Soap bubble
Photograph by Getty Images
By Polina Marinova
August 2, 2018

Antoine Dréan doesn’t think private equity is in a bubble. In fact, he doesn’t think it’s anywhere even close to one.

You may know Dréan as the founder of Triago, one of the first private equity fund placement agents. His latest venture is Palico, a digital marketplace that streamlines fundraising and secondary trading in the PE market. It allows limited partners to search for general partners and even bid on or list secondary stakes. General partners can offer information about their firm and fundraising and follow up on LP leads.

In other words, he plays matchmaker for those in the PE community. He founded Palico in 2011 in an effort to allow PE firms to take advantage of new technology. “People were still relying primarily on phone and email to conduct business,” Dréan told Term Sheet. “At the time when most industries were going digital, I felt like it was time for PE to take advantage of technology to become a bit more efficient.”

As someone who has spent the last 26 years immersed in the private equity market, Dréan offered some context about what’s happening today. Term Sheet caught up with Dréan and Palico spokesman David Lanchner to discuss industry trends, record fundraising, and funds’ ability to generate attractive returns.

TERM SHEET: I recently read an article titled, “Everything About Private Equity Reeks of Bubble.” It lays out the concerns of private equity’s record fundraising that’s pushed the industry’s dry powder to more than $1 trillion. Can you break down what this kind of trend mean for the industry at large?

DRÉAN: My sense there is that private equity is only at the beginning. You may hear people saying that this is a bubble, that there’s too much money, that there’s never been this much dry powder, but I’ve been hearing this same story for the last 15 years.

Of course, there’s much more money today than there was 15 years ago and many more players, so some of this is definitely true. It’s true that there are many more competitors now — for one good buyout opportunity, there are 100 GPs. Now, private capital is $5 trillion of assets under management. For global financial assets, that number is $300 trillion. So PE is only 1.5% of what’s out there. When you think about it, this is still small.

Even though this space is about talent and much more art than science, I think that the risk involved got lower over time. A long time ago, it was possible to get negative returns. Today, that’s less the case. So overall, the asset class is much better than 20 to 25 years ago. It’s returning more money, it’s getting a bit more liquid, and overall, it’s a good asset class. So there’s no reason why this 1.5% number couldn’t grow to 5% or even 10%. This is why I’m saying this is just the beginning, and of course, there’s a flip side to that. There will be more money. There will be more competition. There will be diminishing returns. There will be a strong need for innovation, and a strong need for diminishing costs, fees, etc.

Are you seeing limited partners express concern about PE funds’ ability to generate attractive returns?

DRÉAN: Oh yeah. Obviously, for those who have been in the asset class for 20+ years, there is now a huge difference in returns between then and now. It used to be 20%+ [internal rate of return], I’m talking gross numbers, It’s now between 10% to 15% IRR. It’s almost been divided by two. Now, the good news for PE is that in the same time horizon, the risk-free rate has gone from 10% to zero. If you adjust the PE return on a risk-adjusted basis, the PE number is about the same. Even though LPs are quite concerned about diminishing returns, it’s still much more than the other asset classes.

The question is what happens when, for instance, the risk-free rate goes back to 5%. I mean, who knows when this is going to happen but it will. That’s when the cost of running PE will definitely need to go down. Otherwise, if PE is still 10% IRR and the risk-free rate is 5%, then it makes it difficult for LPs to justify liquidity risk and other risks, and they may at some point, put less money in PE unless this asset class becomes a bit less expensive. To be less expensive, you need to be more efficient, you need to use technology, you need to have interesting ideas such as yield management.

A lot of the capital is flowing to the large funds, so what does it mean for small and mid-sized funds operating in this kind of environment?

DRÉAN: I wouldn’t be surprised if in five years from now, you have two sorts of PE organizations. One category would be large firms with many different strategies. That’s becoming the case already. You already have firms with half a dozen different strategies under one umbrella. The second category will most probably be niche GPs and smaller entities ran by people who are experts in a given field or area. In the middle, it may be a little tougher. If you’re a generalist, mid-market buyout fund in Europe or in North America, it’s going to be difficult to survive unless you have a great track record. Apart from that, it could be difficult. The same thing goes for fund-of-funds. You have already seen many fund-of-funds leave the scene because they had less value, wanted their share of the pie and they were costly on top of an already expensive asset class. Those guys who were not bringing that much value are now pretty much out of business.

This is also why you’re seeing much more consolidation with some more niche GPs trying to find a new home. Some of them are pretty good at managing money, but they’re pretty poor at raising money, and they’re looking for other people who know how to do that.

What are some of the new strategies that firms are deploying?

DRÉAN: Smaller buyouts are moving credit. Some of them are moving into PE real estate. Some of them are adding infrastructure. Some are even moving into VC or growth strategies.

According to Palico’s latest investor survey, more than three out of five GPs say fundraising from sovereign wealth funds is a “fundraising priority.” Is this because of the large amounts of capital SWFs are willing to put to work?

DRÉAN: It depends on the type of GP. Obviously, if you’re raising $100 million, are you going to be appealing to SWFs? Probably not. But some of the larger GPs are all thinking that the sovereign wealth funds are great sources of capital because they’re able to write very large checks.

We, at Palico, believe there are about 15,000 active LPs on the market right now for private equity funds, including 3,000 who are very active. By “very active,” we mean that the groups that allocate almost every month to the asset class. I would guess SWFs are in that category, but you have about 30 of them. It’s a very tiny number.

Another point in the survey that stood out is that 75% of LPs are now willing to invest in first-time funds. This goes against the industry norm. What do you attribute this change in attitude to?

DRÉAN: That’s a really big shift. It was hell to raise a first-time fund 10 to 15 years ago. It’s actually now fairly easy. Well, “easy” may be an exaggeration, but there’s a chance today that if you’re a first time fund, you do raise money — especially if you’re a spin off. The reason why it’s easier now is because it’s linked to this appetite for private equity coming from pretty much every LP out there. It’s also linked to the fact that many LPs feel that some of the strategies are now less interesting as far as returns are concerned. Some funds got too big. Some funds have too many competitors. So some LPs are ready to look at new ideas, new faces, new industries, and new strategies to make sure that they keep their return objective where it should be.

LANCHNER: In the numbers we’ve seen at Palico, there is an interesting disconnect that’s occurring. We’ve seen surveys that say 70% of investors out there are or would like to be investing in first-time funds. The Catch-22 there is that in the survey, it shows that only about 5% of LPs have fixed allocation for first-time funds and approximately 58% invest opportunistically. While there is tremendous enthusiasm in investing in first-time funds, LPs don’t have as much time or resources in some instances to invest in these funds. About 40% of the funds on Palico are first-time funds.

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