Beware of private-equity funds bearing expertise – what they really bring is a crippling debt burden.
Private equity is enjoying a bonanza. As an asset class, it has, over the long run – 25 years or so – soundly beaten the return on the wider stockmarket, according to data from Cambridge Associates. Last year, the volume of global private-equity deals rose to $1.27trn, the highest level since the financial crisis, reports Reuters, while buyout funds are sitting on a record $633bn in “dry powder” – money waiting to be deployed – as pension funds, disillusioned with hedge funds, have piled in. But are today’s buyers going to be disappointed?
We look at what private equity actually is in the box below. But as Daniel Rasmussen of Verdad Advisers notes in American Affairs, talk of private-equity buyers bringing expert leadership to underperforming companies is overblown. The reality is that what they mostly bring is debt. As Rasmussen says, a more efficient capital structure doesn’t have to be bad – but equally, it is very different to what most people might view as “improving” a company. Take the housing market. You might be a genius at spotting gentrification and interior decoration – but as long as prices are rising, it’s the guy who buys with the biggest mortgage and the smallest deposit who makes the most money. So the availability of cheap debt matters more than any notion of management expertise.
The other problem is that private equity has become too popular. As Ben Carlson notes on Bloomberg, big US pension funds now have around 15%-20% of their assets in private equity, up from virtually 0%. As a result, “more assets are chasing the same deals”, and so prices are shooting up. This is exactly what Warren Buffett complains of in his latest letter to Berkshire Hathaway shareholders (see column), and little wonder. The average private-equity deal multiple paid in 2007 was 8.9 times earnings before interest, taxes, depreciation and amortisation (Ebitda). Now it’s nearly 11.
What can individual investors take away from all this? Firstly, be very sceptical of companies that return to the stockmarket from private equity’s hands. What looks like an efficient capital structure to private-equity vendors merely puts an ordinary shareholder right at the back of a very long queue if things go wrong (as in the AA’s recent travails, for example). Secondly, if you’re considering a private-equity fund, remember that this is fundamentally a cheap-debt-driven business. If you’re wary of investing in bonds and utilities because of rising interest rates (see page 24), then you should be very wary of a business model that depends on abundant, cheap money that tends to be most highly leveraged right when the cycle turns.
I wish I knew what private equity was, but I’m too embarrassed to ask
Private equity simply refers to an ownership stake in a company that is not publicly listed. Private-equity investors (usually backed by big institutions, although there are also listed private-equity funds that small investors can buy easily) either invest in unlisted companies, or buy listed companies – typically ones that are viewed to be underperforming – with the goal of taking them private.
Private-equity managers aim to be very hands-on owners, unlike the traditional shareholder in a listed company. By working with unlisted (or delisted) companies, the private-equity owner escapes the short-term focus of the equity markets.
In theory, this gives them the space and time necessary to make the companies more efficient. Having whipped the company into shape, the private-equity manager will then seek an “exit” – generally by re-listing the company on public markets.
This is a time-consuming process, so investors should expect to have to lock up their money for several years. Tying up your cash in an asset whose true value is never entirely clear (much like a house, you only know what an unlisted company is really worth when you try to sell it) is, of course, risky. The reward investors expect to achieve for taking these extra risks is known as the “illiquidity premium”.
The hype behind private equity implies that its highly-experienced practitioners take flabby, inefficient, poorly run firms that have lost their way, and then weed out the dead weight (“restructuring”, as the euphemism has it) and set them back on a course for growth. The reality, according to Daniel Rasmussen (see above), is that in most cases (70% of deals, according to his research) private-equity firms simply borrow lots of money, slash investment spending (which in turn, damages long-term growth prospects) to pay the interest bills, then sell for a higher price than they paid.