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For private equity, the handwriting on the wall is clear: Reinvent or perish

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Private equity firms – The word on the street

The past five years have been hard for private equity firms. They are charged with destroying the jobs of ordinary people while enriching their already-wealthy executives. Across the business spectrum, officials and experts agree that bad publicity is the last thing the industry needs. Even though few liberals have a good word for private equity firms, what the latter actually does involves buying mature companies, fixing them up and selling them off to investors.

With fair justification, although bad deals by some private equity firms are not hard to come by, they are not always employment’s grim reapers. The fact that they usually set their sights on weak and bloated companies in the first place – companies that they can improve – means that some jobs will be lost in the process of fixing them. There is documentary evidence that, while private equity ownership may result in some form of job destruction, it can also lead to faster job creation than other forms of ownership(Economist, 2012).

Yet in some areas, the critics of private equity firms may be right. Broadly speaking, the mission and mandate of private equity firms is not to create jobs, but to produce higher risk-adjusted returns. This is the aspect of their operations that may be judged more harshly by the critiques. Independent studies suggests that investors, especially the public pension funds, will continue to pile into the private equity asset class due to the industry’s claims to having continuous earth-shattering profit performance over the years(Bain & Company, 2013).

It should, however, be noted here that, although fears of a bloodbath among bubble-era buy-outs have not yet materialized, the returns for most of the private equity firms investors’ capitals are going to be middling at best, since most of them has gone into funds that were raised when asset prices were at peak levels.

As a concession to practicality, while there are some private equity firms that are doing very well in terms of investment returns, there is no conclusive evidence that the industry will consistently outperform public companies. In their analysis of private equity performance, Robert Harris(of the University of Virginia’s Darden School), Tim Jenkinson(of Oxford University’s Said Business School), and Steven Kaplan(of the University of Chicago’s Booth School of Business) confirmed this assertion: It is very likely that private equity will outperform the S& P 500 (after fees). But this outcome do not look the same for every database. It differs significantly depending on the database being used, and none of the database has returns for all funds( as cited in the Economist, 2012).

Playing to win

Another issue of contention concerns how private equity firms calculate their returns. Ideally, majority of the private equity firms use the internal rate of return(IRR) as the metric for measuring their returns. But the problem here is that it is rare for two private equity firms to calculate IRR the same way.

Obviously, this can make it an uphill task for investors to compare funds. Besides, the IRR can overstate the actual returns investors realized. This is because IRR as used by the private equity firms implies that the investors’ returns was achieved on all the cash they invested, regardless of the fact that some of the cash were actually given back early and hence were reinvested at a lower rate. In addition to this, the

S & P 500 may not even be a good benchmark for private equity firms, for one important reason: most of them often purchase midsize companies which, during the past decade, have tended to perform better than the big firms included in the S & P 500(Economist, 2012). This implies that, for the private equity firms, an index of midcap stocks could offer a more accurate comparison than S & P 500, even though they can be a higher hurdle for the private equity firms to jump.

One sensible questions that people need to ask is why investors put their money in private equity firms whose managers are not that good in calculating IRR. The most simplest explanation is that investors do sometimes herd mindlessly into asset classes, regardless of the type of firm involved. Another plausible explanation could be that the way the industry manipulates data makes it attractive to the investors.

As Gordon Fyfe, the boss of the PSP Investments(a Canadian pension fund) put it, every private equity firm you talk to is first quartile(Pension Pulse, 2012). On the positive side, it is probably worth the fees and the extra risk of investing in the highly illiquid and leveraged private equity firms if investors can work out a way to place their money with funds that are actually in the top quartile. Otherwise, it is best for the investors to stay far away from private equity investments if they lack superior fund selection skills or extraordinary luck.

If fees ruled the world!

Since the executives of private equity firms can only eat if their investors do, they often claim that their interests are perfectly aligned with those of their investors. However, during the last two decades, private equity firms have morphed from small outfits into behemoths managing billions of dollars, with the result that most of their claims regarding investors’ fees has changed significantly.

Generally speaking, to manage their investors’ capital, most private equity firms usually charge a 2 percent annual fees and they can take as much as 20 percent of the profits(Marples, 2014; Economist, 2012). The implication of this is that big private equity firms can actually support themselves with this form of management fees. Thus, regardless of their performance during a typical year, most private equity firms receives around 75 percent of their revenues from this form of fixed fees.

Yet fees are not the only issue that worries private equity firms’ investors. Start with debt: With easy access to loans and other forms of debt, private equity firms can buy out more mature companies, fix them and sell them on thereby making more profits. In the past, higher debt has accounted for as much as 50 percent of private equity’s returns. But, after receiving severe burns from the 2007-2009 financial crisis, banks today are not willing to lend as much as they did five years ago(Finger, 2013).

This means that the private equity firms will have to seek for a bigger amount of equity than before in other to remain in business – a strategy that would obviously cap returns. In other words, for private equity firms, the prospect for the future looks dim: both the companies, their employees and the investors will make less money.

Another gloomy aspect of the business concerns price: the price that private equity firms pays to take over ailing companies has remained painfully high. In 2011, the average purchase price multiple for firms bought by private equity was 8.4 times higher than it was in 2006. One plausible explanation is that, due to the existing fierce competition for deals at the time, the firms has no option than to either use the industry’s idle $370 billion for buy-out deals or they will risk giving the fund back to the investor(Economist, 2012).

Relearning old lessons

With this current bleak landscape it is not surprising that many private equity firms are now reinventing themselves. Most of the private equity firms now understands that given their current situation, good intelligence should be their first line of defense. Thus a significant percentage of their managers has adopted the strategy of doing more growth equity deals, using less debt and taking minority stakes in companies.

It should be noted here that this strategy has been their hallmark in places like China and other emerging markets which do not welcome control and leveraged deals. Now, with the current gloomy business environment, the industry has no option than to import this strategy back in the west. And for the big American firms like the KKR, Carlyle and Blackstone, a good modus operandi will involve expanding or starting other units that would be focused on investments like property, hedge funds and distressed debt – a strategy they have wholeheartedly adopted, and which had so far lent them an attractive investment glow.

Of course many private equity firms who are not able to raise funds will fade away or die a natural death. But their rate of extinction will be slow, simply because private equity firms are diehards. In any case, for the world’s existing 827 private equity firms(Economist, 2012), survival means diversifying their operations as much as possible. Thus, for private equity firms, the handwriting on the wall is clear: Reinvent or perish.

Reference

Bain & Company(2013): Global Private Equity Report 2013. Retrieved April 27, 2014 from http://www.bain.com/Images/BAIN_REPORT_Global_Private_Equity_Report_2013.pdf

Finger R.(2013): Banks Are Not Lending Like They Should, And With Good Reasons. Forbes. Retrieved April 28, 2014 from http://www.forbes.com/sites/richardfinger/2013/05/30/banks-are-not-lending-like-they-should-and-with-good-reason/

Marples D.J.(2014): Taxation of Hedge Fund and Private Equity Managers. Congressional Research Service. Retrieved April 27, 2014 from https://www.fas.org/sgp/crs/misc/RS22689.pdf

Pension Pulse(2012): Canada’s Subprime Crises? Retrieved April 27, 2014 from http://pensionpulse.blogspot.com/2012_01_01_archive.html

The Economist(2012): Private Equity Under Scrutiny. Retrieved April 26, 2014 from http://www.economist.com/node/21543550

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