“Permanent Capital” as a Strategy for Values-Aligned Investing
The Christian Economic Forum hosts a world-class Global Event each year to connect the top industry leaders and experts from around the world with other individuals who are compelled to act upon the principles of God’s economy. The following paper was presented at CEF 2018.
— by Tom Blaisdell
Much of the capital available to Small and Medium Enterprises (SMEs) around the world, especially in the U.S., is in the form of private equity. The majority of this capital is allocated via Private Equity (PE) firms that are generally structured with 10-year terms, and the investment target is 3x to 5x return in 3 to 5 years on each investment they make. This model has worked well for both investors and companies based on the growth of the amount of capital that is deployed in this manner and the impressive returns these PE firms have delivered as a class.
There is, however, a class of founders/ entrepreneurs/CEOs for whom this model is not a great fit. These “legacy entrepreneurs” are not building companies solely for the purpose of “maximizing shareholder value.” Instead, they have a sense of purpose or mission to serve a customer or address a problem or need. They understand that providing an acceptable return on capital is imperative to grow a for- profit business, but this is a requirement of the business, not the objective. Moreover, because of this “mission” orientation, they are more likely to think in terms of building a lasting or “legacy” business, usually over decades or even generations, and do not think in terms of “exits” or “liquidity events,” which are requirements of the prevailing PE paradigm.
An alternative PE strategy to the “3x to 5x in 3 to 5 years” strategy can be labeled a “permanent capital” strategy. This approach is certainly not new. One could argue it is one of the oldest strategies around, since for centuries many families’ assets have often been concentrated in “permanent” vehicles such as family businesses, land holdings, etc. While the label “permanent” is convenient, it is really short hand for “capital that will not reasonably need to be spent in any currently anticipated timeframe.” Organizations such as endowments, foundations, family offices, insurance companies, pension plans, and Sovereign Wealth Funds (SWFs) all will typically have significant holdings of permanent capital.
Any organization that has “permanent capital” has several reasons to consider an allocation to a permanent capital investment strategy within the Private Equity asset class. A permanent capital strategy has the potential to provide superior returns based on:
Better entry prices
Fewer transaction costs
Better exit prices
Perhaps more importantly for the context of this paper, permanent capital also has the potential to provide better values alignment between investors and entrepreneurs.
Potential Advantages of a Permanent Capital Strategy
Better Entry Price
In many cases when a company is being sold (or is selling significant equity in the business), the sellers are simply looking for the best economic deal. For legacy entrepreneurs, however, non- economic considerations play a major role as well. These considerations may include the ability for the sellers to continue to participate in the business going forward, job protection for management as well as rank and file employees, and in many cases a commitment to ongoing preservation of the “values” of the company being sold.
As suggested above, many company founders who are committed to building “legacy businesses” have no interest in taking the company public or continually “flipping” the company from one financial sponsor to the next. They founded their businesses to serve a customer, not just to make a profit. Their vision is to serve more customers, and to do so better every year. In addition, over time they seek to build a valuable asset for their families and employees. Ideally these founders/owners would find like-minded “permanent capital” providers who are interested in growing value in and through the business rather than by trading the business from one investor to the next. In many cases, they are willing to take a lower price for their business (or shares in their business) to guarantee they can continue to operate their business in this manner.
Fewer Transaction Costs
Every time a company is sold and bought there are substantial transaction costs that are dilutive to the company’s owners. These expenses include legal fees, banker fees, accounting fees, consulting fees, and the immeasurable distraction costs of the transaction. These fees can easily run up to 5% or higher of the value of the company at each transaction point. Considering a 30-year time horizon for a company (long, but not forever) and the usual time horizon of a typical private equity owner of five to seven years (generously, as their target is usually three to five years), this would imply four to five transactions over the 30-year horizon times the associated drag of transaction costs on each transaction. Compare this to having continuous ownership by one entity through the 30-year period and the potential for saving and reinvesting these transaction costs is self-evident. There are also substantial savings in the sourcing, diligencing, closing, fixing, and selling of portfolio companies with a permanent capital strategy.
Using simple assumptions, a traditional firm would need to buy and sell 60 companies over a 30-year period, while a permanent capital strategy investor could invest and hold 10 companies over the same 30-year period. Clearly the traditional approach creates a lot more work sourcing, diligencing, selecting, fixing, and selling companies than the permanent capital approach, and would also require far more (and expensive) investment managers to implement it. The traditional approach—with its 120 transactions (60 companies bought and sold) versus 20 transactions (10 companies bought and sold) for the permanent capital strategy—would also make a lot of bankers, lawyers, consultants, and accountants very happy!
The potential tax advantages of a permanent capital strategy follow along the same vein as transaction costs, since with each transaction, taxes would need to be paid on the increase in value. Moreover, if the company is sold multiple times over a 30-year period, sometimes for a gain, sometimes for a loss, the gains and losses would accrue to different parties who would not be able to net them out against each other. The concept that taxes represent a real drag on investment performance is elementary: if you take your gains each year and reinvest them anew you not only lose the dollars paid in tax each year, but also lose compounding of those dollars over future years. While difficult to capture in hard numbers, it seems plausible that deferral of taxes is one of the biggest transaction cost savings of a permanent capital strategy versus a “3 to 5” trade-out strategy.
Better Exit Price
Nothing lasts forever. While we refer to the strategies in this paper as “permanent,” this is actually shorthand for “having a very long-time horizon with no pressure to sell.” A truism in the private equity business is that “it’s always better to be bought than sold.” But as a fund approaches (and often overshoots) its fund life, many firms are in the position of having to sell rather than waiting to be bought, and anyone who has been in this situation knows exactly how uncomfortable a position it is. On the other hand, if a company is profitable and growing and has no intention of selling itself in the foreseeable future, it is likely over time that it may be approached by interested buyers. If the company decides to sell in this situation, it will be on its own terms and timing, which may be very advantageous indeed.
Admittedly more qualitative, a significant potential advantage of a permanent capital strategy is the ability to create values alignment within a concentrated portfolio. Building a concentrated portfolio of companies with zero to very low company turnover means that an investing platform can wait until target companies match their values as well as their investment objectives. As in our previous example, finding 10 great companies that are consistent with an investor’s values is easier than finding 60. Importantly, investors don’t need to sacrifice returns to pursue this values alignment, but can actually anticipate higher returns based on the analysis above.
Organizations with stewardship of significant amounts of “permanent capital” have several strong arguments for employing a permanent capital investing strategy. Better entry prices, fewer transaction costs, tax avoidance and deferral, higher exit prices, and clearer values alignment are all potential advantages that could equate to measurably higher returns from employing such a strategy versus a typical “3x to 5x in 3 to 5 years” private equity strategy. Perhaps more importantly, allocating capital to this strategy will also provide access to more “values- aligned” capital for legacy entrepreneurs looking to build and grow mission-focused companies.