Smart Money Doing Private Equity in House as General Partners Warn of Lower Returns, Dumb Money Pours In

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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.

From Bloomberg:

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.

‘Saved Millions’

“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.

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  1. Seas of Prometheum

    SWFs are a sham–as if owning a glorified mutual fund could somehow make up for the erosion of sovereign governmental authority. It’s the policy of incorporating Indian reservations as corporations writ large.

  2. vlade

    this is what I was saying half a year ago (iirc). private equity, as investment into non-public companies can be successfull in generating good investment. private equity, as investment into a vehicle run by a third party paid fees is a way to loose your money consistently (as are most actively managed funds, regrdless of investment strategy)

    family offices, oligarchs holding companies, and small ‘friends and families’ firms have much better incentive strutures to perform well

  3. Norb

    You often hear the phrase- new feudalism- bandied about, this trend seems an example of that phenomenon. Wealthy groups have been able to concentrate wealth to such an extent, what action is left for them? When consideration of the broader social welfare and health is not part of your ideology, and only focusing on personal gain and power is your goal, the logical step is to cut out the middleman- any middleman -as a form of efficiency and gain.

    The courtiers of the elite have to see where this trend ends. Participating in this scheme of things only leads to more inequality, and the people making life decisions for the majority of the population are the least qualified to make them. There is no empathy for hardship. No dedication to the larger good.

    What the elite fail to appreciate, or have forgotten, is that the elaborate system they are constructing is only possible due to the consent of the people. When more people stop cooperating, things will fall apart very quickly.

    If the goal is to reestablish a form of aristocracy, how do the elite plan to maintain that system? Ignorant peasants and serfs are one thing, but in the modern world? Success to date can be attributed to the hijacking of the ideals of the enlightenment. The ideals of freedom and democracy have been twisted to enrich the few but people are beginning to understanding the fraud.

    Waiting for the elite to throw the people some scraps or for opportunity to trickle down from upon high just won’t cut it. How can more forms of concentration and elite control be even considered.

    1. Jerry Denim

      “Ignorant peasants and serfs are one thing, but in the modern world? ….The ideals of freedom and democracy have been twisted to enrich the few but people are beginning to understanding the fraud.”

      Sites like this with it’s generally high-quality and thoughtful commenters do give me hope for democracy, but seeing that Donald Trump is now the presumptive Republican nominee and Hillary Clinton is closing in on the Democratic nomination preclude any form of optimism regarding the intelligence of the population. Just because there’s a large number of pissed off citizens doesn’t mean they’re any closer to “understanding the fraud”. I regularly hear people blame all the wrong people and ideas for the things they are rightfully angry about, while supporting the people and ideas responsible for those very things. Once again I give you the supporters of Hillary and Donald as exhibit A. Americans are going to need better sources of information, more knowledge, more motivation, more organization and much more unity if they have any hopes of stoping the drift towards a neo-feudal society.

      I have no love for the Private Equity business, it’s always irked me to see people celebrated and grossly overpaid just to engage in unproductive gambling with other people’s money, but I agree with you wealthy families cutting out the Private Equity middle-man will only accelerate the transition to feudalism as they absorb more of the wealth, knowledge, power and capacity that was previously outside of their domain. The sovereign, democratic, nation-state concept is dying before our eyes and the Kamprads, Gates, Waltons, etc. of the world are becoming the new Medici.

  4. Wiggleswarts

    The over reliance on historical “returns” without analysis as to the economic drivers underlying them has led to this fascination with PE.

    Mark to myth, running every expense possible through the portfolio companies, use of related consulting firms, all encompassing indemnification clauses, the concerns are endless yet no one seems to care.

    There should be immense scrutiny especially since Calpers one of the largest allocators and longest investors was recently unveiled as the industry’s patsy. But I guess its other peoples money and other peoples problems

  5. oho

    what took “smart money” investors so long. If you’re investing for your family, you truly are thinking of the long/infinite-term.

    In the UK, for every multi-generation Downton Abbey there were gobs of upper-crust families who had to pawn their country estates or heirlooms or (gasp!) marry into American new money cuz the family outlived their feudal nest egg.

  6. flora

    Thanks for this post.
    Expect the PE firms will go hard for more pension fund investments now that they’re losing the smart money. Hope pension board members read NC.

  7. TheCatSaid

    Another revealing post. It makes the overall picture increasingly obvious. With rare exception (where there is meaningful, valuable input by individuals with relevant expertise), investment is a gambling exercise that extracts and reduces value of the potentially creative, beneficial activities of the portfolio companies.

    Years ago a highly ethical engineer (since retired) who worked for the innovation department of Enterprise Ireland expressed his disgust at the financial industry. At the time I wanted to believe there were exceptions within the conventional financial industry–that the person/VC who was interested in investing in our company was different as he was a former entrepreneur, etc. Basically I didn’t want to hear what I was being told by the ethically-minded former engineer. Fortunately that particular investment never came to pass, and I learned a lot in the process. I’ve since learned a lot more about the overall investment context here at NC–things that Enterprise Ireland never tells its high potential startup companies.

    There is too little talk about the damage the financial industry does to the business / industrial / creative resources that are the objects of these portfolios “investments” wealth extraction exercises. Sure, certain people will definitely get rich in the process–mostly those who are in a position to take out fees no matter how a portfolio company “performs” (as if an innovative company were a circus act–think about that for a moment–there’s probably more integrity in many good circus acts)–but these activities are not to the advantage of the potentially productive, creative enterprises who took the real risk and invested the most in irreplaceable ways–time, ideas, and often also early-stage money.

    Government incentives to help potential high-growth businesses too often just transfer money into their own country’s financial sectors and elites, whether through interest, fees or all of the above. I’ve heard about bribes being demanded and paid to government officials in the past. (This was not my personal experience.) Despite many of the company-facing government advisers being sincere and well-meaning, they have drunk their own Kool Aid. They do not realize their role is essentially that of grooming companies to become food for the slaughterhouse of the financial services industry. (I remember in our first meeting with David E. Martin he talked about the Consumer Electronics Show (CES) as an abbatoire for innovative companies. He was right.)

    The exceptions prove the rule. (For example, M-CAM only works by actively adding value; there are individual angel investors who unquestionably add value; crowd-sourced funding mechanisms are more likely to avoid the predatory nature of the financial sector.) But generally speaking “investment” means gambling at the ultimate expense of the productive economy. And then we wonder why our economies are hollowed out, having been built on air and speculative greed going back decades if not centuries or more.

    In a conversation related to politics and political parties, M-CAM principal David E. Martin said the most important thing is transparency. His focus on the singular importance of transparency–whether in personal, business or government/politics–gave me a lot to think about. It’s relevant in transactions no matter their size: who’s put in what in the past, who’s putting in what now, who stands to gain what, who are all the players in a given sphere of any action, not just those in the room, what’s the nature of what’s really on the table at the moment.

    Coming back to this post, thanks again to NC for contributing to transparency, for shedding light on current practices, for reducing the fog of long-developed obfuscation strategies, and for stimulating creative thinking ways to make things better.

  8. RUKidding

    Interesting and thanks for this information. I’m an economics/finance dummy, but really it’s obvious that there are limitations on how to invest these days. As more light is shed on shenanigans of various sorts in the world of finance, Wall St, investment vehicles and so forth, it’s difficult to find good ways to invest, even as a peon.

    Not surprising, then, that the really wealthy are just cutting out the parasitic middlemen and doing the heavy lifting, themselves. Why wouldn’t they? What’s the true downside?

    I would like to think that CalPers will pay attention and stop investing in PE which has been proven endlessly to be not worth it with way too high fees for too small of a return.

    Thanks again for enlightening us.

    1. Sluggeaux

      The problem is that investing in PE is like buying heroin or crack from the local mafia. PE shills are telling CalPERS that if they don’t keep pouring money into new funds, they won’t get the “secret sauce” and will be stuck in the under-performing bottom 75 percent of funds. The confidence game quickly becomes extortion.

  9. Arizona Slim

    I think I’d just put my money in index funds and do other things with my life.

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