Wealth Building Lessons

BlackStone’s much hyped IPO brought private-equity companies into the limelight. Along with that came the usual ‘Do you think its a good investment or not‘ questions from friends. While thats difficult to answer, the fact that a private-equity company is going public is ironic in itself. And if some other private-equity company decided to take them private, then that would be down right hysterical!

Researching online, I found an excellent article in the Economist.com on Private Equity & The Business of Making Money[subscription maybe required].

First the good:

The danger is that executives running public companies end up spending so much time dealing with shareholders, regulators and campaigners that they neglect the business. Indeed, these different “stakeholders” may well demand different, and irreconcilable, things. Entrepreneurs, the type of people who like to “get things done” may not want the hassle.

There is another problem, identified by Professor Jensen almost two decades ago. The structure of a public company creates an inherent conflict between investors and the managers they hire to run the business. The main problem is what to do with free cashflow, the money left over after all profitable investment projects have been funded. In theory this money should be returned to shareholders, but managers may be reluctant to do so. Holding on to cash means they do not have to go cap in hand to capital markets.

Professor Jensen argued that borrowing imposed discipline on executives. They needed to generate cash to meet interest payments. And, if they wanted to finance a project, they would have to convince investors that it was worthwhile. The result ought to be fewer unprofitable projects because cash is no longer left burning a hole in managers’ pockets.

Private-equity firms apply this lesson in spades. They gear up the balance sheets of companies they buy with more debt than public firms are willing to accept. Nearly 20 years of economic stability have led some to believe that even notoriously cyclical businesses, such as carmaking, can now bear higher levels of debt.

In theory, executives working for private-equity owners respond by cutting costs, weeding out unprofitable operations and expanding those parts of the business where returns are highest. This is what generates charges of asset-stripping. But some of this occurs in most takeovers, whether public or private. Most takeovers are justified by “synergies”, which usually means shedding jobs at head office. This is all part of the “creative destruction” process that allows capital to be allocated more efficiently. Academic studies have suggested that private-equity firms create jobs rather than destroy them, although a lot more research needs to be done before everybody will be convinced.

Then the bad:

The best that can be done [to measure their performance] is to look at their returns. Here, the evidence is murky. One much-cited study found that average returns, net of fees, were roughly equal to that produced by the S&P 500 index between 1980 and 2001. That implies that private-equity firms do improve the businesses they own, since gross returns outperform the market. But investors do not seem to benefit.

The calculations can be complicated by the tortuous accounting used to calculate the private-equity industry’s returns. A recent study† suggests that the residual values of companies that remain in private-equity portfolios may have been overstated. Allowing for this cuts the average net return to three percentage points below that of the S&P 500 index.

However, analysis does suggest that a small proportion of private-equity groups has consistently achieved superior returns. And a study by three American academics found that the results achieved by end-investors (such as pension funds and private banks) differed widely; college endowments earned returns that were 14 percentage points better than average. This suggests that a headlong rush by pension funds into the sector in pursuit of diversified returns from “alternative assets” might leave many disappointed.

And finally the ugly:

It may well be, however, that the peak of the cycle is close at hand. Private equity is inevitably a “feast and famine” business: when one fund can raise a lot of capital, they all can. Competition to buy companies then pushes up the price of doing deals, increasing the interest burden and reducing the returns for equity holders. More deals will be done this year, but they may not deliver the kind of returns that investors are hoping for, just as the late 1980s buy-out of RJR Nabisco, the emblematic deal of the era, proved a disappointment.

Since 2003 conditions have been almost ideal for private-equity firms, with low interest rates, lots of liquidity and rising asset prices. But recent events have been moving against them. Bond yields have been rising, making takeovers (which replace equity with debt) more expensive. The high level of corporate profits suggests that there may not be much more to be wrung out of businesses. And the relentless campaign against private-equity tax privileges has made the groups look like easy targets for finance ministers. It may be symbolic that Blackstone’s shares quickly slid below the offer price.

There you have it. Private-equity firms may be good at trimming the waste from public companies and it may end up being good for investors, at least initially. But if the private equity firms are thinking of going public, its because they probably think they market will give them a better valuation then they’re actually worth. Its also seems to be a little late in the cycle, with a high possibly of interest rates rising in the next few years and also liquidity drying up. In such a scenario I doubt they would be to give investors returns similar to those experienced over the past few years.

So I personally didn’t buy Blackstone (BX) stock at the IPO, nor would I do so now. It doesn’t mean that all private-equity companies are bad investments. They can be a good investment, especially if they own profitable private businesses. Private businesses don’t have to spend a ton of money on SEC and other financial regulation which can be substantial savings each year. Since the managers don’t have their bonuses tied to an increase in stock price, they’re more inclined to paying out larger dividends than retaining the money for future growth.

So if you really have your heart set on investing in an private-equity firm, there is a Powershares ETF that looks pretty good. According to the ETF prospectus, The PowerShares Listed Private Equity Portfolio Fund (PSP) seeks to replicate the Red Rocks Capital Listed Private Equity Index, which includes more than 30 U.S. publicly listed companies with direct investments in more than 1,000 private businesses. This gives investors diversified exposure to a wide range of growth and value-oriented listed private equity companies in a single product.

While this is by no means a recommendation to buy PSP, I definitely think its a better alternative to buying Blackstone.

Recommended Reading:

1. Barbarians at the Gate

2. Hedgehogging

3. Liar’s Poker: Rising Through the Wreckage on Wall Street

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