What word best describes how distasteful it is to see obscenely rich men complain that they aren’t as rich as they think they ought to be?
The subhead on a new Financial Times story on private equity tell us: “PE believes investors do not grasp their long-term cash flow generation capabilities.” In other words, this is a lament I heard all the time as a young thing at Goldman: company execs believe their stock price is wrong, which always means “too low”.
In this case, one can read between the lines and detect that the frustration is more than a bit personal. All of the eight private equity firms that went public did so in the last decade, which means the founders and top team still have large personal shareholdings. They are upset that their net worths are less than they were not all that long ago:
After a sharp sell-off in recent months that the industry contends is undeserved, their chief executives have resorted to loudly complaining about the market on their earnings calls. Leon Black, chairman of Apollo Global, recently referred to the valuation of his company as an “absurdity”.
Of the group of eight — Fortress, Blackstone, Och-Ziff, KKR, Apollo, Carlyle, Oaktree, Ares — six sit below their initial public offering prices. Their sense of grievance has been consistent since listing but has taken a sharper tone after this most recent sell-off: they believe public market investors simply do not grasp their long-term cash flow generation capabilities.
The article is not specific as to what these deal mavens mean by “long-term”. Analysts don’t forecast longer than 12 to 18 months and even before high-frequency trading collapsed typical ownership time horizons, the average ownership period has been well under a year. So the private equity overlords are telling investors to treat the shares of their companies more generously than other stocks.
The reason investors are skittish is that private equity is cyclical,with deals done in 2015 at multiples that exceeded the peak of the last cycle, right before the crisis. That means investors are skeptical of whether the funds will generate much in the way of carry fee income in the next few years. Stock buyers seems to recognize that the private equity industry got a bailout by virtue of central banks’ asset goosing policies. The fact that the central banks are pushing into negative interest rate territory, which is unfavorable to risky assets and directly threatens the health of banks and long-term investors like pension fund and life insurers, means the central banks are running low on ammo. And investors also don’t like seeing big private equity names getting dinged by the SEC, even if the agency so far has issued only parking-ticket-level fines.
The private equity firms argue that their management fees alone make them plenty attractive. But as the article stresses, investors assign comparatively low multiples to that source of income. Moreover, the savvier investors may also recognize that the big private equity firms used a device called management fee waivers so that much (and for some firms, probably close to all) of these management fees, which are clearly for labor, would be taxed at capital gains rates. The IRS has issued guidance that says, in effect, this treatment was never kosher, and experts expect that guidance to be made final. That not only means lower after tax management fees going forward, but Elizabeth Warren has been saber-rattling about recovering the illegitimate tax deductions in the past, which is within the IRS’s power.
One commentor at the pink paper offered another cause for concern:
Another reason their share prices are suffering is the revolt over the fees they charge. 2% fee in a low yield world in untenable.
Even though the push for more fee transparency is an uphill battle, the general partners don’t have a defensible argument as to why fiduciaries should be kept in the dark as to how much the general partners hoover off in the way of fees and expenses. And the more the economics of private equity becomes apparent, the more obvious it will be that contrary to the industry’s “skin in the game” claims, most of their lofty earnings comes not from performance fees but from fees they earn irrespective of whether deals work out of not. As the full magnitude of private equity fee extraction becomes visible, the more it will become too embarrassing for fiduciaries, particularly public pension funds, not to demand fee reductions.
Nevertheless, the private equity firms are taking matters into their own hands. Most are buying back stock to shore up their share prices:
Precise plans to boost share prices vary across the eight groups. Carlyle and Apollo have announced share repurchases of $200m and $250m, respectively. Blackstone has insisted it will refrain from buybacks, preferring to retain firepower to fund new growth such as through fund manager acquisitions. KKR has the most provocative approach. It too has announced a $500m buyback. But unlike its competitors, it plans to keep the bulk of its deal profits, reducing its dividend to just 16 cents a quarter. It will then invest those cash profits in its investment funds. KKR believes that its investing prowess is so strong that the move will boost its book value alone growing by nearly 20 per cent annually for the next decade.
Generally speaking, share buybacks have not proven to be terribly successful as investments. Perhaps private equity will prove an exception. And the stock market generally is so volatile over the course of a normal year (and this year has the potential to be more volatile than normal), that an adept trader might make a good turn. But even though the private equity industry had gone from strength to strength, it’s raison d’etre is coming under long overdue scrutiny. How it fares going forward is not as certain as its boosters would lead you to believe.