Investing 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 fashionable “alternative investments” in which many large investors (high net worth families and institutional investors) have felt they had to participate. Private equity funds try to acquire companies or businesses cheaply. They use a large amount of tax-deductible debt to leverage 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 out of company assets and eventually (2 to 5 years later) sell to another buyer or go public with the company with a higher valuation.
The favorable conditions that helped fuel the recent private equity boom have changed dramatically over the past year. Future returns on private equity will be much lower than they were in the last 5 years and could prove quite disappointing for many investors. I think the peak of private capital was 2006 and the first half of 2007. The private capital boom was driven by very cheap debt, a bull market for stocks, a strong global economy, rising corporate profits, massive inflows of capital in Private Equity, Oxley Reporting Standards for Public Companies, and Strong Initial Returns. Some of the large private equity companies are Blackstone, Carlyle Group, Kohlberg Kravis Roberts, Texas Pacific, Thomas H. Lee, Cerberus, and Bain Capital.
Historical Venture Capital Returns:
Previous returns from large private equity funds have been very good, outperforming the stock market. According to Fortune magazine, over the 10 years to mid-2006 (the likely peak for PE), returns on private equity averaged 11.4% vs. 6.6% for the SP500 stock index. The longer-term results (20 years) show that private equity investments have earned a premium of between 4% and 5% in the 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 acquisitions. Cheap and plentiful debt was one of the key factors that allowed private equity firms to succeed. Private equity is often just a leverage purchase (LBO) of companies. For the last 5 years, high yield or “junk” debt was very cheap and traded at a very small premium to treasury debt. Over the past 6 months, the cost premiums for junk bond debt have risen significantly (from 3% to 8%) and the availability of high yield debt has dropped dramatically due to the credit crunch. Future PE returns will suffer because of this higher cost debt and because they will not 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 recession right now. Recessions are often very bad for leveraged companies. Given the amount of debt that these companies accumulate on 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, $ 589 million loss in 1Q08) in the current economic downturn.
3. There has been a massive growth in the number of private equity firms and the equity dollars invested in private equity, all pursuing the same deals and paying higher prices. Above-average returns are almost always eliminated as tons of new supply 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 competing for the same assets. Many of the large hedge funds have also entered the private equity business in recent years, making it an even more crowded space. Are more players chasing lower-yielding deals just to “put money to work”?
4. Several large private equity firms have recently gone public. Why would they do that? That’s inconsistent and hypocritical with his whole philosophy of how much better it is to run businesses privately. Did you feel a “top” in the private equity market? I think so. The “smart money” industry insider was selling, so why should we buy? PE companies that went public have seen their shares drop significantly recently due to concerns about the private equity industry. Blackstone (BX) is one of the main players in the private equity business. Its shares have fallen more than 40% since they went public (at the peak) and its fourth-quarter earnings (announced March 10) were down 89%.
5. Some of the private equity firms have recently had trouble landing big deals. Some large purchase deals have collapsed due to less attractive terms with the new environment, a slower economy, or the inability to obtain financing. Conducting less important business and under less attractive conditions means lower future returns for private equity investors.
6. Private equity firms seek smaller, less lucrative deals out of necessity. Companies are now making small investments, making private investments in public companies (PIPEs), supporting small growth companies and buying convertible debt. These types of deals are likely to generate lower returns than traditional large LBO deals of the past. Blackstone boss James says “we are looking for deals that are not reliant on leverage.” Harvard business professor Joshua Lerner says the term LBO is a bit outdated when neither leverage nor buying is at hand. Many of the large private equity companies cannot find good investments, so they currently have a lot of cash, which does not produce much profit.
7. Commissions are very high for investors. Private equity commissions are typically 2% per annum, plus 20% of earnings. That’s very expensive, especially if they are investing in cash, conversions, PIPE, smaller less leveraged businesses, and the expected returns are significantly lower than in the past.
8. Access to the best funds and venture capital firms is restricted. If you are a smaller investor with only a few million to invest in private equity, you are unlikely to gain access to the largest or best private equity companies and funds. The past performance of a particular PE manager may not be a great indicator of future performance. You may have to settle for a less experienced private equity fund or a “fund of funds” with an additional layer of fees.
I think there will still be a place for private equity investment among the big institutional investors, but the returns could be somewhat disappointing over the next 2-3 years for everyone. In my opinion, most individual investors should avoid this investment sector for now.
