Private Equity: "Nothing More than a Clumsy Trick"

It’s remarkable how otherwise sophisticated individuals want to believe in magic bullets. If they get a horrific illness, surely there must be a treatment somewhere that will restore them to health. Similarly, some investors know how to tease superior returns on a consistent basis out of highly efficient markets.

Now I am willing to accept that markets are not perfectly efficient, that there are individuals who can do very well year in, year out. But they probably are 1/10000th the number of the pretenders to the throne. And it’s much easier to be really good if you are obsessive (which usually means anti-social) and manage comparatively small amounts of money. Yet the economics of money management is that profits are a function of the size of the fund. So the industry’s return objectives will every and always conflict with superior results.

Michael Gordon, global head of institutional investment at Fidelity, argues in the Financial Times that private equity, more properly called its original name, leveraged buyouts, is a scam that used leverage to produce the illusion of winning performance (a recent post carried a similar argument about hedge funds).

I’ll give the LBO crowd some credit it may not deserve. In theory, its business model could work, particularly now that the public market have gotten so short-term oriented as to impede the pursuit of prudent strategies. But the popularity of private equity (or one might say its aggressiveness in launching new funds) guaranteed that the economic benefits its professionals might add would be paid to the seller. Many academic studies have concluded that the big reason most corporate acquisitions fail (the estimates range from 60% to over 75%) is that the the value of any synergies winds up being paid to the sellers, With hypercompetitivenes in LBO land (mid-market deals routinely would attract 40 bids), it’s easy to imagine a similar, or even more extreme, process taking place.

From the Financial Times:

So now we know. The boom in private equity, which was promoted as the superior business model, based on patient capital, superior management and an alignment of interests, was nothing more than a trick of financial engineering – and a clumsy one at that. The magic of leverage works both ways, as we are discovering.

Henry Kravis of Kohlberg Kravis Roberts is asking his investors to be patient after a bout of negative returns and writedowns, echoing the cries of Alan Bond and other entrepreneurs of earlier credit cycles. Hamilton James, Blackstone’s president, said at the Super Returns private equity conference on February 26: “We’re a proxy for the credit markets.” David Rubenstein, co-founder of Carlyle Group, recently asked whether “modest return” was a more apt name for private equity. He thinks it’s funny. It’s not.

As investors are increasingly bruised by the recognition that reality has once again triumphed over hope, the private equity barons are having to confess that the benefits of superior management, alignment of interest and, of course, the superior reward structure counted for very little.

Many of the private equity deals look no different from Yell and other highly leveraged public companies. As Warren Buffett notes, when the tide is going out, we find out who has been swimming without their shorts.

Sometimes a simple observation can prove an important point. In November 2006 Citibank published a research report that highlighted how private equity returns could be achieved by just leveraging basic stock market indices. It is a seminal note. “How do they do that?” asked the report, and then went on to provide the answer.

By leveraging the basic stock market indices by three to one, Citibank pointed out, returns could exceed even the best historical private equity returns. Never mind that as they were spellchecking the final version of the note, leverage on that season’s deals was reaching four to one and even five or six to one.

As Citibank pointed out, the private equity barons would always emphasise alpha over beta – their ability to outperform a market rather than merely ride the market wave – but it showed clearly that leveraged beta was where the returns were being generated.

Interestingly, a similar lesson could be being learnt in other asset classes.

Shaken but not stirred, the private equity barons are looking to move on. Dismayed and disillusioned western investors will not play ball. In the leveraged loan markets, assets have been marked down by a fifth, so 80 cents in the dollar is the new par. Thus the financial alchemists have turned to the huge pools of money available in the Middle East and Asia.

Guy Hands of Terra Firma believes they will enable the disintermediation of Wall Street and the City of London. Perhaps, but in what shape and form?

Does he really assume that these new investors will be as naive as many of the investors in some of the five- and six-times-levered private equity deals of the past three years? I would be surprised. Commentators have suggested that many state-backed funds are still in their infancy and thus do not have the experience and organisation to cope with “big debt investments”. That gives the private equity guys something of a problem.

Private equity as we have come to know it is all about debt – lock, stock and sinking barrel. There may have been better management and better incentive structures in the deals of recent years. But they really contribute nothing to the overall return when compared with the impact of the leverage in the capital structure.

So let us be candid. The deals of recent years are leveraged buy-outs. Let us give them their proper name. It is a shame that private equity has been degraded by misused financial engineering that was permitted by easy monetary policy and lax credit conditions. Moreover, the fact that these structures generated enormous management fees bears further questioning. These LBO deals and their business models were held up as superior in structure and therefore in worth. Massive fees were thus justified. That the market was happy to pay these for a simple leveraged structure that could have been assembled in a DIY fashion seems remarkable now.

In reality, private equity should not be about debt. Pure, properly capitalised private equity remains a wonderful business model. It should be able to prosper without recourse to cheap and easy finance.

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  1. a

    I think private equity is best compared to the buy-and-flip strategy of home flippers. So long as the market goes up, they both make money. It’s when the market stalls or goes down that one sees it’s all a mirage.

  2. Molly

    Sounds like that Citi research report is one that ought to be trotted out at regular intervals.

  3. E. Cartman

    I think this article goes too far. Private equity was always tax arbitrage first and foremost. That was always pretty well understood, or so I thought …

    Also, private equity can afford a much longer time horizon than the QoQ basis upon which many public companies operate …

    Sure there are abusers who depreciate long-term assets to shore up a balance sheet just long enough to spin the company off, but there are significant advantages as well.

  4. Richard Kline

    I have _never_ understood why it is even legal for an acquirer to borrow money to buy a publicly quoted company and then leave that company with the acquirer’s debt. This is simply asset striping by another namer, except the ‘asset’ in question is future profit. No one gets anything from the steal except the stealers, so why do we keep letting them play the same game?

    (Self: “Am I really arguing this? I mean, I don’t even _like_ corporations . . . .”)

  5. S

    PE is yet another manifestation of Credit bubble. Look no further than the PEs diversifying their business models.

  6. john c. halasz

    You might also want to look up Ackerlof’s paper on corporate looting/bankruptcy for profit from the early ’90’s.

  7. Mebane Faber

    Private equity is all about the top quartile of funds. They crush the performance of the bottom 75%. If you look at who is best at investing in these funds, it tends to be the endowments with returns 14% higher than the average participant.

    Check out these papers:

    “Secrets of the Academy: The Drivers of University Endowment Success”

    “The Troves of Academe”

  8. Anonymous

    I agree with this and think people should link to Senate and google!!

    We have many people pissed or at least concerned people here. IMHO, if everyone started to search for Dodd or go to these Senate web sites, these senators would eventually get the message that web traffic is going up because of this. You can vote with web traffic and make some difference! If these crooks know that millions of people are watching and waiting, they will be less likely to take the lobby money and to be more accountable…that is my prayer!

    I just went to Google and type in:

    United States Senate Committee on Banking

    Google came up with 1,730,000 results on that “phrase”/ query

    However, if you type in: banking.senate

    The results are just 8,520

    Next search phrase >>>>>>>>>>>>>

    Senate Finance Committee = 924,000 results = 716

    Next Search:

    obama = 84,800,000 results

    68,200,000 for hillary

    The United States Senate Committee on Banking, Housing, and Urban Affairs has jurisdiction over matters related to: banks and banking, price controls, deposit insurance, export promotion and controls, federal monetary policy, financial aid to commerce and industry, issuance of redemption of notes, currency and coinage, public and private housing, urban development and mass transit, and government contracts.

    Members, 110th Congress

    The Committee is chaired by Christopher Dodd (D-Connecticut), and the Ranking Minority member is Richard Shelby (R-Alabama).

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