Investment in Private Equity (PE) has grown dramatically in the last 5 years, and private equity funds have produced excellent returns for investors. Private equity funds have become very popular and trendy “alternative investments” that many large investors (high net worth families and institutional investors) have felt they had to get involved with. Private Equity funds try to acquire companies or businesses at a low price. They use a lot of tax-deductible debt to take advantage of their returns, cut costs to try to improve short- and long-term profitability, and sell assets to raise capital. Sometimes they pay themselves a dividend from the assets owned by the business and eventually (2-5 years later) sell to another buyer or take the business public at a higher valuation.
The favorable conditions that helped fuel the recent private equity boom have changed dramatically over the past year. Future private equity returns will be much lower than they have been in the last 5 years and could be quite disappointing for many investors. I think the peak of private equity was in 2006 and the first half of 2007. The private equity boom was fueled by very cheap debt, a bull market in equities, a strong global economy, rising corporate profits, massive capital inflows into private equity, Sarbanes/Oxley reporting rules for public companies and strong initial returns. Some of the big private equity firms are Blackstone, Carlyle Group, Kohlberg Kravis Roberts, Texas Pacific, Thomas H. Lee, Cerberus, and Bain Capital.
Private Equity Historical Returns:
Past returns from large private equity funds have been very good, outperforming stock market returns. According to Fortune magazine for the 10 years to mid-2006 (the likely peak for PE) private equity returns averaged 11.4% vs. 6.6% for the SP500 stock index. Longer-term results (20 years) show that private equity investments have returned a 4% to 5% premium to public equity markets. Of course, these superior returns are achieved with significantly higher risk and an investment that is “locked in” for many years.
My concerns about investing in private equity and future returns:
1. Debt has become much more expensive for leveraged buyouts. Cheap and abundant debt was one of the key factors that enabled the success of private equity firms. Private equity is often just a leveraged buyout (LBO) of companies. For the past 5 years, high yield or “junk” debt was very cheap and traded at a very small premium to Treasury debt. In the last 6 months, junk bond debt cost premiums have increased significantly (from 3% to 8%) and the availability of high yield debt has decreased dramatically due to the credit crunch. Future PE returns will suffer because of this higher cost debt and because they won’t be able to use as much leverage. Less leverage means lower returns for investors.
2. The economy is much weaker now. We may be in a recession right now. Recessions are usually very bad for leveraged companies. Given the amount of debt these companies accumulate in their investments, these private equity investments carry a fairly high level of risk. Private equity firm Cerberus is struggling with its leveraged ownership of Chrysler and GMAC (home and auto loans, loss of $589 million in 1Q08) in the current economic downturn.
3. There has been a massive growth in the number of private equity firms and the dollars of capital invested in private equity, all chasing the same deals and paying higher prices. Above-average returns are almost always wiped out as tons of new supplies or capital enter the market. Acquisitions are now much more competitive and expensive. Private equity firms can no longer buy “cheap” companies with all competitors bidding for the same assets. Many of the big hedge funds have also gotten into the private equity business in recent years, making it an even more crowded space. More players chasing lower yielding deals just to “put the money to work”?
4. Several large private equity firms have recently gone public. Why would they do that? That is inconsistent and hypocritical with his whole philosophy of how much better it is to run companies privately. Did you feel a “cap” in the private equity market? I think so. Industry “smart money” was selling, so why should we be buying? PE companies that went public have seen their shares fall significantly recently due to concerns about the private equity industry. Blackstone (BX) is one of the leading players in the private equity business. Its shares are down more than 40% since going public (at its peak) and its fourth-quarter earnings (announced March 10) are down 89%.
5. Some of the private equity firms have recently had trouble landing big deals. Some big buyout deals have collapsed due to less attractive terms in the new environment, a slower economy, or an inability to obtain financing. Doing fewer major deals and on less attractive terms means lower future returns for private equity investors.
6. Private Equity firms seek smaller, less lucrative businesses out of necessity. Firms are now making small investments, making private investments in public companies (PIPEs), backing small growth companies and buying convertible debt. These types of transactions are likely to generate lower returns than the large traditional LBO transactions of the past. Blackstone boss James says “we’re looking at deals that are not dependent on leverage.” Harvard business professor Joshua Lerner says the term LBO is a bit outdated when neither leverage nor buying is available. Many of the big private equity firms are unable to find good investments, so they currently have a lot of cash on hand, which doesn’t produce much return at all.
7. Commissions are very high for investors. Private equity fees are typically 2% per year, plus 20% of profits earned. That is very expensive, especially if they are investing in cash, converted, PIPE, smaller, less leveraged businesses and the expected returns are significantly lower than in the past.
8. Access to the best funds and private capital companies is restricted. If you are a small investor with only a few million to invest in private equity, it is unlikely that you will have access to the biggest or best private equity companies and funds. The past performance of a particular PE manager may not be a good indicator of future performance. You may have to settle for a less experienced private equity fund or “fund of funds” with an added layer of fees.
I think there will still be a place for private equity investing among the big institutional investors, but returns could be a bit disappointing in the next 2-3 years for everyone. In my opinion, most individual investors should avoid this investment sector for now.