It should hardly be a surprise that when you violate the hoary old rule of investing, “buy low, sell high,” you probably won’t do so well. It is thus a testament to the mythology that private equity has managed to create around its returns that Bloomberg felt it needed to prove, in what is admittedly a well-resesarched story both in terms of data and quotes, that deals done in the buying frenzy of 2006 and 2007 haven’t been terribly successful.
Bloomberg to its credit focused on 20 transactions intended to skirt the problem fueled by the famed pre-crisis “wall of liquidity,” of too much money chasing too few targets. The biggest firms pursued mega deals, intended to leapfrog the company size where the competition would be heated. Some of these were done on a “club” basis where a group of firms would team up. These arrangements were later pursued successfully by the Department of Justice for violating anti-trust rules.
The problem was that even though the private equity firms might have bought these companies at somewhat more favorable prices, whatever benefit they gained here was offset by the greater difficulty of exiting well and making improvements. From Bloomberg:
The mega-deals produced mostly mediocre returns, falling well short of the profits that leveraged buyout shops typically seek, according to separate compilations by Bloomberg and asset manager Hamilton Lane Advisors. In more than half the deals — each valued at more than $10 billion — the firms would have been better off if they had put their investors’ money into a stock index fund…
“The big deals were done more out of ego than economic sense,” said David Fann, chief executive officer of TorreyCove Capital Partners, which advises pension plans that invest in buyout funds. “People paid steep prices and put on too much debt.”
A former private equity executive disagreed vigorously with this innocent-sounding explanation. As he said via e-mail:
To me, in some ways the most disturbing part of this story is the conclusion offered by the CEO of Torrey Pine, a consulting firm that advises pension funds on PE investments. He attributes the pursuit of the mega-deals in 2005-2007 as being the result of “ego” on the part of PE managers.
While ego is undoubtedly part of the story, it seems obvious to me that the main driver of these deals was that they were incredibly profitable under any scenario for the PE firms that did them. The reason is embedded in the fee structure that PE firms charge, where they get an asset management fee and also portfolio company fees, both of which do not depend on the deal being profitable. Only the carried interest fee depends on profitability. So even an unprofitable deal earns two of the three potential fees, and the loss to the GP of their own investment capital on an unprofitable deal is de minimus compared to these, and the greater likelihood is that the deal will be minimally profitable–which is what actually happened in general–as opposed to an actual money loser.
Like virtually all PE limited partner investors, the Torrey Pines CEO needs to attribute the reason for these deals to “ego” because acknowledging that it was primarily about the money would necessitate confronting the fundamental reality of the industry that there is really no alignment of interest between the LP investors and the PE managers. If the investors actually woke up to the fact that the PE managers win no matter what, they would be forced to say, “Hey, this is crazy and I am not signing up for these terms.” Since the LPs are not willing to put away their checkbooks, they need an alternative explanation for why things go awry, so it becomes about “ego.”
And as we’ve pointed out, the limited partners are completely unwilling to change behavior. We’ve chronicled how at CalPERS and CalSTRS, and no doubt at other private equity investors, consultants are dutifully presenting charts that show private equity firms having paid prices in 2015 that in EBITA multiple terms were even higher than the last market peak. And even with the bailout-by-accident of ZIRP and QE, private equity returns over the last ten years have fallen short of the level needed to justify the strategy’s extra risks resulting from illiquidity and greater use of borrowed funds. So you can imagine what PE returns will look like in the upcoming hangover phase.
The sudden willingness of the media to trash-talk private equity returns is an acknowledgment of another investment bromide: leverage cuts both ways. In a bear market for equities, levered strategies like private equity will suffer. It would be nice if the financial press would remind readers that leverage is hazardous at all times, not just when the chickens are coming home to roost.