‘Private equity’ is an obtuse term that describes a limited partnership that invests in the equity of privately held companies. ‘Private’ refers to the privately held nature of the companies in which these funds invest. But it also intones that it is a ‘private’ – as in exclusive – club. And private it is. Only institutional investors, or accredited investors – those with a net worth greater than a million dollars, excluding their primary residence, or with an income of $200,000 or more – can invest in these limited partnerships. It has indeed been an exclusive club, and many have wanted to join it.
In the 1980’s and 1990’s, these partnerships were referred to as ‘buyout funds’ or ‘LBO funds’. Many were involved with hostile takeovers of publically traded companies. Gordon Gekko, the character played by Michael Douglas in the 1987 film “Wall Street”, was the suspendered, French collared Wall Street takeover artist with ice water running through his veins. This image led to a negative connotation to the terms ‘LBO fund’ and ‘Leveraged Buyout Fund’. In response, the industry rebranded itself as ‘Private Equity’. We now commonly just call them PEGs, for ‘Private Equity Groups’. Whether you adhere to the school of thought that the rebranding is a rose by any other name that smells as sweet, or that we are just putting lipstick on a pig, they are the same things as they were in the 1980’s.
Alternative Asset Classes
Early investors in PEGs reaped handsome rewards. The industry was a hot asset among alternative asset classes. In the early days of the 1980’s, a standard formula was to buy a company, put 10-15% of the purchase price down as equity, borrow the rest of the money, sell the target’s non-core assets, reduce or completely payoff the acquisition debt, and sell the company for a handsome profit. Hold periods might be eighteen months out to five years. During the life of a fund, which might be seven years, a fund could redeploy your capital more than once, and the compounding effect was dramatic. The only skill set required was financial engineering.
Times have changed in the intervening thirty years. Back in the 1980’s, fat public companies were ripe for the picking. Their corporate governance was poor, the managers controlled the board, they sat on each other’s boards, they were self-serving, and they acquired other companies using their stock as the unit of exchange. And their stockholders suffered. They built conglomerates that were globally inefficient, all just so they could justify larger salaries and bigger bonuses. This was a case where the parts were worth more than the whole, and the conglomerates were acquired by the LBO firms and broken up into pure plays, one-by-one, and the parts sold off including their corporate art collections, private jets, and gold plated parking lots.
Many of us felt good about our work in hostile takeovers, and described it as ‘putting America back to work’. There was much truth to this. In the 1980’s many of us were concerned the U.S. had lost its edge, and Japanese management styles were in vogue. The Japanese were hard working, self-effacing, and efficient. We weren’t. We were the only intact industrial base in the post WWII era, and we had been living off the reconstruction dividend of rebuilding the rest of the world for too long. But between 1945 and 1980, ‘Made in Japan’ had become something to fear, not ridicule.
Wall Street’s ‘shot across the bow’
The hostile takeover period in the 1980’s was a shot across the bow for corporate America to get its act together. The LBOs moved down-market to smaller, less prominent, private companies, and strategies changed. As the market ran out of the low-hanging fruit comprised of fat, inefficient companies, the LBO firms started to ‘build-up’ rather than ‘break-up’. By finding a company with a talented management team in a fragmented industry, a PE firm could lever its management by buying smaller companies and ‘tacking’ them on or ‘tucking’ them in. This required the use of operating leverage and management skill rather than just financial leverage.
Management skill and ‘scalability’ became the clarion cry for the buyout business. The identification and acquisition of a strong player in a growing but fragmented industry was the key to success. This theme has been replayed countless times in the last two decades. Small, inefficient companies were either acquired or driven out of business by the larger, better managed and more efficient companies lead by the PEGs. This has had a positive effect on the competiveness of corporate America, and has put many ineffective managers and overpaid rank-and-file employees out of work, thus leveling the global labor market.
This creative destruction has been universally positive for the U.S. economy, in spite of the image projected by Gordon Gekko. A review of the performance of small-to-medium sized companies by Pepperdine University shows a clear performance advantage of companies owned by PEGs in comparison to similar companies still owned by their founders or heirs.
Companies owned by PEGs have superior performance because people perform better when they know someone is paying attention. Second, the principals of PE firms have a breadth and depth of knowledge that is continually fueled by the case study-like aspect of each information memorandum they receive. A PE firm may look at a thousand – or thousands – of transactions in a year – each a case study – in many different industries. They have the luxury of being able to integrate these vast stores of knowledge and gain a perspective not easily emulated by a privately held business owner who is more than fully employed just running his company in the Knowledge Era.
But not all has been rosy for PEGs in recent years. The financial crisis left many with catastrophic losses as their portfolio companies fell short of projection. Liquidations at horrific losses to intrinsic value have decimated the ranks of PE. By some estimates, as many as 25% of PE funds that existed at the start of the financial crisis will never raise another fund. Knowing this, these PE firms – the Walking Dead – maintain their zombie companies in their portfolio so that they can continue to receive their management fees. This has alienated – and educated – many investors in PE funds, and they are redefining the terms under which the general partners earn their fees.
For now, muted returns
At present, the returns for the post financial crisis period are muted. Where a fund might return 17% or 25% in good times, a rate of return above zero in the post-2007 period was solid, and an 8-9% return put them in the upper echelons of the industry. PEGs now pay prices as low as 3x EBITDA for their acquisitions, with 5x a common figure. Granted, this is for companies that are dependent on their owner, have an ill-defined infrastructure, and may have no policy manuals, cross training, or no meaningful HR. But in the hands of a skilled platform company, that is, the one with the skilled management team, an acquisition is accretive and permits taking advantage of the infrastructure of the acquiror. The result is not just a bigger company, but one with higher EBITDA margins.
The future of PE lies in the middle and lower middle market, as far down as companies with $10 million in sales. PE firms are forcing efficiency on U.S. companies, and as they sift through the underpriced larger companies, they seek ever-smaller better performing and underpriced companies. New asset classes are developing as well, such as farmland, which has an inverse correlation with stocks, and which improves the return on the efficient frontier of a diversified portfolio.
Before investing in a PE fund, evaluating its general partners is critical. What is their current strategy? Is it well defined, and is it something you can understand? How have they performed over economic cycles? Warren Buffet is the poster child for believing you should understand what you invest in. Warren refrained from investing in the dotcoms of the 1990’s, explaining he just didn’t understand their valuations. That is a good philosophy, and frankly, a better approach than requiring a specific net worth or income. Do you understand what they are doing? If it is clear to you, then consider the investment. But like Warren, if you don’t fully understand the investment strategy, then, just don’t invest in it.
The lure of the new: Beware of Crowdfunding
Avoiding investing in things you don’t understand includes equity crowdfunding. While rules are supposedly in the works at the SEC for equity crowdfunding that would permit non-accredited investors to invest in equity, these rules have not seen the light of day, and non-accredited investors are prohibited from playing.
There is a vast difference between investing in a PE fund and investing in a crowdfunded company. When you invest in a PE fund, the general partners of the fund and their staff are acting as professional money managers. They actively sit on the board and bring tremendous knowledge to the company. By contrast, crowdfunded companies are small, young, and commonly without real corporate governance. You will be placing a bet entirely on the management of the company. Unless you are very skilled at evaluating management teams and corporate governance – in addition to evaluating the underlying product or service and technology– you are at material risk of loss. If you want to invest in equity crowdfunding, the best approach would be to invest in local companies where you can actually meet with the management and kick the tires to make sure they know what they are doing, actually exist.
Image courtesy DonkeyHotey
by Charles SmithMr. Smith is the founder of Pegasus Intellectual Capital Solutions, a boutique investment bank specializing in mergers and acquisitions, Capital Raising and restructuring and workouts. The firm is an innovator in the use of Intellectual Capital Audit for pre-closing due diligence and in turnarounds. Charles can be reached at firstname.lastname@example.org