The party for pri­vate eq­uity is crowded

New Straits Times - - Business - John Gap­per

THERE are few surer fi­nan­cial warn­ings than Stephen Sch­warz­man, co-founder of the pri­vate eq­uity group Black­stone, throw­ing a big party. His 60th birth­day cel­e­bra­tion a decade ago marked the pre-cri­sis peak for the in­dus­try, so the 70th he held last month in Palm Beach, Florida, fea­tur­ing fire­works, camels, and a cake in the shape of a Chi­nese tem­ple, is wor­ry­ing.

Pri­vate eq­uity en­tered a slump af­ter his 2007 party, with the huge debt-fi­nanced deals struck at the peak look­ing stupid with hind­sight. Ten years later, it is do­ing ex­tremely well for it­self.

As hedge funds stum­ble and pub­lic stock mar­kets are in­creas­ingly dom­i­nated by pas­sive in­dex funds, veter­ans such as Sch­warz­man and Leon Black of Apollo are mas­ters of their uni­verse.

It is a safe bet that this will not last, since it never has be­fore. The global in­dus­try gath­ers ev­ery year at a con­fer­ence called Su­perRe­turn, held in Ber­lin this week.

The name is not al­ways mer­ited but this year’s re­sem­bles a crowded party that could erupt at any mo­ment. Cocky fi­nanciers in ex­pen­sive suits, in­tox­i­cated by cheap credit and high div­i­dends? Run for the ex­its.

Even this was bear­able un­til Black took to the Su­perRe­turn stage on Mon­day to de­clare that, al­though a correction was prob­a­bly im­mi­nent, it could be post­poned by United States Pres­i­dent Don­ald Trump’s pledge of a “revved up” US econ­omy.

That could un­leash a fur­ther three years of “tur­bocharged” growth for lever­aged buy­outs backed by the US$820 bil­lion (RM3.6 tril­lion) of cap­i­tal yet to be in­vested. Then I re­ally got ner­vous.

Pri­vate eq­uity’s prob­lem is not that it is suf­fer­ing but the op­po­site: it has re­cov­ered so fully that it is flush with money. As it sells the busi­nesses it bought a few years ago, many at a high profit, and re­turns cash to the pen­sion funds and in­sti­tu­tions that in­vest through it, more is ar­riv­ing. This is a very good pe­riod to be sell­ing as­sets but a hard one to find a bar­gain.

The in­dus­try should still have ad­van­tages even in these heady times. Com­pared with hedge funds, which also charge stiff fees to in­vest other peo­ple’s money, it has per­formed well.

Warren Buf­fett wrote harshly of hedge fund man­agers in his an­nual let­ter to Berk­shire Hath­away in­vestors, but has part­nered with 3G Cap­i­tal, the Brazil­ian-led pri­vate eq­uity firm.

The clas­sic pri­vate eq­uity deal is to bor­row money to buy a medium-sized com­pany that is in de­cent shape but has po­ten­tial to grow or be­come more ef­fi­cient. A fund of­ten puts in new man­agers, al­lo­cat­ing them a hefty in­cen­tive to im­prove the busi­ness — pri­vate eq­uity chief ex­ec­u­tives get an av­er­age eight per cent stake, ac­cord­ing to one study. It then sells at a higher price five years later.

Hav­ing the lux­ury of pri­vacy and time — not hav­ing to worry about quar­terly re­sults or in­vestors de­mand­ing their money back — helps in­vest­ments thrive.

The in­dus­try con­sis­tently out­per­formed the stock mar­ket up to 2006, one study found, and its long-term per­for­mance has re­cov­ered from a post-2008 dip.

But no mat­ter how much lever­age and am­bi­tion it in­jects into a com­pany, a pri­vate eq­uity fund can­not eas­ily com­pen­sate for over­pay­ing.

This is the press­ing prob­lem: one in­vestor es­ti­mates that his fund must pay 15 or 20 per cent more to buy a com­pany with sta­ble earn­ings than it did two years ago.

Funds pre­fer to find com­pa­nies and take time — some­times years — to size them up and get to know their founders or ex­ec­u­tives. The new re­al­ity is of­ten that, as one part­ner de­scribes it: “You get a book sent by Goldman Sachs, one din­ner with a cam­era-ready ex­ec­u­tive team, and then an auc­tion.”

They are not only com­pet­ing against each other. The most en­thu­si­as­tic bid­ders are of­ten com­pa­nies in the same in­dus­try that can ob­tain cost sav­ings by in­te­grat­ing a smaller ri­val. Pen­sion funds are also get­ting in on the act by co-in­vest­ing with pri­vate eq­uity funds, and some­times in­vest­ing di­rectly.

The ob­vi­ous re­sponse to an over­heated mar­ket is to slow down, and even to take a break from in­vest­ing un­til prices fall. In the­ory, this should be an ad­van­tage of pri­vate eq­uity funds — they do not have to place funds im­me­di­ately, and will not ben­e­fit their in­vestors by rush­ing.

Most are press­ing ahead any­way. They be­lieve they have a unique for­mula that will keep their in­vest­ments safe while oth­ers over­pay.

They do not say, al­though it is true, that they only get re­warded for ac­tion. They charge a 1.5 per cent man­age­ment fee on their in­vest­ments.

If you pay a lot, you need to get value some­how. The dan­ger is that they start treat­ing ev­ery com­pany like a dis­tressed as­set to ob­tain a re­turn, even if it was orig­i­nally fine.

They may be pushed into act­ing more like 3G, which one in­vestor calls a “bru­tal” cost-cut­ter at com­pa­nies in­clud­ing Kraft Heinz, where it elim­i­nated 13,000 jobs.

The pri­vate eq­uity in­dus­try should en­joy the party while it lasts. The fun could soon be over.

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