Private Equity Kingpins Whine as Stock Market Values Languish

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.

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14 comments

  1. MikeNY

    So they cashed out at high valuations and left public shareholders with the tab. Leopard, spots.

    The PE industry is so large now that the easy deals have been done, redone, and overdone. I saw some companies flipped to other PE firms 3x in my relatively short career, always at higher valuations. Also, perhaps the political climate is a factor: the PE biz model of stripping assets, outsourcing production and screwing labor may not be popular in a new administration. You’d think it would be a big target for The Donald.

  2. Larry

    I would think that the case for share buybacks at a private equity firm are even weaker than they are for firms that provide services, make things, and conduct R&D. If I were a shareholder, I would raise hell over reduced dividends and share buybacks that are principally aimed at goosing the GPs net worth.

  3. Eleme

    The last dult in the room, a certain west coast behemoth, has finally wised up to the PE charade, its glory days are well behind it. Financial engineering, tax loopholes, backroom politics, ignorant head nodding LPs can only take you so far

  4. David

    Is 2 / 20% sustainable long term – coupled with getting hit with assorted management fees, dubious legal fees, plus front end acquisition fees?

    If these portfolio companies are in low growth / no growth / negative unit environment and the easy labor savings are over – where is the capacity to cover these fees plus a high multiple price coming from?

  5. Sluggeaux

    This is chilling to read. PE executives at industry “leaders” Carlyle, Apollo, and KKR spending a quarter to half a billion on share buybacks? Doesn’t the FT see the irony of the fact that this industry was supposed to be based on private equity? This circumstance can only be interpreted as evidence that the vandals are taking their final profit before the collapse of their Ponzi, the final Pump-and-Dump of the last scraps of the flayed carcass of the American economy.

    So begins the death-spiral…

  6. RUKidding

    Thanks for the post. I’m an economics/finance dumbo (well a little more enlightened than some but not much). From where I sit, all this PE “stuff” looks like a lot of funny money to me. I realize that’s ridiculously simplistic, but none of it seems to make a lot of sense to me. Maybe I am just dumb but it’s like they’re just trying to make money out of nothing, not even thin air.

    And then: boo hoo my holdings aren’t big enough. Gee, let me get out the world’s smallest violin.

    Is this the lead up to another crash, and if so, will it be smallish or biggish? Serious Q bc I don’t know. Seems like we are heading off a cliff lately, from where I sit in the far reaches of the peanut gallery.

  7. Synoia

    They can push up share prices in a frenzy of mutual acquisitions, fueled by borrowed money, asset strip, and then file Bankruptcy in a couple of years.

    I don’t understand their problem They have one last bite at the cherry by doing uto themselves that which they have done unto others.

    They then could retire to commodious residences at Leavenworth or other scenic Tropical Paradises, such as Guantanamo, fittingly flown by private jets being extraordinarily rendered to their destinations.

    How does one apply for the position of chief server of champagne, served to client while the client is recumbent lying on their back, with their face covered by a washcloth?

    Asset stripping stops when all assets, or asses, are stripped. Criminal prosecutions start when the campaign contributions cease.

    1. polecat

      How about they be rendered……you know, ….as in GLUE….

      Perhaps a more fitting use for such scum!

  8. Mark Ó Dochartaigh

    I’m wondering if our economy has become so financialized that when a credit crunch happens again everything from utilities to grocery stores will shut down within a matter of days. Then billionaires will step in and buy what they want cheap like the oligarchs when the USSR fell. Americans who felt what it was like to live in a third world country briefly and who see areas where no billionaire has stepped in will hail the billionaires as heroes and give them the support an authoritarian leader craves. And of course the billionaires will want to be made whole, with interest, by taxing the populace.

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