If you had to guess who was closer to being right about how private equity firms value their unsold deals, as in the companies currently in their portfolios, whose estimates would you prefer those of the private equity firms, who have a history of overvaluing them at predictable points in time (around fundraising time, in weak equity markets, and for deals they’ve held a long time) or of public market investors?
The reason this matters is that the private equity returns being reported by all investors included a significant proportion of what amount to “mark to model” profits. Anyone who has worked on a company valuation will tell you is that jiggering key assumptions, like the discount rate, margins, revenue growth, reinvestment requirements, within ranges that are plausible, results in a very large range of possible values. It’s not uncommon to find that changing the assumptions would result in a valuation of ten times what you’d get using conservative inputs.
Remember, there are no independent third party valuations in private equity. All valuations are essentially general partner opinions.
And these unrealized profits on “mark to model” valuations constitute a large proportion of the returns now being reported by investors like CalPERS. For instance, when CalPERS reported its carry fee information over the 25 year history of its private equity program last November, it showed that private equity firms had retained $3.4 billion in carry fees. In the Q&A, CalPERS also said that it had $1.7 billion in unearned carry, or carry fees that had already been deducted from the net asset values that general partners were reporting.
Do the math. The total earned and unearned carry fees are $3.4 billion + $1.7 billion, or $5.1 billion. That means that $1.7 billion is a full 1/3 of the carry fees that CalPERS is reporting over the entire life of its private equity program.
If the accrued carry is 1/3 of total carry then accrued but unrealized profits must be 1/3 of total profits. That implies that CalPERS’ repeated tooting that its 20 year private equity returns are attractive needs to be taken with a fistful of salt. And these unearned profits loom even larger in the computation of returns over shorter time-frames, such as 10, 5, 3 and 1 years. Recall that we have pointed out repeatedly that CalPERS is underperforming its own benchmarks by typically hundreds of basis points. That means CalPERS’ own metrics show it is not being paid enough for the risks it is taking in private equity.
Let us look at the dim view public investors in private equity firms are taking of these yet-to-be-earned profits. Keep in mind that public investors in general greatly prefer steady income; they are thus less keen about trading profits as well as the part of income that private equity firms get from carry fees, which depend on their investment success, as opposed to management fees and the charges they extract from portfolio companies. From the Financial Times (emphasis ours):
A sharp drop in profits, including the unrealised value of investments, at Blackstone and Apollo in the fourth quarter has cast buyout groups in an unforgiving light, with Carlyle, KKR and Oaktree still to announce earnings this week.
Since peaking in early 2014, shares in Apollo and Carlyle have fallen by two-thirds, while KKR’s stock has halved and Oaktree’s has declined 30 per cent. Blackstone — the largest group by assets, with $336bn — has dropped nearly 40 per cent since hitting a record $42.92 a share last May….
However, the share price falls of the five buyout groups mean that investors are effectively entirely discounting their future performance fees, or the share of profit the groups take alongside investors in their funds when they exit successful deals, underlining extreme scepticism about the companies’ value.
Now those public investors may indeed be too gloomy, but consider:
1. Private equity has benefitted from a long-term trend of disinflation, from 1982 to 2008. It got an artificial extension due to central bank policies of ZIRP and QE giving them life beyond their natural sell-by date. Equity strategies, and even more, risky equity strategies like levered equity, as in private equity, will do particularly well under this scenario.
2. Private equity EBITDA multiples in the fourth quarter of 2015 were higher even than at the peak of the last cycle in 2007.
3. It’s hard to see how any scenario going forward will be good for private equity. Central banks over the last six years have pushed investors into risky assets. Private equity will no longer have that tailwind. If interest rates go up (unlikely but not impossible) it will depress stock market valuations, increase the cost of borrowing, and make it harder to achieve high levels of leverage.
And if deflationary trends intensify, which seems even more likely, that’s even worse for private equity. Negative interest rates put big private equity investors like pension funds and life insurers into a slow death spiral. And they are even worse for private equity. The last thing you want to be in deflation is a debtor. Deflation increases the value of indebtedness in real terms. It drives investors out of risky assets and into safe havens like cash and very high quality bonds.
If this comment on the Financial Times article is accurate, staffers at some of these firms have the same dim view:
Let’s see Mr. Schwartzman buy some stock personally if it’s so cheap. Don’t hold your breath. Every time Blackstone stock goes up a bit, the insiders dump millions of shares. The only time Blackstone executives buy shares is when they get them for free via stock options.
And it appears some employees don’t even think those stock options are worth all that much. From the article proper (emphasis ours):
For the first time since listing in 2011, Apollo said it would buy back up to $250m of its shares, including future equity grants to employees.
Sallie Krawcheck, back when she was a star analyst at Sanford Bernstein, felt she needed to inform investors of a basic truth about investment banks: “It’s better to be an employee of a Wall Street firm than a shareholder in one.” That logic applies just as well to investors in private equity funds. And as we are soon to see, it’s even more true in down markets.