Saturday, January 28, 2012

Everybody Wants to Tell You about Private Equity

Seems like everybody in the journosphere, blog or otherwise, wants to take a crack at explaining private equity.  Here's a sensible account from The Economist; I'd love to know where they got that "net one percent" number, although it does sound believable.  Here's James Kwak, who says he is much less bothered by Mitt's time at Bain than he is by his current positions--all 180 degrees out from  those he embraced as governor of Massachusetts.   Here's James Surowiecki in The New Yorker, remarking on how little the industry must love all the attention it is getting.   And here's Holman Jenkins in The Wall Street Journal saying everything's all right here folks, move along.

Finally, by special invitation, here is Underbelly guest columnist Ignoto with his own account.  I would warrant him by saying he knows more about the subject than I do.  But that is a low bar; in truth he knows more about  the subject than most people.  Anyway, over to you Ignoto:
So why private equity, you ask?  Good question.  There are two schools of thought, both of which I actually adhere to in certain limited circumstances.  (Naturally, the devil is in the details, and I maintain that private equity as it has been implemented has been a disaster for everyone except the PE firms themselves.)
Thesis 1 – and this is the thesis usually emanating from the mouthpieces of the PE community – is that being private allows for longer-term thinking versus being public.  I get this – to a degree.  A PE-owned firm can put in place dramatic operational and financial changes that may not be necessarily welcome in the public markets.  Or they can commandeer efficiencies by buying two firms in the same industry and integrating them.  (Wilbur Ross is especially good at this – he’s rolled up steel mills, for example, and by using the economies of scale having ten mills in one company rather than ten mills in ten companies he’s created value.) 
All that being said, I don’t know if anyone’s really done a coherent and robust analysis of the “ability” of public companies to do the same kinds of “operational improvements” as private companies.  Frankly, if a company’s management team came out and said “the next two years will involve a high degree of creative destruction as we completely rethink our business model; earnings will drop like a stone and then rebound to previously unheard-of levels,” you might get a lot of sellers of the stock, but unless the company’s on the verge of bankruptcy, it probably doesn’t need access to capital markets anyway, so why does it care?
Thesis 2- and this is the thesis I think makes a hell of a lot more sense – is that it allows investors to lever up their exposure equity using nonrecourse term financing.  If I have $100 of capital to invest, I can invest $100 in the S&P and get one “unit” of equity risk.  I can get $100 in margin financing and invest $200 in the S&P, thereby getting two “units” of equity risk, but I’m subject to the margin loan being called.  OR I can give that $100 to a PE firm, have them take a modestly levered bunch of companies, lever the bejeezus out of them in the credit markets, and gain two or more “units” of equity risk (albeit less diversified than the S&P) with much less risk of the loan being called.  (The high-yield bond and bank loan markets are the sources of capital for LBOs – after the banks provide bridge financing, that is – and those bonds and loans usually go out 5 to 10 years before they come due.  And usually they don’t have triggers that could truncate the repayment period – especially when the capital markets are particularly loose, which is when LBOs are being done easily.  See, e.g., 2005-2007.)
As far as I’m concerned the biggest value-add KKR or Blackstone can provide is using their extensive power over the big banks to wrest cheap long-term capital out of them in ways we can’t (because we don’t bring, say, Morgan Stanley a lot of i-banking business the way KKR and Blackstone do.
The real reason you have so much PE is that it gives politicians access to rich people: the “gains” to the politicians all come up front, and any responsibility for bad decisions is someone else’s problem because the 10+-year lifespan of a PE deal means the politicians in place when the deal gets done are long gone when it blows up…  In essence, a PE guy becoming president is the logical apex of the rise of PE as a political asset class.
 Buce here: marking my own beliefs to market, I'd say for the moment:
  • Does PE pay off for investors?  Sometimes yes, sometimes no.  Maybe more yes than no.
  • Does it pay off for managers? You bet.  Interest deductibility and carried interest help a lot.
  • Does it pay off for target companies?  Complicated question.  Most of the targets were in trouble anyway, so the net effect may be to help them over the edge.
  • Does it help politicians? Sometimes, sure.  But perhaps hard to pin down just how much.

1 comment:

Ken Houghton said...

"Does PE pay off for investors? Sometimes yes, sometimes no. Maybe more yes than no."

Not The Way to Bet if you're looking at investors overall and not just on the Equity side.

The reasoning there follows from "Most of the targets were in trouble anyway, so the net effect may be to help them over the edge." Instead of letting them die--and we can agree that not letting them die may be a good thing in some cases (think TWA or the above-referenced Wilbur Ross).

But the chance of the new entity becoming viable--that is, of that debt getting repaid $1.00 on the dollar--is low at best. Yes, there is compensation (higher interest rate on the debt), but the success of the enterprise depends very much on financial management that is not in the equity holders best shor-term interest.

Shorter version: LBOs (and good on Ignoto for using the real phrase) are a decent idea--and can work really well in an industry that needs to rethink itself completely (as steel production did)--if the people who tend to run LBOs aren't running them.

That that problem is not exclusive to LBOs, but merely exacerbated by them, is another issue.