This week rumours were rife about what could be the biggest private equity deal ever – the buyout of Home Depot. The company later quashed the rumours that they were talking to private equity firms.
These are sweet times for private equity. The deals are bigger and more numerous. Capital is easy to raise. So is debt, that is needed to leverage the buyouts. A recent Fortune article paints a very rosy picture of the private equity business. Here’s a different perspective on it from NPR (audio).
There are many reasons given for why private equity is doing so well. Here are some of them:
1. Capital is easy to raise. Large institutional funds like pension funds are more comfortable allocating some portion of their investible funds into higher risk private equity funds in search of higher returns. Not surprising since private equity funds in the 12 months ending this June returned 22.5% as against 6.6% for the S&P 500.
2. Interest rates have been low, although not any more. But this doesn’t seem to be slowing down the deal machine.
3. The costs and difficulty of running a public company. This is a whole grab bag of reasons, big and small. From the compliance costs of Sarbanes Oxley in the US to the amount of time the CEO has to spend ‘managing’ the outside world – investors and the public at large. Another matter that that has started coming up recently is the increased scrutiny of CEO compensation in public companies.
There was a study undertaken by the University of Chicago GSB that looked at private equity performance that reaches some interesting conclusions. However, looking at average performance over a long period of time, as the study has done, does not throw any light on the today’s difference in returns between private equity and public market investing.
Private equity operates in the same market as Mutual Funds and Hedge Funds that invest in public companies. These institutional investors largely drive the market and valuations of companies. Since the private equity firm will buy the company from its public shareholders and then make a return on it, one or both of these must be true:
1. The ‘true’ long-term value of the company is greater than what the public markets put on it. The private equity firms see this and are basically buying an undervalued asset.
2. The change in status of the company from public to private and the change of its ownership from public shareholders to the private equity firm, is better for the company.
The second hypothesis could be true in many cases. At least it is credible. Being private allows the company to hire a top-notch CEO (like VNU CEO David Calhoun), to give the top management a serious stake in the success of the company, to let them focus on the business and not worry about how the Street looks at every move they make. Basically, to run the business with no objective other than to maximize shareholder returns. It is also believable that private equity firms themselves, who have very talented and experienced people, are better owners than passive public shareholders represented by a Board.
But the first hypothesis is not as straightforward. It has to be true for private equity to generate super-sized returns. The second one, on its own, is not something you would bet billions on. But for the first hypothesis to be true, you have to conclude that public markets aren’t valuing companies at their true worth and are therefore leaving money on the table. Here is an example of such a conclusion in one industry. The question is why?
I think that the reason private equity is able to spot undervalued companies in public markets that are as efficient as they have ever been, is because the investors in private equity funds are conditioned to take the long view while the mutual fund investor is not. If Home Depot is undervalued because of a coming cyclical downturn in the home improvement market, the mutual fund heads for the door knowing that sticking with Home Depot will pull down his performance for this year. He knows that his investors closely track his performance on an annual, if not quarterly basis and that his own rewards are tied to the market value of his investments on an annual basis.
The private equity fund, on the other hand, relishes the idea of buying an undervalued asset that will provide a solid return simply by waiting for the next crest in the cycle. On the way, if the company’s performance can be further improved through good management, all the better. I don’t know how they measure their own performance on a periodic basis, but there are bound to be issues with ‘marking to market’ the investments that have not been exited. It is therefore likely that the investors in the funds pay far more attention to the returns in their hands, rather than any measure of return that includes ‘assessed value’ of companies still private.
I have to admit that much of this is conjecture. But the facts are what they are – private equity returns are great while hedge funds and mutual funds struggle to match their benchmark indexes.
I have perhaps a naive question,How does one compare returns in private equity on an apples to apples basis with the S&P 500?
“Not surprising since private equity funds in the 12 months ending this June returned 22.5% as against 6.6% for the S&P 500.”
Does this mean for the universe of private equity companies their earnings grew 22%?Or is it simply return on equity (in which case the 6.6% would not be the right comparison) ? Or simply return on purchase price,you would ofcourse need to use some multiple to come with a final valuation.
Earnings (EBITDA) seems like an objective measure for comparison.When you bring in the subjective element of an earnings multiple,its not quite the same thing as the market.
RR, good question. The correct comparison against the S&P500 index, in my mind, would be the return in the hands of the pension fund (or other investor) that invests in the private equity fund. Raising a private equity fund actually does not mean that all the money comes in at the beginning. It means that the fund now has the right to call for funds from its investors when it buys company A. When company A is sold, the money from the sale is then returned to its investors.
Good piece of information… Keep them coming..
PE has been very active in India last few years. They don’t do full buyouts as we have in US. But they come in and invest long term. As you suggested, the PEs have patience for the management to grow the firms.
Few quick points ..
The one more important part of management going to PE is cost of capital is usually lower than going for new equity offering or a debt. New equity offering has it’s own issues such as time etc. while debt changes company valuations.
surprising but the money that comes to PE mainly through the US pension funds who have patience to weather the market turns.
The common type of PES are LBOS and other ofcourse equity based.
Public companies are all too often restricted by the quarterly, half-yearly and annual expectations. It is not really surprising that managers don’t take risky paths in such companies. (quite like Mutual funds you mentioned).
Think private equity firms are quite like first generation family run businesses in their hunger to perform.
I say first generation here because, the second generation typically brings in silver-spoon-mouthed, spoilt by riches brats – that are focussed more on splurgin than creating wealth. What say? and i know there might be exceptions to this.
That was an interesting query by RR ( comment dt.12/5/06 ).
In the market parlance, when they say an index returns 6.6%, it usually refers to the composite EPS growth of the index constituents. If a comparison is drawn to the 22% growth returned by PE portfolio companies, then it has to be the composite EPS growth of the portfolio constituents during the corresponding period.
As such, I think it’s just an effort to benchmark against an index to assess the relative efficiencies of Public and Private management styles. Given that scenario, would it be correct to relate to the absolute returns in the hands of PE investors as you seem to explain, especially since the Pension Funds normally invest in a fund which would be redeemed after a lock-in of a ranged period ( say 5-7 years or more ). It could be possible that the investor’s funds could be used to buy more than one company.
Or am I missing something here…?
Good article. At the end of the day, private equity firm returns should be measured once a firm completely exits an investment. For current PE activity, and the expensive multiples being paid, it will be several years to see just how well these firms performed.