“There’s a very strong cultural ‘us and them’. All the pitch decks and PPMs state that private equity produces higher returns. If you believe that then whatever you say or do is ok; you’ll be forgiven because you said you believe in higher returns. If you question that then you’re perceived as an enemy.”
Ludovic Phalippou, Said Business School
Culture is often cited as the cause or solution for many private capital fund challenges, including lack of diversity to ensuring firm-wide compliant behaviours. With the world undergoing major tectonic shifts, brought about by the pandemic, now is the time to reflect on how we got here, and seize the opportunity to change.
One of the most accepted definitions of culture comes from Marvin Bower, who said culture is “the way we do things around here”. There’s another definition that seems more accurate however, “culture is what you do when no one is watching”.
Private equity is undoubtedly unique. Unlike other models of investment, this is about the buying and selling of actual, physical companies, rather than numbers on a screen.
David Cooper, founding partner of Cooper Limon, who received his doctorate for research into opportunities to improve private equity practice, explains: “One of the fundamental findings of my PhD was that the private equity mindset is far more geared up to doing deals. A deal is a major, one-off financial decision. It’s quite a thing to do - you build conviction and effectively press a ‘pause button’ on the world at a single point in time so the deal can happen. But, once the deal is done, the world moves on with all its complexity and uncertainty. Private equity practice is less well-suited to addressing the complexities and trade-offs of that ‘live’ agenda.”
The industry orbits around its rainmakers, almost superhero figures able to execute transformational transactions. With so much focus on deal-doing, remuneration and incentivisation structures have naturally followed suit. But given culture’s intrinsic link to reward systems this could be problematic. Ludovic Phalippou, professor of financial economics at Said Business School, Oxford University observes, “For the people doing deals, the rule is very simple: the more money you generate the bigger cut you take. That’s going to lead to strange behaviours.”
As much as private equity is about deal-doing it is inherently about people. “When you stand back and look at what is going on in private equity there is a much bigger human component than other branches of finance,” notes Cooper. “When you do a small number of large deals, each one really matters – each one is significant. In terms of lived experience, every single deal will change the world for all the parties involved. It changes the world of the portfolio company, but also the world of the GP. One of the most precious and finite resources GPs have is their attention - you can only really pay attention to one thing at once. With every deal they do, the GP takes on one more raft of issues which they have to pay attention to.”
With so much riding on deal execution, there appears to be a sense among some deal teams that legal considerations are an afterthought or inconvenience. Says one former private equity general counsel, “In certain circumstances, deal teams are too eager to close a deal at any cost if the economics make sense, in part because they are incentivised to do deals, in part because they aren’t invested in process or the tax, regulatory or compliance elements of a deal and in part because they are simply unaware. There’s often a real blind spot. Without embedded, deal specific operational controls and GC oversight, it’s too easy for deal teams to go off piste. Where private capital is involved, it’s also easy for managers to forget that they operate in a regulated space.”
This attitude is at the crux of the divisions within each private equity firm. With the deal team often seen as the stars of the show, operational and finance functions - charged with managing risk, ensuring compliance and maintaining a solid operating platform - are understandably frustrated. “It’s not very exciting, but if you want to invest and manage client capital you’ve got to do it responsibly. Managers are after all merely custodians of their investors’ capital and ensuring that the way in which it is invested (minimising costs, losses and risks) and not just ensuring that it is invested in the right asset, is of paramount importance,” says the GC.
“The further away you are from the deal, the more normal people seem,” notes Phalippou.
Diversity and collusion
Richard Taffler, professor of finance and accounting at Warwick Business School, author of numerous studies on the psychology behind financial markets, reasons these behaviours through psychodynamics, “What we talk about in emotional finance are the group psychodynamics. Psychoanalyst Wilfred Bion talked about two types of groups; a work group, where the whole point is to work together to achieve a common goal, and where diversity is vital. Everyone respects each other and works together. The other is basic assumption groups, where the whole purpose of the group is to help each other feel good and warm, so any challenge to that is pushed away. It’s fundamental, and what we’ve got at the moment is a state of basic assumption group.”
Taffler believes the pervasiveness of basic assumption groups in private equity creates a sense of collusion in the industry.
Phalippou agrees. “There’s a very strong cultural ‘us and them’. All the pitch decks and PPMs state that private equity produces higher returns. If you believe that, then whatever you say or do is ok; you’ll be forgiven because you said you believe in higher returns. If you question that then you’re perceived as an enemy.”
Phalippou’s latest publication ‘An Inconvenient Fact: Private Equity Returns & The Billionaire Factory’ questions the industry’s performance as well as the management fees it collects. “Everyone read my study, it’s been downloaded 15,000 times. Some people protested and stated that my numbers are incorrect. But no one said ‘here are the real numbers’.”
Phalippou’s school has received angry complaints about the paper, “Instead of engaging with facts, some people just treat me as an enemy.”
Says a well-known and long-serving industry lawyer, “It’s clear that when something bad happens people don’t want to hear about it. If you look at a pitch deck and it’s all positive that’s treating people like idiots. To build trust you need to see both sides of the equation.”
The power of denial
A large focus of Taffler’s research on emotional finance is the importance of storytelling. “Ultimately, if you’re going to tell a convincing story you have to believe in it yourself. Stories are fundamental, not just in terms of raising capital from LPs but also in terms of being able to do your job. You have to convince yourself and that’s the only way to conviction.”
Phalippou also sees this. “Humans always need specification about what’s going on; a story for why they did what they did. Everyone has a story, everyone justifies what they have done. We need it to stay sane. These guys have made loads of money and they cannot accept that luck might have played a huge role. They justify it by saying they worked hard and are smarter than everyone else. So if someone comes in and questions this belief, the reaction is extremely defensive.”
Linked to this is one of the most common attacks on private equity; its lack of transparency. While GPs and LPs contractually agree on their information flow, when it comes to public relations, the industry prefers to stay away from the spotlight.
Mounir Guen, CEO of MVision explains, “The industry is well meaning and it makes an effort. But it also tries to not be too visible. It finds itself aggressively challenged politically. In some economies this is a significant business, but they’re trying to be modest and quiet.”
However, culture has a lot to do with trust - it’s about believing people will behave a certain way when they’re not being watched. “Trust comes from information. Information in this industry is poorly circulated,” says a lawyer. “Within the fund structure, reporting has improved because of things like the ILPA template, but there are still big things like not agreeing on the performance numbers. People can get distracted by other things to achieve but this is a financial industry; the return figures are pretty fundamental so that doesn’t help on the trust side.”
A common rebuttal to the industry’s lack of transparency is that it’s core mission is delivering returns to investors. Says another prominent lawyer, “It is all about returns but there is increasing demand for transparency and understanding the industry; there’s a social contract and for that people want to know.”
“The reason private equity firms exist is not to create and tend to a great culture - if they only did that they would fail. The links between culture and value creation are unclear and the process of engaging with culture is time-consuming and complex.”
David Cooper, Cooper Limon
None of the industry characteristics highlighted here are new observations, these are all issues that have been raised for decades. So why isn’t private equity thinking more carefully about its culture?
“Part of the problem in private equity is that culture is not itself an end point,” says Cooper. “The reason private equity firms exist is not to create and tend to a great culture - if they only did that they would fail. The links between culture and value creation are unclear and the process of engaging with culture is time-consuming and complex. This can test the patience of busy PE firms, who are more comfortable with the ‘clarity’ provided by financial analysis. That’s why it’s so difficult to get their attention on this - it can really turn them off. Although it’s not the main event, it’s so important. In the increasingly competitive PE market, engaging with culture provides a real opportunity to differentiate and, ultimately, to create more value.”
But it seems things are changing, and culture is rising up the agenda. The last six months have pushed and pulled us all in entirely new and strange ways. It feels as though a new sense of care, empathy and even reflection is coming through.
In a recent survey conducted by The Drawdown on how new working conditions have impacted team culture, the responses were truly heartwarming:
- It has really helped to build camaraderie and strengthen our culture.
- Line managers held frequent online meetings with their team members so as to support them as they adapted to a new way of working and also to check on their mental and physical wellbeing.
- We launched an additional new firm-wide initiative to support those in need with a focus on diversity and inclusion.
- Our staff managed to make the most of the situation and showed a deep care for one another.
- Our teams demonstrated deep compassion
−This built a lot of trust throughout the organisation and allowed for much more flexibility.
- For many companies, Covid-19 was a wake-up call to see that living circumstances differ greatly between people. Some care for their children, some care for parents or relatives, and others live by themselves entirely.
With culture acting as a major influence on behaviour, in testing times we need to trust people will behave in certain ways. Recent events have forced major behavioural changes and have undoubtedly brought about a deep sense of compassion. The barriers between personal and professional are crumbling, removing masks we may have worn when at work.
But as they say, culture comes from the top. It is on the shoulders of those in charge to lead by example. Given the tectonic shifts happening across the world, now is the time to ask what we want private equity to be. If it is simply a driver of returns, then we must accept the cost that incurs. If, however, we believe that private equity can be a force for good then now is the time to reflect, embrace change and move forward.
Apollo in the oasis
A recent Business Insider article reported on Apollo’s plans to ‘soften its culture’. The initiative comes as the $300bn AUM firm looks to double its assets over the next five years.
According to the report, Apollo’s new head of talent Matthew Brietfelder is focused on hiring and retaining the best talent, while providing a more inclusive environment.
As part of this initiative, the firm introduced a new MBA internship, hosting 11 summer associates in 2020. The group was 55% women and 36% minorities. Brietfelder told Business Insider the industry as a whole had a lot of work to do to improve diversity.
Apollo’s efforts are commendable. But the reaction on financial services community platform Wall Street Oasis highlights a resistance to change.
As an upper class white male top target grad, I feel kinda threatened by all these initiatives tbh
Culture has to change from the top down, not the bottom up. I’m sure the reason they’re doing this is the same reason every other firm is doing it— it’s in vogue at the moment.
Don’t think for a second that the culture at [Apollo] has changed overnight because they built a coffee bar.
Lol, good old diversity pandering. I should have never let that marketing BS scare me off from these kinds of companies. They still need to profit after all…