As an insider once told me, the most important skill that private equity firms possess, aside from their ability to hide their sociopathic tendencies, is their finely-honed sense of when to sell.
A Wall Street Journal report today is therefore a strong indicator that the private equity is at or near a market peak. In Private Equity Bubble? What Private Equity Bubble? the Journal describes how firms are selling ownership stakes. Recall that the last time that happened was in 2007. Blackstone launched its IPO just before the crisis. KKR filed for an offering in 2007 but missed the window. It went public in 2009 via merging with its listed fund in Amsterdam.
The amusing part of the story is the effort of the parties who have acquired interests in private equity firms recently, are keen to do so, or are otherwise allies of general partners to depict these firms as great buys. These purchases are taking place when the private equity industry has been paying nosebleed prices for deals for two years and central banks are looking to end their massive monetary stimulus. Even the ECB, which was a believer in super low and negative interest rates after the Fed recognized that its QE experiment hadn’t worked out as it had expected, is now looking to unwind QE, then raise rates. Thus the tremendous central bank tailwind to asset prices is not only stopping but is going to start turning in the opposite direction. Even though any tightening is sure to be administered slowly and with great caution, a central bank regime change is unfriendly to risky investments like private equity.
The boosters also tout private equity’s supposedly illustrious returns, which as we’ve written repeatedly, are in fact exaggerated. Private equity firms use IRR, which is a misleading metric. For the last decade, private equity has regularly underperformed public equities on a risk-adjusted basis. Moreover, the story depicts the entry of sovereign wealth funds and family offices as direct private equity investors as a plus for private equity, when that is a negative. First, more parties bidding up deals means even more likelihood of overpayment and disappointing returns. Second, these very same sovereign wealth funds and family offices have been significant private equity fund investors. The more that go it alone, the less they will see the need to rely on general partners. And more important, if they succeed, they also call into question the need to pay rapacious private equity fees.
The article also touted infrastructure as a new growth area. But as we’ve written, infrastructure deals are getting a deserved bad name in the US. Trump’s infrastructure program is unlikely to amount to anything meaningful. So even if the investor appetite is there, it’s not at all obvious that the deals will be there to be had.
Another justification is that private equity is a small relative to the total equity market and therefore has more growth opportunities. The Journal states that private equity has doubled in the last decade and is now 3% of the equity market. That’s at odds with the estimates of Harvard Professor Josh Lerner, who put private equity as 5.6% of the global equity market as of the end of 2014. But Lerner and the Journal agree that private equity has roughly doubled as a share of global equity.
But the idea that private equity can command a much bigger share of the equity market at its current fee levels is fallacious. Total private equity fees and costs are a staggering 7% of assets per annum. Those fees work only if the private equity fund manager can deliver something approximating a decent growth level after fees. The industry is already failing to do that on average once you allow for its extra risk. To have any ability to persuade investors that it can earn outsized returns, private equity will have to stay more or less where it is, with smaller, higher growth companies, or else cut its fees in a big way in order for investors to earn adequate net returns. Think that is going to happen?
Finally, firms keep raising money even though prices are already sky high and the industry as a whole has lots of dry powder. From the Journal account:
Apollo Capital Management LP this year raised $24.6 billion for the world’s biggest buyout fund. CVC Capital Partners raised €16 billion ($19 billion) for Europe’s biggest buyout fund.
We’ve seen this movie all too often. As the Financial Times’ John Dizard wrote in August 2007:
The problem is the structure of incentive compensation in most funds and institutions. A once-in- 10-years-comet-wiping-out-the-dinosaurs disaster is a problem for the investor, not the manager-mammal who collects his compensation annually, in cash, thank you. He has what they call a “résumé put”, not a term you will find in offering memoranda, and nine years of bonuses.
Of course investors have been told this before – it’s called “agency theory” in the finance class they skipped. They figured, “Hey, I’m a dinosaur. Who’s bigger than me? Besides, how else am I going to make the 9 per cent I need to avoid making a payment into the pension fund?”
All this makes life easy for the financial journalist, since once you’ve been through one cycle, you can just dust off your old commentary.
Thanks to the tender ministrations of central banks wreaking havoc on investor returns, pension funds like CalPERS are now sweating bullets to try to hit a 7% number on a regular basis, but otherwise, plus ça change, plus c’est la même chose.