I’m late to a Bloomberg story that ran under the anodyne headline, Wealthy Families Have $4 Trillion Up for Grabs. The Washington Post used the more apt World’s Rich Families Are Putting Private Equity Firms on Notice.
The message is simple: super rich families are figuring out that private equity firms are charging more that they are worth. The very rich, starting in a serious way in the 1980s, have brought more of their investing in house in the form of “family offices”. At the small end, they replicate what a private banker would do, as in put them in various investments, without the conflicts of interest or (hopefully) the ego issues (as in a private banker would have incentives to recommend in house products and actively-managed stock and bond funds). They might also oversee direct investments, such as in real estate or angel/venture investments.
The biggest families are getting more serious about doing private equity on their own. Given total annual fees estimated at 7%, they don’t have to hit home runs to beat private equity performance. In addition, they don’t have the bad incentives of private equity. For instance, the general partners make money irrespective of whether their deals succeed or not, making them too willing to do marginal deals, since a fund can afford a few dogs and still eke out a decent return. Similarly, private equity funds often sell winners earlier than is optimal to show tangible investment results prior to raising a new fund.
In December, a half-dozen of some of the richest families in the U.S., from agriculture to beverages, gathered in a conference room on the 10th floor of an office building in Miami.
This was not some cabal to rule the world. Instead, for an hour over coffee and bagels they listened to a dealmaker for billionaire brothers J.B. and Tony Pritzker talk about how to buy companies….
Now, following the likes of Buffett, Michael Dell and Bill Gates, many are acting like private equity firms, buying large stakes in companies or acquiring them outright. Families can exert tighter control over their money, give the kids something to do and cut their deal fees.
But the trend has meant that private equity shops have been forced to scramble to make sure they don’t lose a critical source of money for their buyout funds. Blackstone Group LP assigned an executive to court wealthy families, and Carlyle Group LP and other private equity firms are allowing many to invest alongside them in deals.
“After a decade of direct investing we found that we actually saved millions, which were reinvested in companies and assets — huge, huge savings,” said Chad Hagan, whose family built its wealth in private health-care and financial businesses.
And here is the real threat: the family investors are putting the soi disant pros of private equity to shame:
Almost 70 percent of family offices engage in direct investing, according to an April survey of 80 offices by the Family Office Exchange. And in 2015 they outperformed buyout firms. Direct deals returned them 15 percent on average, the survey showed — more than double private equity results that year.
Mind you, this family office outperformance is even more striking in light of the fact that general partners are managing down return expectations without cutting fees. From Pensions & Investments last week:
Titans of private equity shared some hard truths at the Milken Institute Global Conference: Returns now will be lower than investors had come to expect from the asset class; capital distributed back to limited partners will decrease; and their firms will be launching funds with lives as long as 20 years.
Speaking on a panel titled “Private Equity Outlook from Industry Titans,” Leon Black, chairman, CEO and director of Apollo Global Management; Jonathan Nelson, founder and CEO of Providence Equity Partners; David Rubenstein, co-founder and co-CEO of The Carlyle Group; and Robert Smith, founder, chairman and CEO of Vista Equity Partners kicked off Monday afternoon’s discussion with a question from moderator Andrea Kramer, managing director of consulting and money management firm Hamilton Lane, on the asset class’ biggest risks.
Mr. Black said private equity transactions are “priced to perfection” meaning they are highly priced. The average private equity deal of more than $500 million is selling at an 11 times multiple of earnings before interest, taxes, depreciation and amortization, he said. Before the financial crisis, private equity deals were selling for 10.5 times EBITDA.
At the same time, there is less debt available for private equity deals. The more equity invested in deals decreases returns, he said…..
“’Priced to perfection’ is a nice way of saying overpriced,” Mr. Nelson said….
Recall that the chief investment officer of CalSTRS uses the same “priced to perfection” coded admission in a board meeting last year. In other words, the limited partners, or at least the more observant ones, are aware that private equity is almost certain to underperform, yet continue to plow more money into the strategy.
And what is the general partners’ response? To make terms even worse by locking up money longer. They recognize this may be the end of the rich pickings for the industry and they want to get their hands on as much capital as they can while the fundraising environment still favors them. And they have a new source of money that’s even dumber than their old standby, public pension funds:
Sovereign wealth funds “want an enormous amount of co-investment,” and are happier with lower returns than other types of investors like public pension funds, Mr. Rubenstein said.
Vista Equity’s Mr. Smith said there has been a “surge in demand from sovereign wealth funds.” Not only are they committing capital, but also they want to embed officials from the sovereign wealth fund with private equity firms to learn the business, he said. “We would not have seen that a year ago,” he added.
Now the desire to have sovereign wealth staff acquire skills points to a desire, as with the rich families, to eventually do private equity deals on their own. But then the article provides a misapprehension of how most private equity transactions work:
Sovereign wealth funds also are asking for investment funds with longer lockups so general partners can hold onto performing assets, Mr. Smith said.
“Good companies in a lower-interest-environment are hard to replace,” Mr. Nelson said.
Contrast this with David Stockman’s expose in Newsweek of how Bain achieved superior-looking performance:
In a nutshell, that’s the story of Bain Capital during Mitt Romney’s tenure. The Wall Street Journal examined 77 significant deals completed during that period based on fundraising documents from Bain, and the results are a perfect illustration of bull-market asymmetry. Overall, Bain generated an impressive $2.5 billion in investor gains on $1.1 billion in investments. But 10 of Bain’s deals accounted for 75 percent of the investor profits.
Accordingly, Bain’s returns on the overwhelming bulk of the deals—67 out of 77—were actually lower than what a passive S&P 500 indexer would have earned even without the risk of leverage or paying all the private-equity fees. Investor profits amounted to a prosaic 0.7X the original investment on these deals and, based on its average five-year holding period, the annual return would have computed to about 12 percent—well below the 17 percent average return on the S&P in this period.
By contrast, the 10 home runs generated profits of $1.8 billion on investments of only $250 million, yielding a spectacular return of 7X investment. Yet it is this handful of home runs that both make the Romney investment legend and also seal the indictment: they show that Bain Capital was a vehicle for leveraged speculation that was gifted immeasurably by the Greenspan bubble. It was a fortunate place where leverage got lucky, not a higher form of capitalist endeavor or training school for presidential aspirants…The startling fact is that four of the 10 Bain Capital home runs ended up in bankruptcy.
In other words, private equity returns for the large funds are dependent on leverage and on a finely-tuned sense of when to unload. And for smaller investments (per the work of Eileen Appelbaum and Rosemary Batt, deal sizes up to $350 million), where the returns depend on operating improvements, again the pretty returns depend on selling them once the companies have moved to a better level of profits and/or market reach, and the exit market is favorable. They weren’t bought to be long-term cash flow generators.
Underwhelming performance plus high fees is now leading to it being respectable to pull money out of hedge funds, and more and more investors are questioning the logic of that strategy. With its long time commitments and the generosity of sovereign wealth funds, private equity is a good ten years at a minimum away from having a day of reckoning in light of the ZIRP-driven mania to be in risky assets despite their dubious potential. Readers may recall that last week in Mania in Private Equity as Investors Throw Money at Funds, we pointed out that money was flooding into private equity despite an unfavorable fundamental outlook.
Unfortunately, this froth is all too reminiscent of the late 1980s, where an LBO boom led to a wave of bankruptcies, and the 2006-2007 frenzy, where the downside was dampened by central banks’ “goose risky assets” policies, which gave private equity an unintended bailout. As we concluded last week:
In other words, this movie is unlikely to have a happy ending as far as investors and the taxpayers who backstop them are concerned. But don’t buy the story that no one could have seen this coming.