Private-equity (PE) firms are partnerships that create a series of portfolios to invest in mature, usually troubled companies whose valuations are depressed. PE firms get their money from pension funds, endowments, foundations, and wealthy individuals, and then they borrow heavily to “leverage” up that investment, by about five times. After they have straightened out the acquired companies and get them operating profitably, they sell the newly fit companies back to the stock market, presumably at a big profit.
PE firms are stuffed with very smart people who specialize in turnarounds. PE is very glamorous. Most recent graduates from the prestigious business schools want to work in PE or for hedge funds. Like hedge funds, private equity charges a 2 percent fixed fee and 20 percent of the profits so the partners and employees can become enormously rich if the fund does well. In fact, with that 2 percent fixed fee they can do pretty well even if the investors don’t make any money. The prevailing wisdom is that PE has delivered much higher returns than listed stocks, and it has been a popular asset class for sophisticated institutional investors. Its allure has also been heightened by the wealth—and the flaunting of that wealth by the leading PE firms and their senior partners.
The truth about performance is somewhat different. Studies have found that the long-term returns for all PE funds have lagged behind the S&P 500, which is hardly inspiring considering the leverage used by PE firms and how difficult they make it for investors to take their money back. In the 20 years before the 2008 financial panic, the top quartile of PE firms had beaten the S&P by about 4 percentage points annually; the bottom half actually lost money. If the S&P over the same period was leveraged by a similar amount, its returns would bury PE’s results. As David Swensen, the revered manager of the Yale Endowment, has written: “On a risk adjusted basis, marketable equities win in a landslide. In the absence of truly superior fund selection (or extraordinary luck), investors should stay far away from private equity investments.”
Obviously investing large amounts of borrowed money in sick companies is a risky business model. PE firms basically are paying a premium to buy and probably enduring a discount to sell. Over the last 30 years, one quarter of all PE transactions ended up as money losers or went bankrupt, while another 25 percent were huge winners.
PE has had a rough time in recent years. No one really knows exactly how rough because their investments are not publicly traded, which makes portfolio valuations arbitrary. It’s generally believed that if there was a PE index, it fell around 30 percent in 2008–09, or more than the S&P. To add insult to injury, most PE contracts allow the firms in extremis to demand additional capital from existing investors, and in both 2008 and 2009 PE firms made large cash calls on their investors. To have to put up more capital, when they were losing money hand over fist, was particularly galling to the colleges, endowments, and pension funds that were and are the principal investors in PE. To meet their contractual commitments, some proud universities like Yale and Harvard had to sell debt issues.
However, now may be a more propitious time for this beleaguered industry. PE funds are sitting on around $500 billion of cash, accumulated during the crisis, and their clients are urging them to get the money to work. A recent survey found that one third of PE clients actually plan to increase their allocations while only 3 percent want to cut. The clients have lowered their return expectations to about 9 percent annually, still substantially in excess of their forecasts for public stocks.
Meanwhile, the macro environment for PE has improved. PE depends on leverage, so it needs low-cost money, and the lower the interest rate, the higher the cash-flow multiples that can be justified. The other key factor is the availability of valuable target companies, based on high cash-flow yields. Stock markets around the world are afloat in such bargains. For example, more than a quarter of public companies in the U.S., both large and small, are priced for free cash-flow yields that exceed the pretax cost of junk debt. Assuming the world holds together, purchases made today could work out very well.
Not only does PE have the wind at its back, all that money that needs to be put to work should be bullish for cheap stocks in general. Bear in mind that the itchy $500 billion in PE’s coffers probably will be leveraged up five times. That’s a lot of incremental buying power coming into the equity markets.
Biggs is managing partner of Traxis Partners hedge fund in New York.