Episode 005
What LPs are Looking for and Trends Every GP Should Know | Brian Bank, Kirkland & Ellis
Host Sean Mooney sits down with Kirkland & Ellis' Strategy and Client Relations, Investment Funds, Brian Bank, to discuss what LPs are looking for, investment trends and, other trends every GP should know.
EPISODE TRANSCRIPT
Sean Mooney (00:05):
Welcome to the Karma School of Business podcast. Today's podcast is brought to you by BluWave, an intelligent, highly curated B2B business network that is trusted by more than 500 of the world's leading private equity firms and thousands of proactive companies, connecting them with the very best third-party resources they need to expertly assess opportunities and build value in their companies with speed and certainty. I'm Sean Mooney, the founder and CEO of BluWave. Today we have a great interview with my friend Brian Bank, a strategy and client development executive with Kirkland & Ellis. Enjoy.
Brian, I'm very excited to have you on today, your firm Kirkland & Ellis in many ways, is the gold standard in private equity for legal counsel and advice, and you all are at the forefront of many of the top trends and private equity. Today we're gonna cover a number of things that I think every PE firm is or should be thinking about. So we have an exciting podcast on the way. Maybe to kick things off, Brian, can you share a little bit about what your role is at Kirkland & Ellis, how you got involved at the intersection of PE and the legal world, et cetera?
Brian Bank (01:13):
Yeah, absolutely, and thanks for having me. Quick answers, Luck is how I ended up here at the intersection of private equity and legal. I spent about 15 years as an institutional limited partner, investing across all asset classes, private equity, venture real estate, and some fixed income. Then I spent a few years as a placement agent, and the placement agent decided San Francisco wasn't where they wanted to have an office. So I was on the way out from that situation when Kirkland came calling and Kirkland basically called, said, We'd love for you to come in, leverage your experience to help our clients, however you can. Very nebulous. There was no job description, there was no job title. We came up with a title called Strategy and Client Relations. As you know, Sean, law firms are built for lawyers. So you're a lawyer or you're not a lawyer.
I am not a lawyer, so they kind of had to create something for me. But back to the role, it is technically a non-bill role where I provide assistance to clients thinking about fundraising, thinking about investor relations, thinking about firm formation as well as fund formation. I'm part of what's called the investment funds group, which is a 500-lawyer team focused entirely on fund formation and liquidity solutions. In addition to those 500 attorneys, we have about a hundred attorneys dedicated to tax and regulatory matters, but specific to closed-ended funds and alternative strategies. So unlike a lot of other law firms that have a broader private equity category where they do fund formation, they do liquidity, they do secondaries, and they do m and a. We separate the m and a, the transactional side, Kirkland & Ellis is a 3000-plus attorney law firm on a global basis, and I'd say about half of those attorneys are involved in private equity, if not more. We are, as you mentioned, the largest player in private equity.
SM (03:14):
That's really helpful to set the stage. Full disclosure, while I was in private equity, I was a longtime Kirkland & Ellis client, and the one thing that was the constant, I always loved having Kirkland & Ellis on my side, and I never liked seeing him on the other side.
BB (03:30):
I hear that very frequently. It was funny, actually, Sean, when I joined Kirkland, having been on the LP side for a long time, a lot of my friends didn't mix their words with regards to what the culture, what the tone of things at Kirkland are. It is really though an evolving team and evolving entity. We took a very strong approach towards softening our edges about eight or nine years ago. We have a no-jerk policy, to be perfectly honest. Everyone is very professional and unbelievably intelligent, a hundred percent dedicated to our clients. But that said, of the, you know, several hundred attorneys I deal with, there's not one that I wouldn't be happy sitting down having lunch or a coffee or a dinner with and truly consider my friends. And I think as a law firm, we really differentiate that we have that friendship, that close relationship with our clients that call us for both legal as well as personal advice.
And the fun thing about fund formation is you really work with entrepreneurs at inception, at launch. You sit down with them, you strategize with them. I do that on a daily basis, You know, is now the right time to launch a new firm? What is the strategy? What should your size be? Who would you compete with? How do you position your story so that it's best delivered to both LPs, the general market and upfront placement agents, and other service providers, which is another big piece of my job is introducing fund managers and GPs to other service providers, other people who play in the same playground as the rest of us. You know, if you miss that initial window or don't have that great first impression for whatever reason, that could be the difference between a successful firm and an unsuccessful firm. So we try to facilitate introductions, we try to smooth the process as much as possible so that the funds get launched easier, that the strategy is articulated properly, and at the end of the day, everyone's happier that way.
SM (05:27):
The way that you're describing how you operate is one of the reasons why Kirkland & Ellis has the largest market share in private equity. The fact that I, I think you all think about the business of legal advice in the business of being a law firm as a business, and the fact that they have a business person like you in the mix shows how they're thinking about and evolving the business model versus maybe some of the more traditional constructs. I think with that in mind, I think that's a great way to set the stage for some of the discussions we're gonna have today. As you think about all of these, these funds that come through, and to frame this, how many new fund formations are you involved with approximately every year?
BB (06:03):
Personally, I probably touch 50 to 60 new fund formations in the calendar year as a firm, we're probably in the 150 to 200 range. Yeah, we've got over 650 clients or discrete GP clients. And to put things into a little bit further context, and this is the number that shocks me every time I say it is in the last five years, our clients have raised over a trillion and a half dollars of committed capital.
SM (06:30):
So you are seeing a hugely statistically significant portion of what's happening in private equity in terms of particularly the new fund formation. So what would you say are some of the top things that limited partners are looking for when making new general partner PE firm commitments?
BB (06:48):
Great question. Honestly, I don't know that that's changed very much in the last 15, 20 years. I think there's been an increase in selectivity based on other market conditions, which I think we can talk about in a little bit. But at the end of the day, it's the team and it's the team's experience team is critical. The team's experience is critical. More importantly, the team's cohesiveness. So you could have an individual who was a fantastic investor at a large well-known buyout firm, put together a group of individuals to build out a new entity. But if that team hasn't worked together, if it's not a complete lift out, it's gonna be a much harder fundraise. The SEC is much more diligent with regards to what attribution can and can't be shared with prospects and LPs, and that's gonna actually increase even more. So LPs need to be able to navigate the due diligence process, understand what deals a GP has worked on in the past, but at the end of the day, it's the experience of the individuals, it's the experience of the individuals together. It's their track record investing in the same asset class, the same strategy, the same size, in the same stage as what they are proposing in their terms and in their new entity. Perfect example, as I was recently working with a client who's become a very good friend who's raising a billion dollar fund in advance of raising that fund though, he decided to do some one-off transactions and the first transaction that he came across was a 700 million transaction. Our advice, and ultimately the LP's advice was to slow down, not necessarily exercise or undertake that transaction because it would dilute his message. He's saying that I'm making 100, 150 million investments, that's what I've done historically, and now he's coming across the finish line or presenting this first deal that's significantly larger than what he has shared thus far. So staying on target, we're both golfers. To use the golf analogy, stay right down the middle of the fairway. Yep. Is critical.
SM (08:57):
You gotta be the ball, right? Absolutely. Consistency, focus, you know, be who you are, and continue to do so. So I think that makes a ton of sense and that resonates on multiple levels with me.
BB (09:09):
Sean, one other point that's probably worth referencing now and we can talk about also later, is the importance of diversity and inclusion in your team. So yeah, there's not an LP of significance. There's not an institutional caliber LP that's not looking at a PE firm's composition from a team dynamic. Everyone can't be 50-year-old Caucasian men and you look at the websites and 80% of them are not diverse to an extent that they need to be. So every team that I deal with needs to have a different composition than it was 10, 15 years ago. And again, it's not only a box-checking exercise for the LPs, which in many cases it is but there's a better understanding and a recognition in the industry that diversity of experience, diversity of background, general diversity, improves returns and improves returns materially. It also improves your ability to source transactions, to sell transactions, and it's a critical component that new fund managers as well as existing fund managers need to wrap their arms around at this point.
SM (10:22):
That's a great perspective and it's something as we think about the 500-plus PE firms that BluWave works with every day, it is on the forefront of virtually every fund. I heard of this great term about doing good things that are not only good for the world but good for you. And someone described it as selfish altruism, it's altruistic, but it's selfishly great for these firms because there's strategic value and you've seen study after study that shows the value that it creates by bringing in diversity of perspectives and a diversity of people. And I think it's one of the top trends in all of PE right now for good reason.
BB (10:54):
Absolutely. And it's been a trend in Europe for 20 years. We, for whatever reason, have been in the second inning. This is literally the longest baseball game ever. We've been in the second inning for 20, 25 years.
SM (11:06):
A hundred percent. So when you think about the market right now and you think about particularly fundraising where you're, you're intimately involved, how healthy is the fundraising environment compared to last year?
BB (11:18):
It's certainly slowing down compared to years past. It's still a very vibrant, very active, very exciting time to be in the market. Frequent recently disclosed some numbers that compared to this time last year, the market's down about 50% from a fundraising perspective in private equity. That said, it's still an incredibly robust market in certain ways it's a binary barbelled market if you will. The large funds, the household brands, and the established bigger firms are able to raise large funds. Several years ago, you never saw a fund larger than 10 billion. Now it's a very common thing to see a GP raising 10, 15, or even 20 billion fund sizes. On the other end of the spectrum, though, emerging managers, managers that haven't yet really got in into their stride with an LP base or an institutional LP base are having a hard time. It's not uncommon to see a fund in the market for more than 24 months.
I've recently had a conversation with a first-time manager who's looking to raise over a billion dollars and thought that he could do it inside 12 months. And I tried to put the breaks on and reminded him that that first close is actually the starting point to the fundraise. Everything's a pre-close for that first six, eight months, get to that first close and then per most limited partner agreements, you've got 12 months to reach that final close. So the market is still difficult. My placement agent friends are telling me they've never seen more activity, they've never seen more inbounds, they have never been more selective in the GPs that they choose to work with. I tend to make introductions for my GP clients to placement agents and other service providers, and it's often taking 10 to 12 introductions to placement agents for a good GP to find an agent who will take them on, not necessarily because they're not a good firm, it's just that their slots are filled.
Placement agents have a discrete number of mandates that they can take on at any time. Factoring in existing relationships, factoring in competing strategies, factoring in competing sizes, it's a challenge to find the right partner. And the market is certainly tightening from the perspective of the placement agents. From the perspective of the LPs, I mean, speaking of LPs, the result of these larger funds coming to market with much larger funds also coming to market faster historically than they have in the past is leading LPs to being either overallocated or frankly over committed from a time perspective to even analyze new funds. I recently read that one of the large pension plan would be at 150% of their annual allocation if they only re-upped with existing managers not even speaking to anything new.
SM (14:13):
To what extent do you think the denominator effect is impacting that? And maybe to describe this, for those who aren't familiar with the denominator effect, really what's happening right now is for large asset managers, they have publicly traded portfolios that are declining quite rapidly with the markets today. The private equity industry in general does not mark their markets nearly as in a volatile as way as the public markets because they're projecting through the storm. And so their values are staying the same while their public portfolios are going down. And so their percentage of private equities it relates to their total portfolio is almost going up because you have apples and oranges calculation that's occurring. How is that impacting fundraising right now?
BB (14:58):
Yeah, it's absolutely impacting it. I mean, the denominator effect comes into play every 10 to 12 years. Every time we see some kind of public market negative behaviors, it, it's funny, you don't hear it when the public markets are skyrocketing, right? You don't hear, "oh my God, my allocation's gone through the roof because there's been so much public profits." But when a institution has a predetermined allocation limitation and the private equity piece grows, they are stuck and what can you do? You can cut off all new allocations, which we're seeing a lot of, at least we're hearing from a lot of institutions that they're just tapped out, they can't make new commitments. The other option that they can do is cut back on existing relationships. They can say, you know, instead of coming in at a hundred million commitment, we're gonna come in at 50, we're gonna come in at 25 to keep that relationship going.
Some groups are looking at skipping, this vintage will not come into this fund will come into the next fund. But again, that's problematic. You try to maintain vintage diversification, so you want to always be in the funds. But the denominator effect is a real issue. I think that some groups are going back to their investment committees and their oversight committees and asking for adjustments. Can we increase the PE allocation? Because if you look at the public markets, they're in a decline. The private equity assets are very strong. They are somewhat counter-cyclical to public stocks. It's beneficial to stay in. And of course the third piece or the, I don't know what fourth piece at this point, is participating in the secondary market. And we'll talk about the secondary market a little bit later, but unfortunately, you don't wanna sell assets in a secondary market when it's disadvantageous to you. And reacting to the denominator effect in forcing you to sell things in the secondary market will lead to deeper discounts and a less efficient process for you as the seller. That said, it is something that a lot of groups are taking a closer look at right now.
SM (17:04):
I think this, it's an important topic for asset allocators right now because, and one thing that is, they're thinking about their allocations. One, they've gotta, I think, understand that there is this disconnect. They've got public portfolios that are marked to market on a day to day basis, not necessarily rationally in the short term. You've got private equity portfolios that mark to market much less real time. They have to understand there's that disconnect. The other thing that I think they should really think about is that private equity firms and their portfolios do absolutely the best when times are the worst. If you look at the data, the best returns occur during times. Exactly right. Now, I would think that some of these asset allocators would be completely greedy and selfish in these times and maybe think about increasing their their allocations to PE because this is the time when it gets to be really
BB (17:52):
Good. No question about it. I mean, look, the last 15 years, cash has been cheap. Debt has been incredibly cheap and it's been a real free for all, frankly for the PE industry. So some of the programs are actually asking for increased allocations. Some of them are looking at the secondary market and we're actually just about to start to talk about the secondary market a little bit. And the secondary market is a great tool for portfolio management. The negative of course, though, is you don't want to do it when the times are bad and you're gonna sell it at a discount or an artificially required discount.
SM (18:25):
That's a great segue. And so for private equity firms, one of the great things is I think they can be quite creative in terms of being able to continue to make investments and finding ways to maybe go around challenging times. Right now, two of the biggest kind of trends that we're seeing here today are secondary funds and continuation funds. Can you share a little bit about what those two are and how private equity firms are using them?
BB (18:52):
So we'll start with just secondary funds as a starting point. Secondary funds are essentially funds created to buy assets, existing assets from LPs selling. And those could either be individual assets and individual company shares, individual interests in a GP or a bundle of interests in GPs or a bundle of individual companies. 20, 25 years ago when secondaries first started, it had a very bad perception in the market. It was like a used interest. What you were selling didn't have a lot of value. We all know the term zombie funds and zombie assets. So historically people thought, Oh god, what's wrong with this thing? It was gonna sell it a huge discount, 50, 60% just to get it off the books. Over the last 15 years, this market has matured and evolved and really grown into a standalone asset class that is, as I referenced a few seconds ago, a real tool, a tangible tool to balance your portfolio and utilize your portfolio so a new CIO could come on board and decide he doesn't like a certain asset class and put the entire portfolio on the market.
I worked for a firm in the past that that situation happened and we put a portfolio of 20 GP interests into the secondary sale. You decide you don't like venture anymore and you want to free up some cash so you can invest into real estate. Again, perfect opportunity. You put a process together, you bundle your VC assets, sell them, You might get a discount to current nav, but from a time use of money perspective, from a cash flow perspective, you're better off and you can invest in a different asset class. So the secondary market has grown into a very significant piece of the business as a category. Last year it did somewhere in the 50 to 60 billion of transactions in the first half rather there was over a hundred billion of transactions last year in the secondary market continuation funds, which you referenced, Sean, is a reasonably new dynamic, very active, very important.
What this refers to are funds created to extend the life of an individual asset, generally launched by the GP. So it's a GP led transaction where they take an asset that they love that has been in their portfolio for a long time, it could be past the point of the fun term or realistically they just know that it's not ready to be sold, it's an asset that's better cash flowing, It's an asset better to be held for a longer period. And what they do is they bundle either a single asset or multiple assets into a new vehicle. They offer existing limited partners the opportunity to sell their interest or roll their interest into the new fund and then they can go out and actually get new capital from new LPs. And what this does is it essentially restarts the clock on this asset. It restarts the clock from a management fee perspective, it restarts the clock from a carried interest perspective, but it eliminates the need to force a sale of a good company. And again, this is something that we've been incredibly active with IT at Kirkland over the last few years. They are incredibly beneficial. There have been some articles out there saying that LPs are starting to sour on continuation funds a little bit, but personally I think they're a fantastic outcome. They're a fantastic tool in the toolbox for GPs at this point.
SM (22:26):
The continuation fund I think is one of the best tools that have emerged in a long time. And, and if I go back on my own experiences as a private equity GP, you feel the pressure to be back in the market and fundraise every three to five years to fundraise. You've gotta have illustrative exits from that prior fund. What that often meant is we were forced to, in some ways, monetize our best investments that had really long runways in front of them so that we could park a return. And that was something we would always sit around the table and say, Geez, this company's great. We've got a long way to go with this, but we have to show some real realized returns in order to get back to market. And so I think this is a tool that's gonna allow P firms to keep on getting multiples of money versus IRS and maybe serve both at the same time.
BB (23:16):
No question about it. I mean as as a participant in the industry, when I was in LP way back when, I participated in a co-investment let it Go investment in a very interesting technology company, the company knocked it outta the park under every metric you can imagine. And for a variety of reasons, the company has still not been sold. We've done a few recaps, we've taken some money off the table. But that said, and this is again, I'm two companies removed from the firm I was with when I, I made this investment. We've had this investment for 15 years. It's been in the portfolio of LPs for over 15 years. And this was the last investment from the vintage fund that made the investment. So realistically, this is about an 18 year old investment. This is a perfect example of a continuation fund candidate because it's still a good company. It's, you know, EBIT does a very impressive number. It's cash flowing, but there are a lot of LPs that just wanna close the books on this one particular partnership and be done with it and take capital off the table and realize some liquidity. And I'm sure the GP doesn't want to continue to have to answer to an LP who made a commitment in 2000 for this company.
SM (24:26):
Yeah, I think this is a tool that every PE firm should be thoughtful about in terms of adding to their arsenal secondary funds. I think as we, for your first point is also a really good one in terms of one of the things that we're seeing a lot within our client base is increased focus and specialization and evolution over time. And it's a tool that I think every GP should similarly be thoughtful, particularly if they're navigating changes in their focus areas where they can, as you said, kind of come to market it really at the beginning of our conversation with a focus story and narrative around who you're going to be in in the future. And that's another tool that I think helps kind of clean that up for the going forward period and saying, this is who we are and who we're gonna be and our portfolio reflects it.
BB (25:07):
No question about it. And as a firm Kirkland, we consider liquidity solutions in the secondary market as core part of our investment funds practice. Like I said, we've got 500 lawyers working on both the fund formation side and the liquidity solution side, which a big piece of is the secondary market and the creation of these GP led continuation funds. I mean, it's important to really understand this space cuz it's not going anywhere except up right now. I think the statistic is the secondary market constitutes about 2% of the total alternative investment dollar if that doubles every year for the next few years. We're still very small in the context of the industry, but it can easily be a trillion dollar piece of the puzzle within the next 10 years.
SM (25:55):
I think it's gonna be incredibly important and massive trend going forward and and for good reason. And I think it's gonna benefit not only the GPs but the LPs as this continues to evolve.
BB (26:04):
No question about it. One
SM (26:06):
Of the other things, the general partner, which is for those who are not familiar with it, this is the vehicle that is essentially the partners of the private equity firm and houses much of the economics of the fund structure and it's the controlling entity very often of a private equity fund or firm per se. And so one of the things that we're seeing happen more and more is that private equity firms are using the GP as a source of liquidity, particularly for the maybe the founding partners or existing partners. And they're either selling their GP stakes or they're using some other tool to bring capital into the senior professionals of the firm. What are some of the things that you're seeing right now in terms of selling stakes in the GP? Why is it used and what are maybe some of the newly evolving resources that are also coming to bear?
BB (26:55):
Selling a GP stake has become a growing piece of the business. I think it's been, last year there were over 50 transactions of private equity firms selling a piece of themselves, frankly. And as you alluded to, I mean there's a lot of reasons to do so. It's not only a opportunity to realize a lot of liquidity for the founders, which it is, but there's strategic rationale for that. Often it's associated with succession planning, so they can raise a lot of capital by selling pieces. Anyone who has a fractional ownership in the management company will get a piece. So that allows the older founders, the seasoned founders, to essentially ride off into the sunset comfortable that they've become more comfortable than they already are. The junior partners, the next generation now has a little bit more capital handy. They can use that capital to build their firm.
You look at these GPs that are raising larger and larger funds, obviously it's nice, but it also is a hugely troublesome financial burden for the younger partners as there's a one, two to 3% GP commitment and a 2% GP commitment on a 5 billion, 10 billion fund is materially different than a two 3% GP commitment on a 200, 500, 700 million fund. So yes, they could go to some of the leading financial institutions and ask for GP commitment loans or other types of borrowings, but many times they're utilizing this minority stake sale as a cash flow opportunity for them to increase their GP commitment. Also using that cash from this event to build their firms, increase their real estate, hire new hires, increase the salaries of their younger people, potentially look to new strategies and do the research and pay for the outside consultants and so forth that a good long term entity needs to do to make an informed decision.
So again, a perception is that these are only intended to make the rich richer, to make the GPs right off into the sunset with multi-generational wealth. The reality is, is it's a very effective tactical tool for the younger generations and even existing generations of leaderships of firms to build their entities and really grow them. The funds that are being launched and the buyers of these minority stakes are also big strategic players in the industry. And there is thought and rational decision making behind which partner, which GP partner they're looking for. So there's the Blackstones, the Goldman Sachs, the Alliance Newberg, the dials, all these different groups are involved and the expectation from both the GP as well, frankly as their LPs is that there are other intangible benefits that will come by selling to the right counterparty. And these are very passive transactions. It's not the case that a buyer of a GP stake is going to immediately assume two seats on the investment committee is going to assume a role in the day to day management of the general partnership. These are frankly financial investment opportunities for the buyers. They're looking at frankly, management fee streams as opposed to carried interest streams and they don't want to be hands on. They are truly looking at it as another investment opportunity, which is why we've seen dozens of GP stake funds being launched in the multi-billion dollar range. So LPs can invest in one of these funds to see a high single digit, low double digit, almost fixed income like return.
SM (30:56):
That's a great kind of delineation behind what's happening. But as I think about what's going on in the GP stakes, it's another example of how the business of private equity is becoming more like a business. And so these GP stakes are just as if you are running an operating company or portfolio company and you said, Hey, I need some growth capital. I wanna bring in some outside capital so we can maybe take some money off the table, but also fuel growth and development. So we're gonna bring in an equity partner. And so it's the same way that the private equity firms are starting to think about themselves and the same way they think about a portfolio company. And with that, I think the considerations as a GP is if you're bringing in an equity partner, they're gonna be part of the fabric of your business for quite some time and they're gonna be an equity holder, a partner in potentially in perpetuity.
And that brings a lot with it. That brings a partner, another thoughtful person in your capital structure to think about. One of the things that I think is also evolving, I'd love your perspective on this, is not only are there equity tools that they can use in terms of selling stakes in the GP, but as you pointed out just a moment ago, there's also almost like debt or preferred equity type structures that can pay down over time. Talk a little bit about those tools, how people are using 'em and maybe some of the benefits that come along with that.
BB (32:10):
A sale of a piece of your management company is probably not right for everybody and they don't wanna dilute their ownership. They have a perception for whatever reason that you know, it is more involved than it could be. So all the major financial institutions, you know, I don't want to name names, but we know who are the leading lenders to the industry, have all created solutions from a cash flow or from a capital call line perspective. You know, subscription lines, things like that. But there are also very well positioned to make direct loans to the general partner for the operating expenses that we discussed. Once you're a GP with a steady stream of management fees and that predictability of cash flow you can borrow against that, you can borrow against that as an individual, you can borrow against it as a firm. Preferred equity is another interesting piece that you just referenced, and that's both to the GP directly as well as a new solution within the secondary world.
So basically what they're doing is creating a tiered return profile, for lack of a better term, or a strip, creating strips of equity. So rather than sell an entire piece, rather than sell down your, lose that equity in your firm or your company, it's a partial sale with a preferred return established over the course of say, 10 years. So I'm gonna sell you 50% of my interest, here's the price we're gonna negotiate a prenegotiated rate of return. Once we hit that rate of return, there's gonna be a preference, a liquidity preference, and then a pref. And once you hit that pref, the seller gets the entire piece back, it creates a more balanced, aligned approach to that equity requirement.
SM (34:01):
I think these are also tools that every GP should be thinking about and it enables them to think about their own business like they would as if they were a, an operating company, a portfolio company where you can think about capital structure and the optionality that it provides, the resources it provides to not only very rightfully enables some people to have liquidity but also enable them to make stronger, bigger, deeper investments in the growth and development of their own businesses.
BB (34:26):
No question about it. And you know, when you think about it, the LPs really, if an LP thinks properly about it, they want to see this, They want to see a GP focusing on themselves with that same financial engineering, with that same strategic vision that they're gonna bring to their companies. And if an LP sees a GP that's not operating effectively internally, it's gonna raise question with regards to how they can affect and manage their investments and what kind of advice they can bring to their portfolio companies.
SM (34:57):
That's great. Let's talk about some of the other trends that are popping up here and there's a number of things, technology, ESG compliance. What are some of the things that you're seeing on the technology front within the PE firms themselves?
BB (35:12):
So technology is critical. I mean it's always been critical, but I think it's become more so in this post covid post pandemic world because the LP has frankly become comfortable with technology, comfortable with Zoom, comfortable with virtual due diligence. And as a result the GP needs to raise the bar, for lack of a better term. Technology has really evolved into something far more important than it was before the pandemic. We've all become comfortable with the use of technology, but importantly LPs have become comfortable with it from the due diligence perspective, from the meetings perspective, the reality is is very few first meetings will be held in person. So that first impression is now gonna be over zoom. Consequently, you need to ensure that you've got a high quality, high definition camera, you have a good microphone, you've got a good lighting, you've got an appropriate or neutral background.
You don't wanna blow that one chance you have with an LP, with a placement agent, with another service provider based on poor technology. Make sure you have the right wifi and if you don't have the right wifi and the right bandwidth, make sure that you're going to a location where you do. Another interesting component is the multi-team member Zoom meetings and for lack of a better term, the Brady Bunch screen where you see three or four or five people on the board. It's always gonna be hard to make a connection with someone virtually. What you don't want to do though is appear bored and appeared completely disinterested when someone else on your team is talking. And LPs will try to read body language in person and it's even easier to read body language virtually because frankly the audience doesn't know who you're looking at when it's on Zoom.
So I could be looking at two or three non speakers to see what their response is to their colleagues speaking. So you need to really be trained and think carefully about how your appearance is online, what your technologies look like online. And then secondly, this evolves into the use of video and technology for annual meetings. LPs really like the virtual annual meeting option. It's not gonna replace the annual meeting, unfortunately. I think on a go-forward basis, most GPs are gonna have to provide a virtual solution in parallel to the in-person solution. But when you think about it, it's beneficial to both sides. It reduces costs for the LP, for the GP, it actually can increase the number of attendees and the exposure. You can have prospects, you can have three or four members of an LPs investment committee, you can have the entirety of an investment committee in attendance. It doesn't necessarily need to have all the bells and whistles that we saw during some virtual annual meetings during the pandemic, but it is something that every GP needs to think about.
SM (38:10):
I think technology like everything else in our hybrid world, but living is gonna make a big difference. I think many of the LPs are gonna be very happy that they're not gonna go to seven chicken dinners with either white or brown sauce. That's you named the University Club in Midtown.
BB (38:24):
No question about it. I mean, you know, we all know that October, November, March, April are incredibly busy and you know, if you can hit two or three meetings in the course of a day virtually versus getting on a plane and blowing two or three days crossing the country, it's just beneficial for everyone. The big negative of course is you don't get the networking, you don't get the face to face, you don't get that interaction with both the GPs, their management companies and the other LPs. So I mean, I do think that the meetings will continue to exist. I just think that you're not gonna hit as many of them as an LP. You're gonna be more selective. And as a result, the in person meetings should be stronger than they were in the past. And the virtual ones need to have, yeah, you know, be successful and need to be more than an iPhone aimed at the podium. There needs to be a technology function there.
SM (39:17):
And I think even from the GP side, it's gonna be great on the fundraising front because every GPs got the story where they flew all the way to Zurich and the person wasn't there, right? And that took six months to schedule. And so if we can have these first meetings virtually in a high quality environment where you don't have to fly to Hong Kong and realize that the person isn't there or for a one hour meeting and get these first interactions through, and not only will happen faster, but it'll be a more, I think it'll be a lighter lift on everyone. That's a really thoughtful trend for GPs and LPs to be thoughtful about. One other thing that I think is coming up in virtually every part of PE right now, and this started in the upper markets of PE, but now is a hundred percent resident in lower middle market is ESG. Talk about what you're seeing there, Brian.
BB (40:02):
Yeah, no question about it. I mean, I referenced it earlier in the conversation, but ESG permeates the industry now and it has to permeate the industry. ESG also, however, is a overused term. It means different things for different people. Environmental, social and governance is what the ES and the G stand for. But the reality and the the important factor is that limited partners, the industry, the public, the press, everyone wants to ensure that people are doing the right thing and that investment firms are doing the right things. This permeates from the first look at the website down to every individual company that a GP makes an investment in. Is there, uh, diversity on the board? Is there a environmental awareness that the company's byproducts aren't damaging the local economy or the local environment? Is the team doing the right thing from a social perspective?
There's so many different pieces that ESG really needs to be considered. From the inception of a firm, who are the other partners on your team? Who are the junior people on your team? What's the location of your office? Do you have an ESG policy statement in your offering documents? Is ESG mentioned in your initial pitch deck? If the answer is no to any of these things, you need to think about it. You need to, to talk to your attorneys, you need to read articles, you need to reach out to an ESG consultant. Most funded administrators these days have an ESG team to help walk you through these topics. It's again, something that is growing in importance across the world, frankly. But importantly in our industry, the more institutional, the larger the LP, the more important these issues will be. And it's just past the point you can ignore them. It's past the point that you can have every partner at the team being a, again, a mid fifties white guy for lack of a better description. Within Kirkland and I think it's consistent with banks and some of the larger GPs. We've built an ESG team. We've got over 25 lawyers who are entirely focused on ESG. They're involved in ding, they're involved in company sales, they're involved in green debt, green financing. Every conversation that I have with a new manager or an existing manager, we bring in a lawyer or two whose focus entirely is on ESG. And ESG also doesn't need to be signing the UNPRI and other global policy statements about ESG. It's being prepared to answer the question, being positioned to demonstrate that you're doing what you say you're gonna do. LPs have gotten really strong and really smart and they recognize when someone's greenwashing, when someone's insincere, don't get caught doing that. Don't get caught misleading. It will only come back to haunt you.
SM (43:11):
Yeah, I remember as a personal anecdote years ago, I was involved with helping to raise a fund that I was working with and I remember getting a DDQ, which is called a due diligence questionnaire from an LP. And they said, What is your ESG policy? As I think back, I kind of laugh and I go, I go, First thing I did was Google what is ESG? I had no clue what it even was. And this was a while ago, right? So, So the first thing I did is Google what's ESG? And then when I realized was, wait a minute, we're doing a lot of this stuff already. We just hadn't put it around a framework. And some people think about this as broccoli, it's good for the world. But I was like, well it can be broccoli with cheese on it because it's good for the world, but this stuff is good for business too. And we can do both or not mutually exclusive. And in fact, we already are doing most of this. And so why not be able to just capture it in a framework? And the reality is it's important to to LPs. It should be important to the GPs at the same time. I think a lot of firms, particularly at the upper market, are much more comfortable and and capable in terms of the exact framework because the large companies they're investing in, we're already doing this really through a framework of corporate social responsibility. That's right. So CSR and it's now, it's maybe some different acronyms and it's coming down to the lower middle market. And really where they have to really work through is not having the data capture capabilities. And so there's some technology tools that are evolving that will make this easier, I think, for everyone. But I think everyone can agree that this is important to the LPs. It may not win you an LP, but it surely could lose you one.
BB (44:42):
Absolutely could lose you one. And as I often tell my clients, it's much easier for an LP to say "no" than to say "yes." And the other point that I would add to what you just said, Sean, is think in terms of building blocks. You're a lower mid-market buyout firm right now, ESG and these, you know, the CSR things aren't as important today, but as you move up market, as you go from a 200 million fund to a 500 million fund and you're talking to different LPs, they're gonna ask you about these ESG matters and the diversity matters and the social matters from your earlier portfolio companies. So get into the habit as a GP today of capturing that information, putting the metrics together, building a annual or quarterly ESG report. The upper market firms all have chief impact officers are starting to higher impact officers. Not necessarily important for the smaller and the lower mid-market firms, but assign that responsibility to people. Ensure that you're capturing the diversity and the dynamic at every portfolio board, every portfolio company's leadership. I just saw a DDQ that came across and asked literally for the DNI of every officer and every key executive of every portfolio company for a GP. So start capturing that information now. It's only gonna be helpful down the road because you want to grow. You want to be a billion dollar GP to get there. You need the big institutional LPs, the big institutional LPs need you to recognize and act on ESG before they write you a check.
SM (46:13):
That's great advice. We've covered a lot of, I think, incredibly important and value added information here. With just a couple minutes left, can you share a little bit about what you're seeing real time and the latest in terms of SEC compliance and what private equity firms need to be thoughtful about what's coming real time real soon?
BB (46:32):
I'm gonna caveat my answer that I am not a lawyer. I work for Kirkland & Ellis, the biggest law firm in the space, but I am not a lawyer that said, the SEC's new marketing rule is gonna take effect on November 4th. This is a very significant change and will have implications across all marketing, all relationships, all emails and presentations. If you do not have a CCO who's knowledgeable about these new rules, you need to have your CCO or your GCs get smarter on what this rule means. If you've got an outside compliance consultant, talk to your consultant. If you've got an attorney that is strong on the regulatory front, have a conversation with them. If you don't, please call me. We've got one of the strongest regulatory practices in the industry that said, this new rule is gonna change the definition of what an advertisement is.
Instead of only covering what traditional advertising means, it's now gonna talk about testimonials and endorsements, social media and the impact of social media on advertising, what's considered advertising, what's not considered advertising. It's gonna impact so many different pieces of the puzzle that we deal with on a daily basis. What emails you need to keep, how the email can be treated cherry picking versus non cherry picking, gross IRR versus net IRR. There's so many key points that we deal with on a daily basis that will be impacted by this, that it's critical to get a better understanding. And what's interesting, and it's important to note, the SEC introduced this about two years ago, and they've given the industry this 18 month transitional period. So November 4th isn't the time to start thinking about it and assume that they're gonna be lenient. What we've heard and what we're anticipating is very little leniency at this point. They consider the SEC views this as having been an 18 month grandfather period. Now it's ready to go. So you're gonna start seeing GPs getting not only deficiency letters, but enforcement if they're not fully following this new mandate, these new rules.
SM (48:50):
I think this is incredibly important information that every GP, every PE firm leadership team needs to be thoughtful about right now. And I'm sure many of most are taking action, but if not, they're gonna get going real quick.
BB (49:04):
Many of them are sitting back and saying, oh, you know what, it's not clear. We're not sure what they're gonna do. They're gonna sit back and wait for those first rulings and thinking that they're just gonna be deficiency statements. And the reality is, is I think there are gonna be a lot of people who are very disappointed very quickly when the SEC comes down on this. So just get comfortable with it. And again, it's not necessarily calling Kirkland, although we'd be happy to have that conversation. It's talking to your compliance consultants, talking to your GCs, your CCOs, et cetera. This is a pretty significant change.
SM (49:34):
That's great advice and I think everyone's gonna start looking into this real quickly. So Brian, my friend Brian Bank, I'd like to thank you very much for sharing all sorts of information. I've got a notepad full of takeaways here. We want to thank you for coming here and sharing these insights with our listeners.
BB (49:50):
Sean, my pleasure. Thank you so much and thanks for everything that you guys do. It's uh, a fantastic business you've built there and look forward to chatting soon.
SM (49:58):
Thanks, Brian, I appreciate you.
BB (49:59):
Thanks. Take care, Sean.
SM (50:06):
Thank you for joining us during our discussion with Brian Bank. For more information, go to bluwave.net/podcast. Please continue to look for us anywhere you find your favorite podcast, including Apple, Google, and Spotify. We truly appreciate your support. If you like what you hear, please subscribe, review and share. In the meantime, let us know if there's anything, anything we can do to support your success.
Onward.
Welcome to the Karma School of Business podcast. Today's podcast is brought to you by BluWave, an intelligent, highly curated B2B business network that is trusted by more than 500 of the world's leading private equity firms and thousands of proactive companies, connecting them with the very best third-party resources they need to expertly assess opportunities and build value in their companies with speed and certainty. I'm Sean Mooney, the founder and CEO of BluWave. Today we have a great interview with my friend Brian Bank, a strategy and client development executive with Kirkland & Ellis. Enjoy.
Brian, I'm very excited to have you on today, your firm Kirkland & Ellis in many ways, is the gold standard in private equity for legal counsel and advice, and you all are at the forefront of many of the top trends and private equity. Today we're gonna cover a number of things that I think every PE firm is or should be thinking about. So we have an exciting podcast on the way. Maybe to kick things off, Brian, can you share a little bit about what your role is at Kirkland & Ellis, how you got involved at the intersection of PE and the legal world, et cetera?
Brian Bank (01:13):
Yeah, absolutely, and thanks for having me. Quick answers, Luck is how I ended up here at the intersection of private equity and legal. I spent about 15 years as an institutional limited partner, investing across all asset classes, private equity, venture real estate, and some fixed income. Then I spent a few years as a placement agent, and the placement agent decided San Francisco wasn't where they wanted to have an office. So I was on the way out from that situation when Kirkland came calling and Kirkland basically called, said, We'd love for you to come in, leverage your experience to help our clients, however you can. Very nebulous. There was no job description, there was no job title. We came up with a title called Strategy and Client Relations. As you know, Sean, law firms are built for lawyers. So you're a lawyer or you're not a lawyer.
I am not a lawyer, so they kind of had to create something for me. But back to the role, it is technically a non-bill role where I provide assistance to clients thinking about fundraising, thinking about investor relations, thinking about firm formation as well as fund formation. I'm part of what's called the investment funds group, which is a 500-lawyer team focused entirely on fund formation and liquidity solutions. In addition to those 500 attorneys, we have about a hundred attorneys dedicated to tax and regulatory matters, but specific to closed-ended funds and alternative strategies. So unlike a lot of other law firms that have a broader private equity category where they do fund formation, they do liquidity, they do secondaries, and they do m and a. We separate the m and a, the transactional side, Kirkland & Ellis is a 3000-plus attorney law firm on a global basis, and I'd say about half of those attorneys are involved in private equity, if not more. We are, as you mentioned, the largest player in private equity.
SM (03:14):
That's really helpful to set the stage. Full disclosure, while I was in private equity, I was a longtime Kirkland & Ellis client, and the one thing that was the constant, I always loved having Kirkland & Ellis on my side, and I never liked seeing him on the other side.
BB (03:30):
I hear that very frequently. It was funny, actually, Sean, when I joined Kirkland, having been on the LP side for a long time, a lot of my friends didn't mix their words with regards to what the culture, what the tone of things at Kirkland are. It is really though an evolving team and evolving entity. We took a very strong approach towards softening our edges about eight or nine years ago. We have a no-jerk policy, to be perfectly honest. Everyone is very professional and unbelievably intelligent, a hundred percent dedicated to our clients. But that said, of the, you know, several hundred attorneys I deal with, there's not one that I wouldn't be happy sitting down having lunch or a coffee or a dinner with and truly consider my friends. And I think as a law firm, we really differentiate that we have that friendship, that close relationship with our clients that call us for both legal as well as personal advice.
And the fun thing about fund formation is you really work with entrepreneurs at inception, at launch. You sit down with them, you strategize with them. I do that on a daily basis, You know, is now the right time to launch a new firm? What is the strategy? What should your size be? Who would you compete with? How do you position your story so that it's best delivered to both LPs, the general market and upfront placement agents, and other service providers, which is another big piece of my job is introducing fund managers and GPs to other service providers, other people who play in the same playground as the rest of us. You know, if you miss that initial window or don't have that great first impression for whatever reason, that could be the difference between a successful firm and an unsuccessful firm. So we try to facilitate introductions, we try to smooth the process as much as possible so that the funds get launched easier, that the strategy is articulated properly, and at the end of the day, everyone's happier that way.
SM (05:27):
The way that you're describing how you operate is one of the reasons why Kirkland & Ellis has the largest market share in private equity. The fact that I, I think you all think about the business of legal advice in the business of being a law firm as a business, and the fact that they have a business person like you in the mix shows how they're thinking about and evolving the business model versus maybe some of the more traditional constructs. I think with that in mind, I think that's a great way to set the stage for some of the discussions we're gonna have today. As you think about all of these, these funds that come through, and to frame this, how many new fund formations are you involved with approximately every year?
BB (06:03):
Personally, I probably touch 50 to 60 new fund formations in the calendar year as a firm, we're probably in the 150 to 200 range. Yeah, we've got over 650 clients or discrete GP clients. And to put things into a little bit further context, and this is the number that shocks me every time I say it is in the last five years, our clients have raised over a trillion and a half dollars of committed capital.
SM (06:30):
So you are seeing a hugely statistically significant portion of what's happening in private equity in terms of particularly the new fund formation. So what would you say are some of the top things that limited partners are looking for when making new general partner PE firm commitments?
BB (06:48):
Great question. Honestly, I don't know that that's changed very much in the last 15, 20 years. I think there's been an increase in selectivity based on other market conditions, which I think we can talk about in a little bit. But at the end of the day, it's the team and it's the team's experience team is critical. The team's experience is critical. More importantly, the team's cohesiveness. So you could have an individual who was a fantastic investor at a large well-known buyout firm, put together a group of individuals to build out a new entity. But if that team hasn't worked together, if it's not a complete lift out, it's gonna be a much harder fundraise. The SEC is much more diligent with regards to what attribution can and can't be shared with prospects and LPs, and that's gonna actually increase even more. So LPs need to be able to navigate the due diligence process, understand what deals a GP has worked on in the past, but at the end of the day, it's the experience of the individuals, it's the experience of the individuals together. It's their track record investing in the same asset class, the same strategy, the same size, in the same stage as what they are proposing in their terms and in their new entity. Perfect example, as I was recently working with a client who's become a very good friend who's raising a billion dollar fund in advance of raising that fund though, he decided to do some one-off transactions and the first transaction that he came across was a 700 million transaction. Our advice, and ultimately the LP's advice was to slow down, not necessarily exercise or undertake that transaction because it would dilute his message. He's saying that I'm making 100, 150 million investments, that's what I've done historically, and now he's coming across the finish line or presenting this first deal that's significantly larger than what he has shared thus far. So staying on target, we're both golfers. To use the golf analogy, stay right down the middle of the fairway. Yep. Is critical.
SM (08:57):
You gotta be the ball, right? Absolutely. Consistency, focus, you know, be who you are, and continue to do so. So I think that makes a ton of sense and that resonates on multiple levels with me.
BB (09:09):
Sean, one other point that's probably worth referencing now and we can talk about also later, is the importance of diversity and inclusion in your team. So yeah, there's not an LP of significance. There's not an institutional caliber LP that's not looking at a PE firm's composition from a team dynamic. Everyone can't be 50-year-old Caucasian men and you look at the websites and 80% of them are not diverse to an extent that they need to be. So every team that I deal with needs to have a different composition than it was 10, 15 years ago. And again, it's not only a box-checking exercise for the LPs, which in many cases it is but there's a better understanding and a recognition in the industry that diversity of experience, diversity of background, general diversity, improves returns and improves returns materially. It also improves your ability to source transactions, to sell transactions, and it's a critical component that new fund managers as well as existing fund managers need to wrap their arms around at this point.
SM (10:22):
That's a great perspective and it's something as we think about the 500-plus PE firms that BluWave works with every day, it is on the forefront of virtually every fund. I heard of this great term about doing good things that are not only good for the world but good for you. And someone described it as selfish altruism, it's altruistic, but it's selfishly great for these firms because there's strategic value and you've seen study after study that shows the value that it creates by bringing in diversity of perspectives and a diversity of people. And I think it's one of the top trends in all of PE right now for good reason.
BB (10:54):
Absolutely. And it's been a trend in Europe for 20 years. We, for whatever reason, have been in the second inning. This is literally the longest baseball game ever. We've been in the second inning for 20, 25 years.
SM (11:06):
A hundred percent. So when you think about the market right now and you think about particularly fundraising where you're, you're intimately involved, how healthy is the fundraising environment compared to last year?
BB (11:18):
It's certainly slowing down compared to years past. It's still a very vibrant, very active, very exciting time to be in the market. Frequent recently disclosed some numbers that compared to this time last year, the market's down about 50% from a fundraising perspective in private equity. That said, it's still an incredibly robust market in certain ways it's a binary barbelled market if you will. The large funds, the household brands, and the established bigger firms are able to raise large funds. Several years ago, you never saw a fund larger than 10 billion. Now it's a very common thing to see a GP raising 10, 15, or even 20 billion fund sizes. On the other end of the spectrum, though, emerging managers, managers that haven't yet really got in into their stride with an LP base or an institutional LP base are having a hard time. It's not uncommon to see a fund in the market for more than 24 months.
I've recently had a conversation with a first-time manager who's looking to raise over a billion dollars and thought that he could do it inside 12 months. And I tried to put the breaks on and reminded him that that first close is actually the starting point to the fundraise. Everything's a pre-close for that first six, eight months, get to that first close and then per most limited partner agreements, you've got 12 months to reach that final close. So the market is still difficult. My placement agent friends are telling me they've never seen more activity, they've never seen more inbounds, they have never been more selective in the GPs that they choose to work with. I tend to make introductions for my GP clients to placement agents and other service providers, and it's often taking 10 to 12 introductions to placement agents for a good GP to find an agent who will take them on, not necessarily because they're not a good firm, it's just that their slots are filled.
Placement agents have a discrete number of mandates that they can take on at any time. Factoring in existing relationships, factoring in competing strategies, factoring in competing sizes, it's a challenge to find the right partner. And the market is certainly tightening from the perspective of the placement agents. From the perspective of the LPs, I mean, speaking of LPs, the result of these larger funds coming to market with much larger funds also coming to market faster historically than they have in the past is leading LPs to being either overallocated or frankly over committed from a time perspective to even analyze new funds. I recently read that one of the large pension plan would be at 150% of their annual allocation if they only re-upped with existing managers not even speaking to anything new.
SM (14:13):
To what extent do you think the denominator effect is impacting that? And maybe to describe this, for those who aren't familiar with the denominator effect, really what's happening right now is for large asset managers, they have publicly traded portfolios that are declining quite rapidly with the markets today. The private equity industry in general does not mark their markets nearly as in a volatile as way as the public markets because they're projecting through the storm. And so their values are staying the same while their public portfolios are going down. And so their percentage of private equities it relates to their total portfolio is almost going up because you have apples and oranges calculation that's occurring. How is that impacting fundraising right now?
BB (14:58):
Yeah, it's absolutely impacting it. I mean, the denominator effect comes into play every 10 to 12 years. Every time we see some kind of public market negative behaviors, it, it's funny, you don't hear it when the public markets are skyrocketing, right? You don't hear, "oh my God, my allocation's gone through the roof because there's been so much public profits." But when a institution has a predetermined allocation limitation and the private equity piece grows, they are stuck and what can you do? You can cut off all new allocations, which we're seeing a lot of, at least we're hearing from a lot of institutions that they're just tapped out, they can't make new commitments. The other option that they can do is cut back on existing relationships. They can say, you know, instead of coming in at a hundred million commitment, we're gonna come in at 50, we're gonna come in at 25 to keep that relationship going.
Some groups are looking at skipping, this vintage will not come into this fund will come into the next fund. But again, that's problematic. You try to maintain vintage diversification, so you want to always be in the funds. But the denominator effect is a real issue. I think that some groups are going back to their investment committees and their oversight committees and asking for adjustments. Can we increase the PE allocation? Because if you look at the public markets, they're in a decline. The private equity assets are very strong. They are somewhat counter-cyclical to public stocks. It's beneficial to stay in. And of course the third piece or the, I don't know what fourth piece at this point, is participating in the secondary market. And we'll talk about the secondary market a little bit later, but unfortunately, you don't wanna sell assets in a secondary market when it's disadvantageous to you. And reacting to the denominator effect in forcing you to sell things in the secondary market will lead to deeper discounts and a less efficient process for you as the seller. That said, it is something that a lot of groups are taking a closer look at right now.
SM (17:04):
I think this, it's an important topic for asset allocators right now because, and one thing that is, they're thinking about their allocations. One, they've gotta, I think, understand that there is this disconnect. They've got public portfolios that are marked to market on a day to day basis, not necessarily rationally in the short term. You've got private equity portfolios that mark to market much less real time. They have to understand there's that disconnect. The other thing that I think they should really think about is that private equity firms and their portfolios do absolutely the best when times are the worst. If you look at the data, the best returns occur during times. Exactly right. Now, I would think that some of these asset allocators would be completely greedy and selfish in these times and maybe think about increasing their their allocations to PE because this is the time when it gets to be really
BB (17:52):
Good. No question about it. I mean, look, the last 15 years, cash has been cheap. Debt has been incredibly cheap and it's been a real free for all, frankly for the PE industry. So some of the programs are actually asking for increased allocations. Some of them are looking at the secondary market and we're actually just about to start to talk about the secondary market a little bit. And the secondary market is a great tool for portfolio management. The negative of course, though, is you don't want to do it when the times are bad and you're gonna sell it at a discount or an artificially required discount.
SM (18:25):
That's a great segue. And so for private equity firms, one of the great things is I think they can be quite creative in terms of being able to continue to make investments and finding ways to maybe go around challenging times. Right now, two of the biggest kind of trends that we're seeing here today are secondary funds and continuation funds. Can you share a little bit about what those two are and how private equity firms are using them?
BB (18:52):
So we'll start with just secondary funds as a starting point. Secondary funds are essentially funds created to buy assets, existing assets from LPs selling. And those could either be individual assets and individual company shares, individual interests in a GP or a bundle of interests in GPs or a bundle of individual companies. 20, 25 years ago when secondaries first started, it had a very bad perception in the market. It was like a used interest. What you were selling didn't have a lot of value. We all know the term zombie funds and zombie assets. So historically people thought, Oh god, what's wrong with this thing? It was gonna sell it a huge discount, 50, 60% just to get it off the books. Over the last 15 years, this market has matured and evolved and really grown into a standalone asset class that is, as I referenced a few seconds ago, a real tool, a tangible tool to balance your portfolio and utilize your portfolio so a new CIO could come on board and decide he doesn't like a certain asset class and put the entire portfolio on the market.
I worked for a firm in the past that that situation happened and we put a portfolio of 20 GP interests into the secondary sale. You decide you don't like venture anymore and you want to free up some cash so you can invest into real estate. Again, perfect opportunity. You put a process together, you bundle your VC assets, sell them, You might get a discount to current nav, but from a time use of money perspective, from a cash flow perspective, you're better off and you can invest in a different asset class. So the secondary market has grown into a very significant piece of the business as a category. Last year it did somewhere in the 50 to 60 billion of transactions in the first half rather there was over a hundred billion of transactions last year in the secondary market continuation funds, which you referenced, Sean, is a reasonably new dynamic, very active, very important.
What this refers to are funds created to extend the life of an individual asset, generally launched by the GP. So it's a GP led transaction where they take an asset that they love that has been in their portfolio for a long time, it could be past the point of the fun term or realistically they just know that it's not ready to be sold, it's an asset that's better cash flowing, It's an asset better to be held for a longer period. And what they do is they bundle either a single asset or multiple assets into a new vehicle. They offer existing limited partners the opportunity to sell their interest or roll their interest into the new fund and then they can go out and actually get new capital from new LPs. And what this does is it essentially restarts the clock on this asset. It restarts the clock from a management fee perspective, it restarts the clock from a carried interest perspective, but it eliminates the need to force a sale of a good company. And again, this is something that we've been incredibly active with IT at Kirkland over the last few years. They are incredibly beneficial. There have been some articles out there saying that LPs are starting to sour on continuation funds a little bit, but personally I think they're a fantastic outcome. They're a fantastic tool in the toolbox for GPs at this point.
SM (22:26):
The continuation fund I think is one of the best tools that have emerged in a long time. And, and if I go back on my own experiences as a private equity GP, you feel the pressure to be back in the market and fundraise every three to five years to fundraise. You've gotta have illustrative exits from that prior fund. What that often meant is we were forced to, in some ways, monetize our best investments that had really long runways in front of them so that we could park a return. And that was something we would always sit around the table and say, Geez, this company's great. We've got a long way to go with this, but we have to show some real realized returns in order to get back to market. And so I think this is a tool that's gonna allow P firms to keep on getting multiples of money versus IRS and maybe serve both at the same time.
BB (23:16):
No question about it. I mean as as a participant in the industry, when I was in LP way back when, I participated in a co-investment let it Go investment in a very interesting technology company, the company knocked it outta the park under every metric you can imagine. And for a variety of reasons, the company has still not been sold. We've done a few recaps, we've taken some money off the table. But that said, and this is again, I'm two companies removed from the firm I was with when I, I made this investment. We've had this investment for 15 years. It's been in the portfolio of LPs for over 15 years. And this was the last investment from the vintage fund that made the investment. So realistically, this is about an 18 year old investment. This is a perfect example of a continuation fund candidate because it's still a good company. It's, you know, EBIT does a very impressive number. It's cash flowing, but there are a lot of LPs that just wanna close the books on this one particular partnership and be done with it and take capital off the table and realize some liquidity. And I'm sure the GP doesn't want to continue to have to answer to an LP who made a commitment in 2000 for this company.
SM (24:26):
Yeah, I think this is a tool that every PE firm should be thoughtful about in terms of adding to their arsenal secondary funds. I think as we, for your first point is also a really good one in terms of one of the things that we're seeing a lot within our client base is increased focus and specialization and evolution over time. And it's a tool that I think every GP should similarly be thoughtful, particularly if they're navigating changes in their focus areas where they can, as you said, kind of come to market it really at the beginning of our conversation with a focus story and narrative around who you're going to be in in the future. And that's another tool that I think helps kind of clean that up for the going forward period and saying, this is who we are and who we're gonna be and our portfolio reflects it.
BB (25:07):
No question about it. And as a firm Kirkland, we consider liquidity solutions in the secondary market as core part of our investment funds practice. Like I said, we've got 500 lawyers working on both the fund formation side and the liquidity solution side, which a big piece of is the secondary market and the creation of these GP led continuation funds. I mean, it's important to really understand this space cuz it's not going anywhere except up right now. I think the statistic is the secondary market constitutes about 2% of the total alternative investment dollar if that doubles every year for the next few years. We're still very small in the context of the industry, but it can easily be a trillion dollar piece of the puzzle within the next 10 years.
SM (25:55):
I think it's gonna be incredibly important and massive trend going forward and and for good reason. And I think it's gonna benefit not only the GPs but the LPs as this continues to evolve.
BB (26:04):
No question about it. One
SM (26:06):
Of the other things, the general partner, which is for those who are not familiar with it, this is the vehicle that is essentially the partners of the private equity firm and houses much of the economics of the fund structure and it's the controlling entity very often of a private equity fund or firm per se. And so one of the things that we're seeing happen more and more is that private equity firms are using the GP as a source of liquidity, particularly for the maybe the founding partners or existing partners. And they're either selling their GP stakes or they're using some other tool to bring capital into the senior professionals of the firm. What are some of the things that you're seeing right now in terms of selling stakes in the GP? Why is it used and what are maybe some of the newly evolving resources that are also coming to bear?
BB (26:55):
Selling a GP stake has become a growing piece of the business. I think it's been, last year there were over 50 transactions of private equity firms selling a piece of themselves, frankly. And as you alluded to, I mean there's a lot of reasons to do so. It's not only a opportunity to realize a lot of liquidity for the founders, which it is, but there's strategic rationale for that. Often it's associated with succession planning, so they can raise a lot of capital by selling pieces. Anyone who has a fractional ownership in the management company will get a piece. So that allows the older founders, the seasoned founders, to essentially ride off into the sunset comfortable that they've become more comfortable than they already are. The junior partners, the next generation now has a little bit more capital handy. They can use that capital to build their firm.
You look at these GPs that are raising larger and larger funds, obviously it's nice, but it also is a hugely troublesome financial burden for the younger partners as there's a one, two to 3% GP commitment and a 2% GP commitment on a 5 billion, 10 billion fund is materially different than a two 3% GP commitment on a 200, 500, 700 million fund. So yes, they could go to some of the leading financial institutions and ask for GP commitment loans or other types of borrowings, but many times they're utilizing this minority stake sale as a cash flow opportunity for them to increase their GP commitment. Also using that cash from this event to build their firms, increase their real estate, hire new hires, increase the salaries of their younger people, potentially look to new strategies and do the research and pay for the outside consultants and so forth that a good long term entity needs to do to make an informed decision.
So again, a perception is that these are only intended to make the rich richer, to make the GPs right off into the sunset with multi-generational wealth. The reality is, is it's a very effective tactical tool for the younger generations and even existing generations of leaderships of firms to build their entities and really grow them. The funds that are being launched and the buyers of these minority stakes are also big strategic players in the industry. And there is thought and rational decision making behind which partner, which GP partner they're looking for. So there's the Blackstones, the Goldman Sachs, the Alliance Newberg, the dials, all these different groups are involved and the expectation from both the GP as well, frankly as their LPs is that there are other intangible benefits that will come by selling to the right counterparty. And these are very passive transactions. It's not the case that a buyer of a GP stake is going to immediately assume two seats on the investment committee is going to assume a role in the day to day management of the general partnership. These are frankly financial investment opportunities for the buyers. They're looking at frankly, management fee streams as opposed to carried interest streams and they don't want to be hands on. They are truly looking at it as another investment opportunity, which is why we've seen dozens of GP stake funds being launched in the multi-billion dollar range. So LPs can invest in one of these funds to see a high single digit, low double digit, almost fixed income like return.
SM (30:56):
That's a great kind of delineation behind what's happening. But as I think about what's going on in the GP stakes, it's another example of how the business of private equity is becoming more like a business. And so these GP stakes are just as if you are running an operating company or portfolio company and you said, Hey, I need some growth capital. I wanna bring in some outside capital so we can maybe take some money off the table, but also fuel growth and development. So we're gonna bring in an equity partner. And so it's the same way that the private equity firms are starting to think about themselves and the same way they think about a portfolio company. And with that, I think the considerations as a GP is if you're bringing in an equity partner, they're gonna be part of the fabric of your business for quite some time and they're gonna be an equity holder, a partner in potentially in perpetuity.
And that brings a lot with it. That brings a partner, another thoughtful person in your capital structure to think about. One of the things that I think is also evolving, I'd love your perspective on this, is not only are there equity tools that they can use in terms of selling stakes in the GP, but as you pointed out just a moment ago, there's also almost like debt or preferred equity type structures that can pay down over time. Talk a little bit about those tools, how people are using 'em and maybe some of the benefits that come along with that.
BB (32:10):
A sale of a piece of your management company is probably not right for everybody and they don't wanna dilute their ownership. They have a perception for whatever reason that you know, it is more involved than it could be. So all the major financial institutions, you know, I don't want to name names, but we know who are the leading lenders to the industry, have all created solutions from a cash flow or from a capital call line perspective. You know, subscription lines, things like that. But there are also very well positioned to make direct loans to the general partner for the operating expenses that we discussed. Once you're a GP with a steady stream of management fees and that predictability of cash flow you can borrow against that, you can borrow against that as an individual, you can borrow against it as a firm. Preferred equity is another interesting piece that you just referenced, and that's both to the GP directly as well as a new solution within the secondary world.
So basically what they're doing is creating a tiered return profile, for lack of a better term, or a strip, creating strips of equity. So rather than sell an entire piece, rather than sell down your, lose that equity in your firm or your company, it's a partial sale with a preferred return established over the course of say, 10 years. So I'm gonna sell you 50% of my interest, here's the price we're gonna negotiate a prenegotiated rate of return. Once we hit that rate of return, there's gonna be a preference, a liquidity preference, and then a pref. And once you hit that pref, the seller gets the entire piece back, it creates a more balanced, aligned approach to that equity requirement.
SM (34:01):
I think these are also tools that every GP should be thinking about and it enables them to think about their own business like they would as if they were a, an operating company, a portfolio company where you can think about capital structure and the optionality that it provides, the resources it provides to not only very rightfully enables some people to have liquidity but also enable them to make stronger, bigger, deeper investments in the growth and development of their own businesses.
BB (34:26):
No question about it. And you know, when you think about it, the LPs really, if an LP thinks properly about it, they want to see this, They want to see a GP focusing on themselves with that same financial engineering, with that same strategic vision that they're gonna bring to their companies. And if an LP sees a GP that's not operating effectively internally, it's gonna raise question with regards to how they can affect and manage their investments and what kind of advice they can bring to their portfolio companies.
SM (34:57):
That's great. Let's talk about some of the other trends that are popping up here and there's a number of things, technology, ESG compliance. What are some of the things that you're seeing on the technology front within the PE firms themselves?
BB (35:12):
So technology is critical. I mean it's always been critical, but I think it's become more so in this post covid post pandemic world because the LP has frankly become comfortable with technology, comfortable with Zoom, comfortable with virtual due diligence. And as a result the GP needs to raise the bar, for lack of a better term. Technology has really evolved into something far more important than it was before the pandemic. We've all become comfortable with the use of technology, but importantly LPs have become comfortable with it from the due diligence perspective, from the meetings perspective, the reality is is very few first meetings will be held in person. So that first impression is now gonna be over zoom. Consequently, you need to ensure that you've got a high quality, high definition camera, you have a good microphone, you've got a good lighting, you've got an appropriate or neutral background.
You don't wanna blow that one chance you have with an LP, with a placement agent, with another service provider based on poor technology. Make sure you have the right wifi and if you don't have the right wifi and the right bandwidth, make sure that you're going to a location where you do. Another interesting component is the multi-team member Zoom meetings and for lack of a better term, the Brady Bunch screen where you see three or four or five people on the board. It's always gonna be hard to make a connection with someone virtually. What you don't want to do though is appear bored and appeared completely disinterested when someone else on your team is talking. And LPs will try to read body language in person and it's even easier to read body language virtually because frankly the audience doesn't know who you're looking at when it's on Zoom.
So I could be looking at two or three non speakers to see what their response is to their colleagues speaking. So you need to really be trained and think carefully about how your appearance is online, what your technologies look like online. And then secondly, this evolves into the use of video and technology for annual meetings. LPs really like the virtual annual meeting option. It's not gonna replace the annual meeting, unfortunately. I think on a go-forward basis, most GPs are gonna have to provide a virtual solution in parallel to the in-person solution. But when you think about it, it's beneficial to both sides. It reduces costs for the LP, for the GP, it actually can increase the number of attendees and the exposure. You can have prospects, you can have three or four members of an LPs investment committee, you can have the entirety of an investment committee in attendance. It doesn't necessarily need to have all the bells and whistles that we saw during some virtual annual meetings during the pandemic, but it is something that every GP needs to think about.
SM (38:10):
I think technology like everything else in our hybrid world, but living is gonna make a big difference. I think many of the LPs are gonna be very happy that they're not gonna go to seven chicken dinners with either white or brown sauce. That's you named the University Club in Midtown.
BB (38:24):
No question about it. I mean, you know, we all know that October, November, March, April are incredibly busy and you know, if you can hit two or three meetings in the course of a day virtually versus getting on a plane and blowing two or three days crossing the country, it's just beneficial for everyone. The big negative of course is you don't get the networking, you don't get the face to face, you don't get that interaction with both the GPs, their management companies and the other LPs. So I mean, I do think that the meetings will continue to exist. I just think that you're not gonna hit as many of them as an LP. You're gonna be more selective. And as a result, the in person meetings should be stronger than they were in the past. And the virtual ones need to have, yeah, you know, be successful and need to be more than an iPhone aimed at the podium. There needs to be a technology function there.
SM (39:17):
And I think even from the GP side, it's gonna be great on the fundraising front because every GPs got the story where they flew all the way to Zurich and the person wasn't there, right? And that took six months to schedule. And so if we can have these first meetings virtually in a high quality environment where you don't have to fly to Hong Kong and realize that the person isn't there or for a one hour meeting and get these first interactions through, and not only will happen faster, but it'll be a more, I think it'll be a lighter lift on everyone. That's a really thoughtful trend for GPs and LPs to be thoughtful about. One other thing that I think is coming up in virtually every part of PE right now, and this started in the upper markets of PE, but now is a hundred percent resident in lower middle market is ESG. Talk about what you're seeing there, Brian.
BB (40:02):
Yeah, no question about it. I mean, I referenced it earlier in the conversation, but ESG permeates the industry now and it has to permeate the industry. ESG also, however, is a overused term. It means different things for different people. Environmental, social and governance is what the ES and the G stand for. But the reality and the the important factor is that limited partners, the industry, the public, the press, everyone wants to ensure that people are doing the right thing and that investment firms are doing the right things. This permeates from the first look at the website down to every individual company that a GP makes an investment in. Is there, uh, diversity on the board? Is there a environmental awareness that the company's byproducts aren't damaging the local economy or the local environment? Is the team doing the right thing from a social perspective?
There's so many different pieces that ESG really needs to be considered. From the inception of a firm, who are the other partners on your team? Who are the junior people on your team? What's the location of your office? Do you have an ESG policy statement in your offering documents? Is ESG mentioned in your initial pitch deck? If the answer is no to any of these things, you need to think about it. You need to, to talk to your attorneys, you need to read articles, you need to reach out to an ESG consultant. Most funded administrators these days have an ESG team to help walk you through these topics. It's again, something that is growing in importance across the world, frankly. But importantly in our industry, the more institutional, the larger the LP, the more important these issues will be. And it's just past the point you can ignore them. It's past the point that you can have every partner at the team being a, again, a mid fifties white guy for lack of a better description. Within Kirkland and I think it's consistent with banks and some of the larger GPs. We've built an ESG team. We've got over 25 lawyers who are entirely focused on ESG. They're involved in ding, they're involved in company sales, they're involved in green debt, green financing. Every conversation that I have with a new manager or an existing manager, we bring in a lawyer or two whose focus entirely is on ESG. And ESG also doesn't need to be signing the UNPRI and other global policy statements about ESG. It's being prepared to answer the question, being positioned to demonstrate that you're doing what you say you're gonna do. LPs have gotten really strong and really smart and they recognize when someone's greenwashing, when someone's insincere, don't get caught doing that. Don't get caught misleading. It will only come back to haunt you.
SM (43:11):
Yeah, I remember as a personal anecdote years ago, I was involved with helping to raise a fund that I was working with and I remember getting a DDQ, which is called a due diligence questionnaire from an LP. And they said, What is your ESG policy? As I think back, I kind of laugh and I go, I go, First thing I did was Google what is ESG? I had no clue what it even was. And this was a while ago, right? So, So the first thing I did is Google what's ESG? And then when I realized was, wait a minute, we're doing a lot of this stuff already. We just hadn't put it around a framework. And some people think about this as broccoli, it's good for the world. But I was like, well it can be broccoli with cheese on it because it's good for the world, but this stuff is good for business too. And we can do both or not mutually exclusive. And in fact, we already are doing most of this. And so why not be able to just capture it in a framework? And the reality is it's important to to LPs. It should be important to the GPs at the same time. I think a lot of firms, particularly at the upper market, are much more comfortable and and capable in terms of the exact framework because the large companies they're investing in, we're already doing this really through a framework of corporate social responsibility. That's right. So CSR and it's now, it's maybe some different acronyms and it's coming down to the lower middle market. And really where they have to really work through is not having the data capture capabilities. And so there's some technology tools that are evolving that will make this easier, I think, for everyone. But I think everyone can agree that this is important to the LPs. It may not win you an LP, but it surely could lose you one.
BB (44:42):
Absolutely could lose you one. And as I often tell my clients, it's much easier for an LP to say "no" than to say "yes." And the other point that I would add to what you just said, Sean, is think in terms of building blocks. You're a lower mid-market buyout firm right now, ESG and these, you know, the CSR things aren't as important today, but as you move up market, as you go from a 200 million fund to a 500 million fund and you're talking to different LPs, they're gonna ask you about these ESG matters and the diversity matters and the social matters from your earlier portfolio companies. So get into the habit as a GP today of capturing that information, putting the metrics together, building a annual or quarterly ESG report. The upper market firms all have chief impact officers are starting to higher impact officers. Not necessarily important for the smaller and the lower mid-market firms, but assign that responsibility to people. Ensure that you're capturing the diversity and the dynamic at every portfolio board, every portfolio company's leadership. I just saw a DDQ that came across and asked literally for the DNI of every officer and every key executive of every portfolio company for a GP. So start capturing that information now. It's only gonna be helpful down the road because you want to grow. You want to be a billion dollar GP to get there. You need the big institutional LPs, the big institutional LPs need you to recognize and act on ESG before they write you a check.
SM (46:13):
That's great advice. We've covered a lot of, I think, incredibly important and value added information here. With just a couple minutes left, can you share a little bit about what you're seeing real time and the latest in terms of SEC compliance and what private equity firms need to be thoughtful about what's coming real time real soon?
BB (46:32):
I'm gonna caveat my answer that I am not a lawyer. I work for Kirkland & Ellis, the biggest law firm in the space, but I am not a lawyer that said, the SEC's new marketing rule is gonna take effect on November 4th. This is a very significant change and will have implications across all marketing, all relationships, all emails and presentations. If you do not have a CCO who's knowledgeable about these new rules, you need to have your CCO or your GCs get smarter on what this rule means. If you've got an outside compliance consultant, talk to your consultant. If you've got an attorney that is strong on the regulatory front, have a conversation with them. If you don't, please call me. We've got one of the strongest regulatory practices in the industry that said, this new rule is gonna change the definition of what an advertisement is.
Instead of only covering what traditional advertising means, it's now gonna talk about testimonials and endorsements, social media and the impact of social media on advertising, what's considered advertising, what's not considered advertising. It's gonna impact so many different pieces of the puzzle that we deal with on a daily basis. What emails you need to keep, how the email can be treated cherry picking versus non cherry picking, gross IRR versus net IRR. There's so many key points that we deal with on a daily basis that will be impacted by this, that it's critical to get a better understanding. And what's interesting, and it's important to note, the SEC introduced this about two years ago, and they've given the industry this 18 month transitional period. So November 4th isn't the time to start thinking about it and assume that they're gonna be lenient. What we've heard and what we're anticipating is very little leniency at this point. They consider the SEC views this as having been an 18 month grandfather period. Now it's ready to go. So you're gonna start seeing GPs getting not only deficiency letters, but enforcement if they're not fully following this new mandate, these new rules.
SM (48:50):
I think this is incredibly important information that every GP, every PE firm leadership team needs to be thoughtful about right now. And I'm sure many of most are taking action, but if not, they're gonna get going real quick.
BB (49:04):
Many of them are sitting back and saying, oh, you know what, it's not clear. We're not sure what they're gonna do. They're gonna sit back and wait for those first rulings and thinking that they're just gonna be deficiency statements. And the reality is, is I think there are gonna be a lot of people who are very disappointed very quickly when the SEC comes down on this. So just get comfortable with it. And again, it's not necessarily calling Kirkland, although we'd be happy to have that conversation. It's talking to your compliance consultants, talking to your GCs, your CCOs, et cetera. This is a pretty significant change.
SM (49:34):
That's great advice and I think everyone's gonna start looking into this real quickly. So Brian, my friend Brian Bank, I'd like to thank you very much for sharing all sorts of information. I've got a notepad full of takeaways here. We want to thank you for coming here and sharing these insights with our listeners.
BB (49:50):
Sean, my pleasure. Thank you so much and thanks for everything that you guys do. It's uh, a fantastic business you've built there and look forward to chatting soon.
SM (49:58):
Thanks, Brian, I appreciate you.
BB (49:59):
Thanks. Take care, Sean.
SM (50:06):
Thank you for joining us during our discussion with Brian Bank. For more information, go to bluwave.net/podcast. Please continue to look for us anywhere you find your favorite podcast, including Apple, Google, and Spotify. We truly appreciate your support. If you like what you hear, please subscribe, review and share. In the meantime, let us know if there's anything, anything we can do to support your success.
Onward.
THE BUSINESS BUILDER’S PODCAST
Private equity insights for and with top business builders, including investors, operators, executives and industry thought leaders. The Karma School of Business Podcast goes behind the scenes of PE, talking about business best practices and real-time industry trends. You'll learn from leading professionals and visionary business executives who will help you take action and enhance your life, whether you’re at a PE firm, a portco or a private or public company.
BluWave Founder & CEO Sean Mooney hosts the Private Equity Karma School of Business Podcast. BluWave is the business builders’ network for private equity grade due diligence and value creation needs.
BluWave Founder & CEO Sean Mooney hosts the Private Equity Karma School of Business Podcast. BluWave is the business builders’ network for private equity grade due diligence and value creation needs.
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