Private Equity

The bear market of 2000-2002 launched to headline prominence the world of alternative investments (private real estate, hedge funds, private equity), which hedged against or avoided the pain of the public markets. Over our history, Kochis Fitz has made extensive investments in private real estate and, when appropriate, hedge funds on behalf of our clients. We have made only sparing use of private equity, however, because of the sky high fees and (we thought) overemphasis on financial engineering rather than operational improvement. We say more on this point below. This article describes the current state of the private equity industry and asks what (if anything) should we be doing to help our clients earn attractive investment returns in private equity? The small deal size and difficulty accessing top tier “venture” capital funds, severely limits our options in that space. Consequently, since almost all of what is actually accessible in the world of private equity is “buyout,” we’ll focus on the opportunity in the “buyout” space.

What is Private Equity?

Private equity is a term that, broadly defined, refers to any type of equity investment in an asset in which the equity is not freely tradable on a public stock market. Private equity funds are pools of capital, generally organized as limited partnerships, managed by the private equity firm as general partner. As the general partner identifies investments, it is entitled to “call” the funds required from its limited partners according to their pre-specified commitments. Over the life of a fund (which often extends up to ten years), the fund will typically make between 15 and 25 separate investments, returning capital to investors as gains are realized through a sale or public offering. General partners are typically compensated both by a management fee, defined as a percentage of the fund’s total commitment, and by “carried interest”, a percentage of the profits. Typical compensation structures feature an annual management fee of 1% to 2.5% of committed capital and carried interest of 20% to 30% of profits!!

The most common categories of private equity investment include angel investing, venture capital, growth capital, mezzanine capital, and buyout. Angel investors and venture capitalists typically support company founders with capital and strategic advice, while buyout funds typically take direct control of established, but, so it is thought, underperforming companies. We describe these strategies in greater detail in the box below.

What exactly does a buyout firm do? Fundamentally, buyout funds take capital from pension plans and wealthy individuals, add lots of leverage by borrowing from banks or issuing bonds, and buy (usually) public companies, typically at a premium to the market price. After owning the company for a period of years (during which time the private equity firm has probably changed the management team, cut costs in some areas and made investments in others), the company is sold or taken public for a multiple of the price originally paid. Having taken various management, transaction and advisory fees over the course of those years, the private equity firm receives its really big payday through its carried interest.

The rise of the modern private equity buyout industry began in the 1960s, when public conglomerates were the rage. Large companies with ever rising stock prices bought smaller companies in many unrelated businesses on the expectation that management skill was fungible and the conglomerates could achieve economies of scale.

One of the conglomerates’ chief assets had been their high stock prices, which created an attractive acquisition currency, but when the stock market stopped cooperating, a big part of their reason for existence disappeared. In their place arose a new breed of investor, the leveraged buyout (LBO) fund, which used borrowed money to take underperforming conglomerates companies off the public market in order to sell unrelated and underperforming assets and businesses. The value they added was primarily financial engineering, focusing on the ownership and capital structures of the businesses, rather than the operations. LBO specialists became very aggressive in the 1980s, as “corporate raiders” took aim at underperforming companies and companies they thought were overly conservative. After a period of lackluster returns compared to the surging public equity markets in the 1990s, private equity has regained its luster. Top tier private equity firms like Blackstone, Bain, and Carlyle have posted stellar returns, aided by capital from pension funds and by rock-bottom interest rates. No longer content to reengineer balance sheets, these private equity firms have attracted world renown business managers to help manage their portfolio companies (more on their current strategies below).

The Performance of Private Equity

While private equity is the current rage, a little publicized fact is that the median investor has done very poorly in private equity. The following table shows the returns for the entire private equity industry (including venture, buyouts, etc.) tracked by Venture Economics. Because the private equity funds do not value their holdings regularly, timely quarterly performance data is not available.

And while Venture Economics is a widely cited aggregator of private equity performance data, the data is self-reported and as a result the database suffers from self-selection and survivorship bias. Consequently, actual results are probably less than reported.

One thing is clear: manager selection is critical in determining an investor’s private equity performance. A few spectacular winners outweigh a large number of poor performers. And while the conventional wisdom is that good performance is persistent in private equity (i.e., “good” managers are able to consistent post above average returns), the long timeframe of most funds (as long as 10 years) makes it difficult to say anything with much confidence because there are so few data observations. Further, as the first generation of private equity leaders retire, their track records will become less appropriate to evaluate the next generation, who will face ever greater competition.

Current Trends

Private equity fundraising reached new record levels in 2006, with data from Private Equity Intelligence showing that a total of 684 funds worldwide raised an aggregate $432 billion in commitments over the course of 2006.

The biggest fund type in terms of commitments accumulated was buyout, with 188 funds raising an aggregate $212 billion. Mega buyout funds, usually with more than $5 billion in commitments, contributed a significant proportion of this amount, with the ten largest funds of 2006 raising $101 billion alone – almost a quarter of the global total for 2006. The only fund type to not perform so well was venture, which saw a drop of 10% from 2005 levels.

Geographically, 62% of capital raised in 2006 was focused on the United States. European focused funds account for 26% of the global total, while funds focusing on Asia and the rest of world account for the remaining 11%.

Private Equity and the Kochis Fitz Investment Philosophy

To explain our historical aversion to buyout funds, we return to the first principles of our investment philosophy. As investors, we earn a return on our capital because we participate in economic activity and bear risk as a result. This return, called a risk premium, is available to all investors just for showing up. While the return we might earn from investing in the equity of an individual company (thereby becoming a fractional business owner) depends importantly on the performance of that company, our return also depends on the return to business owners more generally. As we add more companies to our portfolio, our return becomes more dependent on the performance of the general economy or the “market” and our total risk is reduced because of diversification. A fundamental element of mainstream (and Kochis Fitz’s) investment philosophy is that reducing company-specific risk in client portfolios allows us to take more market risk and increases the expected return of the portfolio without increasing the total risk. Diversification, along with cost effectiveness and tax efficiency, are thus the three pillars of our investment platform.

On the surface, investing in a buyout fund goes against all of that – buyout funds invest in a small number of companies, are extremely expensive, and are tax inefficient relative to a long-term holding of tax efficient funds or individual stocks. Further, the (pre-tax) returns to the best buyout funds are not very impressive relative to a comparably levered investment in public equity, particularly considering the illiquidity and lack of transparency associated with private equity. Finally, over the last few years, the tsunami of capital from pension plans into private equity generally has driven valuations and purchase premiums to record levels. And adding insult to injury, since 2003 top buyout firms have increasingly banded together in “club” deals to buy ever larger companies, but reducing investors’ ability to diversify risk by investing with different managers. So why would anyone invest in buyouts?

Historically, the argument in favor of buyouts has centered around deal flow, managerial expertise and alignment of interests. The well-connected deal makers at buyout firms identify diamonds in the rough, woo company executives and boards and make deals to take companies private. These newly private companies can make tough decisions to improve operations, with a longer time horizon and without the quarterly earnings mentality of the large public market investors. Because the buyout firms make most of their money through carried interest, their interest is aligned with the fund investors, avoiding the public company problem of a CEO pulling down a giant compensation package during a time when the company’s stock has declined in value.

We have been unimpressed with this argument. People can disagree about the business management skills of private equity investors, but skepticism seems warranted about the ability of private equity firms to double the enterprise value of a large company in just a few years. Are public company managers really that bad? Are private equity managers really that smart? What about the notion of efficient markets? For long-term investors, the most controversial contention of the efficient markets hypothesis – that stock prices reflect all of the publicly available information available about the economic value of a company at any moment – is not of primary importance. The long-term investor, wanting simply to capture the rewards of economic activity, only demands that stock prices reflect the publicly available information eventually. Assuming that public companies are managed well (i.e., the companies capture the potential rewards to business owners in that industry), short-term price movements are irrelevant. The long-term investor maximizes risk-adjusted, after-tax returns through broadly diversified portfolio of cost effective and tax efficient exposures to asset classes offering a high risk premium. And if the absolute level of the return to that portfolio is not high enough, borrowing on margin to buy more of the portfolio is a better solution than high cost, tax inefficient strategies with lower risk-adjusted expected return.

So why spend so much time discussing buyout funds, only to throw them in the trash heap? We think a number of current issues in the equity capital markets support the future success of buyout funds. Still smarting from the last bear market, many large companies are in cash conservation and cost cutting mode. The rise of activist hedge funds, some run by reborn corporate raiders from the 1980s, who buy a small stake in a company and agitate for measures can increase the stock price in the very short-term. Finally, a culture of class action shareholder lawsuits and the (mostly invalid) hue and cry against executive compensation could make some public companies more attractive candidates for value enhancement though a private equity transition.

Market strategist, Jason Trennert, in Fortune Magazine, recently put it bit more strongly than we would: “The average CEO has been in a fetal position for the past five years, basically trying to stay out of trouble and hold on to his job. There has been more of a focus on cost cutting, operating leverage, and building up cash balances.” Our first inclination is to consider this hyper-conservative management mentality a cycle, to be followed by a phase of more aggressive management. And with the volatility in equity markets at record lows that may be a consequence of this management conservatism (see sidebar on What has been happening to risk?), there may have been some benefit to investors.

However, the tremendous expense and managerial distraction associated with complying with Sarbanes-Oxley, coupled with pressure from activist hedge funds and mutual fund portfolio managers, may be creating a persistent, structural benefit to being private. And with the increase in management led buyouts, it could be that some company managements are saving their best ideas for the private equity firms who are all too willing to pay handsomely to be their partners in enhancing the firm’s enterprise value. In the current environment, there is the real possibility that a few public company investments may never realize their full potential – at least not with us as owners. We are left with a choice: explore buyout opportunities despite their many unattractive characteristics or watch while private equity investors reap the rewards of helping a few, well-selected companies reach their potential.

At the same time, the buyout industry is changing. Only two years ago, seven of the biggest buyout shops had to pool their capital to complete what was then the second-largest buyout in history, the $11.3 billion privatization of SunGard Data Systems. Since then, three deals can lay claim to being the largest ever – the $33 billion LBO of hospital operator HCA; the $39 billion deal for the Equity Office Properties REIT; and the proposed $45 billion LBO of Texas utility TXU – but none of these deals involved more than three sponsors. Supplemental equity capital from institutions and banks is enabling buyout funds to execute larger deals on their own, allowing investors to diversify among funds. Investors are also able to “co-invest,” supplying this supplemental equity capital at their discretion to regain some control over the composition of their portfolio of private investments.

Conclusion

We describe our approach to investing as finding cost effective, tax efficient and preferably liquid vehicles which allow clients to participate in valuable streams of economic performance. Public markets fit that bill very well and provide the lion’s share of our clients’ investment returns. Further, our work with clients who are public company executives has created a deep respect for the skill and passion they bring to their jobs. Consequently, we have argued that, in general, the drawbacks of investments in private equity – lack of transparency illiquidity, high fees, and hidden risks – outweighed the prospect of outsized returns (which might be otherwise available simply through leverage). However, for reasons we discuss above, we are re-evaluating the role of private equity as a potential, small component of client portfolios and are working to find (or, if necessary, build) access to private equity which does meet our investment criteria as much as possible.

Jason Thomas and Monica Ma