Private Equity

An expensive and riskier way to own value companies.

News about private equity investments has reached a point of saturation. Perhaps this is the time to discuss the basics of this vehicle. As many of our clients might suspect, the private equity craze is a retread of the leveraged buyout trend of the 1980s. The problem is that it is being sold as an exclusive avenue to capturing undiscovered value among undervalued companies.

To the unsuspecting investor, the private equity investment model seems compelling enough: A buyout firm pools capital from wealthy investors to purchase an undervalued company. The firm highly leverages the acquired business and hires top executives who can refine strategy, streamline operations, develop new markets and create a well-oiled profit machine. After a few years, the management team converts this value to cash by taking the company public or negotiating a sale or merger.

That’s how it works on paper—and the private equity industry’s high-profile success stories have attracted billions of dollars from institutions and wealthy individuals. In recent years, even smaller investors have found ways to own private equity funds that offer the promise of getting rich while feeling like an insider.

According to Private Equity Intelligence, the industry has raised $240 billion in the first half of 2007, well on the way to surpassing last year’s record $459 billion. That far exceeds the $10 billion raised in 1991.(1) By one estimate, private equity firms control about $800 billion in capital, compared to about $1 billion 15 years ago.(2)

Private equity now appears to be moving through the boom phase of the investment product life cycle. From a macroeconomic standpoint, the private buyout model may benefit the economy by squeezing out corporate inefficiencies, providing a market for more sophisticated debt instruments, and fueling innovation across industries. But these benefits may not translate to individual and institutional investors.

In fact, many aspects of the model may contradict a prudent investment approach.

Consider these facts

  • Risky strategies and shaky fundamentals. Private equity managers make concentrated bets in a handful of companies they consider to be undervalued.(3) They typically load up these companies with massive levels of debt to recoup their investment. With a typical sale window of five to eight years, they may not be positioning the company for the long term.
  • Lack of transparency. Public companies are accountable to investors and regulators, while private equity managers have no such obligations. Their own investors may never know the details of their strategies, management practices, operational results and compensation.
  • High acquisition and management costs. Private equity firms typically receive compensation similar to hedge fund managers-a 2% annual management fee plus 20% of the profits. These high costs place a heavy burden on economics of the deal. Equally suspect, the private equity boom has intensified competition for acquisition targets, which has driven up company valuations and sales prices. High fees and inflated prices drive down returns and require ambitious assumptions about future growth, profits and cashout method.
  • Uncertain exit strategy. Private equity firms need an exit route to convert their company holdings to cash and pay off investors. The most common avenues are initial public offerings (IPOs) and sales to other companies or private equity groups. But more expensive debt, dwindling returns and eroding economics could substantially reduce the universe of motivated and capable buyers.(4)
  • Questionable performance. According to figures available in the venture capital industry, from 1986 through 2006, private equity funds averaged about 14.2% annually. For the year ending June 30, 2006, private equity funds returned an average 22.5%.(5) Another industry source reports an 18% annualized return between 1980 and 2005.(6)But academic research casts doubt on these numbers. One study found that average returns, net of fees, were roughly equal to the S&P 500’s annual return between 1980 and 2001.(7) A recent study determined that many managers have overstated the value of companies held in their portfolios, and that average performance falls below S&P 500 returns after adjusting the values downward.(8) Moreover, another well-known study found a significant performance gap among private equity ventures held by pension funds, private banks and college endowments.(9)

Better avenues to value

Market observers warn that the private equity boom could be primed for a setback. A combination of rising interest rates, shrinking liquidity, tighter lending standards, falling asset prices and rising default rates could jeopardize the returns or solvency of many private equity investments. This would expose individual investors, pension funds and college endowments to potential losses.

Perhaps many of the early private equity deals made sense for well-connected investors and institutions. It now appears the industry offers an expensive, narrowly concentrated play on value stocks. There are more prudent avenues to value investing. This includes broad asset class diversification, combined with careful management of risk and costs, and a measured exposure to higher risk components, such as small cap and value stocks.

Private equity is having its day in the sun, but investors should make sure they don’t get burned. A structured portfolio with a value tilt is a better alternative to capture the compensated risk factor of value stocks.

Endnotes

1)”The Business of Making Money”, The Economist, 7 July 2007, p 68.

2) “Going Private”, Business Week, 27 Feb. 2006, p56.

3) As the average size of a leveraged buyout has increased, more private equity firms have begun pooling their capital and bidding as groups. Although these firms may buy and operate a number of companies for added diversification, investors who hold a stake in multiple private equity deals may ultimately own the same company in more than one portfolio. (“Riding the Rise in Private Equity”, Worth, p54.)

4) The Blackstone IPO may offer a recent example of rising market resistance to escalating values. Shortly after this large private equity firm went public, its exchange-listed shares fell below offering price. (“The Trouble with Private Equity”, The Economist, 7 July 2007, p11.)

5) “Riding the Rise in Private Equity”, Worth, p52.

6) “Not Just for the Big Guys”, Business Week, 12 Feb. 2007, p92.

7) “Private Equity Performance: Returns, Persistence and Capital Flows,” by Steven Kaplan and Antoinette Schoar, Journal of Finance, Aug. 2005.

8) “The Performance of Private Equity Funds”, by Ludovic Phalippou and Oliver Gottschalg, http://ssrn.com/abstract=686782 April 2007.

9) “Smart Institutions, Foolish Choices?”, by Josh Lerner, Antoinette Schoar and Wan Wong, MIT Sloan Research Paper 4523-05, Jan. 2005.

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