Private Equity Ate Finance, and Now It’s Taking Over the World
JOHANNESBURG - Private equity (PE) managers won the financial crisis.
A decade since the world economy almost came apart, big banks are more heavily regulated and scrutinized.
Hedge funds, which live on the volatility central banks have worked so hard to quash, have mostly lost their flair. But the firms once known as leveraged buyout shops are thriving.
Almost everything that’s happened since 2008 has tilted in their favor.
The PE industry, which runs funds that can invest outside public markets, has trillions of dollars in assets under management. In a world where bonds are paying next to nothing, big investors are desperate for higher returns PE managers seem to be able to squeeze from the markets.
The business has made billionaires out of its founders. Funds have snapped up businesses from pet stores to doctors’ practices to newspapers. PE firms may also be deep into real estate, loans to businesses, and startup investments - but the heart of their craft is using debt to acquire companies and sell them later.
The basic idea is a little like house flipping: take over a company that’s relatively cheap and spruce it up to make it more attractive to other buyers so you can sell it at a profit in a
The target might be a struggling public company or a small private business that can be combined—or “rolled up”—with others in the same industry.
A few things make PE different from other kinds of investing. First is the leverage. Acquisitions are typically financed with a lot of debt that ends up being owed by the acquired company. That means the PE firm and its investors can put in a comparatively small amount of cash, magnifying gains if they sell at a profit.
Second, it’s a hands-on investment. PE firms overhaul how a business is managed. Over the years, firms say they’ve shifted from brute-force cost-cutting and layoffs to McKinsey-style operational consulting and reorganisation, with the aim of leaving companies better off than they found them.
“When you grow businesses, you typically need more people,” said Blackstone Group’s Stephen Schwarzman in September.
Still, the business model has put PE at the forefront of the financialisation of the economy - any business it touches is under pressure to realise value for far-flung investors. Quickly.
Finally, the fees are huge. Conventional money managers are lucky if they can get investors to pay them 1 percent of their assets a year.
The traditional PE structure is “2 and 20” - a 2 percent annual fee, plus 20 percent of profits above a certain level. The 20 part, known as carried interest, is especially lucrative because
it gets favorable tax treatment.
For investors the draw of private equity is simple: Over the 25 years ended in March, PE funds returned more than 13 percent annualised compared with about 9 percent for an equivalent investment in the S&P 500, according to an index created by investment firm
Cambridge Associates LLC. Private equity fans say the funds can find value you can’t get in public markets, in part because private managers have more leeway to overhaul undervalued companies.
“You cannot make transformational changes in a public company today,” said Neuberger Berman Group LLC managing director Tony Tutrone.
Big institutional investors such as pensions and university endowments also see a diversification benefit: PE funds don’t move in lockstep with broader markets.
But some say investors need to be more skeptical.
“We have seen a number of proposals from private equity funds where the returns are really not calculated in a manner that I would regard as honest,” said billionaire investor Warren Buffett earlier this year.
There are three main concerns.
• The value of private investments is hard to measure
Because private company shares aren’t being constantly bought and sold, you can’t look up their price by typing in a stock ticker. So private funds have some flexibility in valuing their holdings. Andrea Auerbach, Cambridge’s head of global private investments, says a measure that PE firms often use to assess a company’s performance- earnings before interest, taxes, depreciation, and amortization (Ebitda) is often overstated using various adjustments.
“It’s not an honest number anymore,” she says. Ultimately, though, there’s a limit to how much these valuations can inflate a PE fund’s returns. When the fund sells the investment, its true value is exactly whatever buyers are willing to pay.
Another concern is that the lack of trading in private investments may mask a fund’s volatility, giving the appearance of smoother returns over time and the illusion that illiquid assets are less risky, according to a 2019 report by asset manager AQR Capital Management, which runs funds that compete with private equity.
• Returns can be gamed
Private equity funds don’t immediately take all the money their clients have committed. Instead, they wait until they find an attractive investment. The internal rate of return is calculated from the time the investor money comes in. The shorter the period the investor capital is put to work, the higher the annualized rate of return. That opens up a chance to
juice the figures. Funds can borrow money to make the initial investment and ask for the clients’ money a bit later, making it look as if they produced profits at a faster rate.
“Over the last several years, more private equity funds have pursued this as a way to ensure their returns keep up with the Joneses,” Auerbach says. The American Investment Council, the trade group for PE, says short-term borrowing allows fund managers to react quickly to opportunities and sophisticated investors to use a variety of measures besides internal rate of return to evaluate PE performance. There are now 8 000-plus PE-backed companies, almost double the number of their publicly listed counterparts
• The best returns might be in the rearview mirror
Two decades ago an investor could pick a private equity fund at random and have a better than 75 percent chance of beating the stock market, according to a report by financial data company PitchBook. Since 2006 those odds have dropped to worse than a
coin flip. “Not only are fewer managers beating the market but their level of outperformance has shrunk, too,” the report says. One likely reason will be familiar to investors in mutual funds and hedge funds. When strategies succeed, more people pile in - and it gets harder and harder to find the kinds of bargains that fueled the early gains. The PE playbook informs activist hedge funds and has been mimicked by pensions and sovereign funds. Some of PE’s secret sauce has been shared liberally in business school seminars and management books.
A deeper problem could be that the first generation of buyout managers wrung out the easiest profits. PE thinking pervades the corporate suite - few chief executives are
now sitting around waiting for PE managers to tell them to sell underperforming divisions and cut costs. Auerbach says there are still good PE managers out there and all these changes have “forced evolution and innovation.” But it’s possible that a cosmic alignment of lax corporate management, cheap debt, and desperate-for-yield pensions created a moment that won’t be repeated soon.
Private equity and hedge funds gained control of more than 80 retailers in the past decade, according to a July report by a group of progressive organisations including Americans for Financial Reform and United for Respect. And PE-owned merchants account for most of the biggest recent retail bankruptcies, including those of Gymboree, Payless, and Shopko in the past year alone. Those bankruptcies wiped out 1.3 million jobs - including positions at retailers and related jobs, such as at vendors - according to the report, which estimates that “Wall Street firms have destroyed eight times as many retail jobs as they have created in the past decade.”
Research by Eileen Appelbaum, co-director of the Center for Economic and Policy Research, says the problem isn’t leverage per se but too much of it. She points to guidance issued by the Federal Deposit Insurance Corp. in 2013 saying debt levels of more than six times Ebitda, “raises concerns for most industries.” If that’s the case, plenty of upheaval lies
A 2018 McKinsey report shows that multiples for median private equity Ebitda ticked up to more than 10 in 2017, from 9.2 the previous year.