending has reduced the flow of information that once supported individual stock prices, which has contributed to lessening the appeal of public listings.12

Finally, changes in the structure of the economy have in-creased the risks associated with public listings. As ideas,

6 Source: Jay Ritter, University of Florida. 2018. based on CRSP Data.7 Ewens, M. and J. Farre-Mensa (2017), “The Evolution of the Private Equity Market and the Decline in IPOs,” CalTech Working Paper.8 Carney, W. (2006), “The Costs of Being Public after Sarbanes-Oxley: The Irony of Going Private,” Emory Law Review. Empirical research suggests that initial compliance costs from Sarbanes-Oxley reduced gross proceeds from public listings by nearly a full percentage point, with significant ongoing costs. C.f. aserer, C. et al. (2011), “The Impact of the Sarbanes-Oxley Act on the Cost of Going Public,” Business Research.9 Boettrich and Starykh, “Recent Trends in Securities Class Action Litigation: 2016 Full-Year Review” (2017).10 Activist Insight Half-Year Review Volume 6 Issue 6 July 2017.11 Bradshaw, M, et al. (2017), “Financial Analysts and Their Contributions to Well-Functioning Capital Markets,” Working Paper.12 “Where Have All the Public Companies Gone?,” November 16, 2017, Wall Street Journal

proprietary technology, software, brand, business methods, and distribution networks account for a larger share of enterprise value, broad disclosures of the sort required of public companies become more problematic. To justify a high share price, companies often have to reveal sensitive competitive information about their nascent technology or strategy. Rather than disclose such information to the world through an IPO, businesses with valuable intangible assets may prefer to convey these sensitive details to a select group of private investors through non-disclosure agreements (NDAs). Perhaps not surprisingly, the propensity to go public has declined steadily as intangible assets have grown from 10% of net corporate assets to more than 50% today.13

FIGURE 2

Growth in Private Companies Mirrors Fall in Public Listings14

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The Rise of Secondary TransactionsThe decline in public listings has been the mirror image of the increase in private equity-backed companies, which have risen 3x since 2000 (Figure 2). Over the same peri-od, the percentage of all companies with between 1,000 to 5,000 employees that choose to go public has fallen by more than 60%.15 Taken together, more companies are in private equity portfolios but far fewer seek to go public16 at the end of the three-to-six-year holding period imposed by the standard 10-year private equity fund life.17 The result has been the proliferation of “secondary buyouts,” or the sale of a company from one private equity fund to another, which now account for nearly one-third of all exits (Figure 3).

13 Doidge, C., et al. (2018), “Eclipse of the Public Corporation or Eclipse of the Public Markets?” ECGI Working Paper 547.14 Source: Mauboussin, Michael J., Dan Callahan, CFA, and Darius Majd. The Incredible Shrinking Uni-verse of Stocks: The Causes and Consequences of Fewer US Equities. Report. Global Financial Strategies, Credit Suisse. March 22, 2017; PitchBook 2016 Annual U.S. PE Breakdown. There is no guarantee these trends will continue.15 Center for Research in Security Prices (CRSP).16 “Where Have All the Public Companies Gone?,” November 16, 2017, Wall Street Journal17 Private equity funds generally intend to invest over five years and then sell companies over the subsequent five years, resulting in a three-to-six year holding period.

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FIGURE 3

Exits of Buyouts and the Share of Secondary Buyouts18

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Not long ago, secondary buyouts were viewed as a sign of an “unhealthy” market.19 Many LPs decried the practice, wondering why one fund would buy a company after it had already been “fixed” by a prior sponsor. Yet, available data indicate that secondary buyouts have virtually the same return profile as primary investments, after controlling for other observable company characteristics.20 Indeed, such transactions have tended to outperform primary buyouts if the buyer and seller had complementary skills.21 Rather than a sign of ill health, secondary buyouts appear to arise naturally when the shift toward private intermediation interacts with the fixed 10-year life of virtually all private equity funds.

The Rise of Direct Investing The strong performance of secondary buyouts raises ques-tions about the extent to which the standard industry fund life forces exits in cases where the portfolio company could continue to generate returns in excess of the existing own-er’s cost of capital. Value creation in private equity differs across assets. In some cases, excess returns are available only for a brief period and accrue from discrete events such as geographic expansion, entry into a new market, or corpo-rate reorganization. In other cases, operating earnings can continue to compound at comparable rates over a much longer horizon than can be accommodated by existing fund lives.

The absence of fund structures capable of accommodating longer-term holding periods has led some LPs to embark on direct investments, bypassing traditional partnership 18 Source: Dealogic, accessed 4/30/18. For illustrative purposes only. There is no assurance that any trends noted will continue. Note this data refer to global buyouts.19 C.f. “Secondary Buyouts Don’t Mean Market’s Healthy,” October 22, 2013, Wall Street Journal.20 Achleitner, A.K. and C. Figge. (2014), “Private Equity Lemons? Evidence on Value Creation in Secondary Buyouts,” European Financial Management. 21 Degeorge, F., Martin, J., and Phalippou, L. (2016), On Secondary Buyouts, Journal of Financial Economics 120 (1), 124 – 145.

structures.22 While direct investments in private companies account for a small share of overall private equity invest-ments, in recent years financial disintermediation has gained momentum.23 The motivation for direct investments is often attributed to the absence of fees, but the ability to hold assets longer also plays a role. For institutions with infinitely-lived liabilities and no short-term liquidity needs, the duration of investments under standard fund terms may result in excessive portfolio churn and reinvestment risk. In some cases, LPs have engaged in “secondary buyouts” of companies sold by funds in which they were investors pre-cisely because of their desire to hold the asset longer than permitted by the contractual life of the fund. 24

Investments Not Made The absence of longer duration fund structures also likely results in less aggregate investment, as some companies may require capital that is even more patient than can be provided by traditional private equity funds. In these cases, companies may refuse private equity capital due to an unwillingness to endure an exit in three-to-six years, or because of fears that the private equity investor may exit through an IPO or trade sale. Likewise, a private equity fund may decide that the standard horizon is too short relative to the value creation opportunity. As a result of these constraints, family-owned businesses or other companies adverse to public listings may be deprived of capital that would have otherwise helped them scale employment and sales. In these cases, longer-duration private equity may not only be a more sensible option, but the only format that could allow intermediation to take place.25

The Case for Longer Duration FundsThe last 20 years has been witness to profound changes in corporate finance, with a sharp decline in public listings mirrored by exponential growth in private equity-backed companies. The reasons for the shift towards private inter-mediation are manifold, but generally involve private equi-ty’s superior execution capabilities, the increased frictions associated with public listings, and changes in the structure of the economy towards businesses with intangible assets for whom public disclosures pose unacceptable competitive risks.

While private capital markets have grown in depth and breadth over the past 20 years, the industry standard fund life of 10 years has remained largely unchanged. A larger,

22 Fang, L., V. Ivashina, and J. Lerner (2015). “The Disintermediation of Financial Markets: Direct Investing in Private Equity.” Journal of Financial Economics 116 (1), pp. 160 – 178.23 Direct investments are sourced and executed by investors who typically serve as LPs in private equity funds. Essentially, LPs undertaking direct investment are indistinguishable from general partners (GPs) and may directly compete with traditional fund managers for investment opportunities. Direct investments should be clearly differentiated from co-investments, which have substantially gained in popularity in recent years. Although co-investments also contribute to financial disintermediation, LPs still rely on GPs to source and execute private equity investments. Instead of investing directly in portfolio companies, co-investors invest alongside a private equity fund. 24 Confidential Carlyle Data, 201825 While the proliferation of direct investments may be regarded as an important indication of the availability of capital for these transactions, few LPs have the resources to put in place the necessary infrastructure to invest directly in privately held companies, particularly those not previously subject to a buyout transaction.

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more diverse set of businesses is able to secure private cap-ital, but the time horizon for such investment has remained stubbornly fixed at three-to-six years. Longer-duration funds, able to provide more permanent homes for private companies, are likely to mark the next step in the private market’s evolution. The benefits of such arrangements are likely to accrue both to companies eager to secure more patient capital, and to investors looking to reduce reinvest-ment risk, better match assets to liabilities, and maximize multiple of money returns from longer-term compounding of invested capital.

Economic and market views and forecasts reflect our judg-ment as of the date of this presentation and are subject to change without notice. In particular, forecasts are estimat-ed, based on assumptions, and may change materially as economic and market conditions change. The Carlyle Group has no obligation to provide updates or changes to these forecasts.

Certain information contained herein has been obtained from sources prepared by other parties, which in certain cases have not been updated through the date hereof. While such information is believed to be reliable for the purpose used herein, The Carlyle Group and its affiliates assume no responsibility for the accuracy, completeness or fairness of such information.

References to particular portfolio companies are not intend-ed as, and should not be construed as, recommendations for any particular company, investment, or security. The investments described herein were not made by a single in-vestment fund or other product and do not represent all of the investments purchased or sold by any fund or product.

This material should not be construed as an offer to sell or the solicitation of an offer to buy any security in any juris-diction where such an offer or solicitation would be illegal. We are not soliciting any action based on this material. It is for the general information of clients of The Carlyle Group. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors.

Jason M. Thomas is a Managing Director and the Director of Re-search at The Carlyle Group, focusing on economic and statistical analysis of the Carlyle portfolio, asset prices, and broader trends in the global economy. He is based in Washington, D.C.

Mr. Thomas serves as the economic adviser to the firm’s corporate private equity and real estate investment committees. His research helps to identify new investment opportunities, advance strategic initiatives and corporate development, and support Carlyle inves-tors.

Previous to joining Carlyle, Mr. Thomas was Vice President, Re-search at the Private Equity Council. Prior to that, he served on the White House staff as Special Assistant to the President and Director for Policy Development at the National Economic Council. In this capacity, he served as the primary adviser to the President for public finance.

Mr. Thomas received a B.A. from Claremont McKenna College and an M.S. and Ph.D. in finance from George Washington University where he studied as a Bank of America Foundation, Leo and Lillian Goodwin Foundation, and School of Business Fellow.

He has earned the Chartered Financial Analyst (CFA) designation and is a financial risk manager (FRM) certified by the Global Asso-ciation of Risk Professionals.

Peter Cornelius is a Managing Director responsible for analyzing the economic and financial environment for private equity markets and examining the implications for AlpInvest Partners’ strategic asset allocation.

Mr. Cornelius joined the firm in 2005 from Royal Dutch Shell, where he was Group Chief Economist. Previously, he was chief economist and Director of the World Economic Forum’s Global Competitiveness Program. Prior to that, he was head of interna-tional economic research at Deutsche Bank and a senior econo-mist with the International Monetary Fund. He also served on the staff of the German Council of Economic Advisors.

Mr. Cornelius was a visiting professor at the Vlerick Business School, an adjunct professor at Brandeis International Business School and a Visiting Scholar at Harvard University. He serves on the Board of Directors of the BTI Institute and is a research fellow of the Emerging Markets Institute at Cornell University. He also serves on the advisory boards of the Private Capital Research Institute at Harvard Business School and the Institute of Private Capital at the Kenan–Flagler Business School of the University of North Carolina at Chapel Hill as well as on EMPEA’s Latin Amer-ican Council.

Mr. Cornelius studied at the London School of Economics and Political Science and received his doctorate in economics from the University of Göttingen. He is the author of International Investments in Private Equity (Elsevier, 2011) and a co-author of Mastering Illiquidity (Wiley, 2013).

CONTACT INFORMATIONJason ThomasDirector of Researchjason.thomas@carlyle.com(202) 729-5420