The truth about private equity
Posted on March 7, 2007 by Richard Beddard
Filed Under Investing |
Tuesday-to-Tuesday, headlines have been dominated by falling stock prices around the world but I detect signs of change. In the daily torrent that is Alphaville, the FT’s City Blog, were two stories yesterday that remind me of what used to make the front pages all of about a week ago; Private equity mega-deals. Blackstone, a private equity group, has bought Kylie’s bottom, along with the rest of her, thousands more waxworks and the London Eye. It’s also in the market for Chrysler.
Since Chrysler is American and Tussauds was already in private hands, perhaps these deals are less newsworthy than the stalking of Sainsbury’s and yesterday’s bid-fever, or the GMB union’s harassment of the private equity owners of companies like the AA and Birds Eye. Employees don’t do well out of private equity, it seems, but I’ll let the GMB’s press office do the talking on behalf of workers because I have an axe of my own to grind; whether private equity is good for investors.
Private equity partnerships are notoriously secretive and although Damon Buffini, a managing partner at Permira, has emerged offering talk and transparency, he really wants to tell the unions what a good job private equity does. I don’t think they’re up for it. So who to go to, to get the truth about private equity?
Guy Fraser-Sampson, has just written the world’s first textbook about private equity for investors: Private Equity as an Asset Class. The investors in question are pension funds but surprisingly, because textbook plus pension fund does not always equal good read, it’s written in plain English. A former fund of funds manager for Horsley Bridge, Mr Fraser Sampson, is a private equity insider who’s spent the last three years writing books and lecturing to the pensions industry, mostly about how they could do a better job investing our money. Betraying his literary ambition, he says he’s as much a writer who invests as an investor who writes, he agreed to meet me at the Arts Club in London, also home of the Authors’ Club. Sadly, we met in the bar and he allowed me to tape the conversation. No cloaks or daggers then.
He’d just returned from Frankfurt where he’d addressed the provocatively titled “Super Returns” conference for private equity investors. The GMB had promised banners saying; “Slam the door as your leave the EU”, “Plague of locusts” and “Private equity asset strippers” but, says Mr Fraser-Sampson, there were:
about a dozen very respectably dressed people standing around with very small placards, and then at lunchtime they all went home.
This is what he told me about private equity:
Instead of owning shares in listed companies, private equity funds take a stake in unlisted companies or buy them outright. There are two faces to private equity: Venture capital and buyout funds. Typically, venture funds buy relatively small stakes in young technology companies and hold on to them for seven or so years. Buyout companies take over established profitable companies, often using large amounts of debt, and seek to sell them on within a couple of years. He says:
It’s undoubtedly true that in pure socio-economic terms… venture is good because it creates businesses, it creates jobs, it creates economic growth, it increases tax yield. And buyout is bad in that typically they proceed by rationalisation, which will mean job losses. They structure the deals financially so that they won’t pay any tax so you are reducing tax yield.
But buyout is not all bad, he says:
Companies typically perform more efficiently in private ownership than they do in public ownership.
That’s because the big funds that invest in public companies are mainly interested in short-term profitability and are wary of anything that might damage fund performance. Out of the analysts’ eye managers can take a longer-term view and avoid the regulatory expense of a stockmarket listing. If major surgery needs to be done, it can be done more effectively with private equity owners.
If the government acted to discourage the buyout industry, as the unions would by taxing loan interest, what is in-effect a global industry headquartered in London would decamp, he says:
You’re talking about an enormous economic multiplier effect. For every transaction that happens, and bear in mind there’s also probably two or three unsuccessful buyout firms who’ve been working on it and incurring the same sort of fees, you’ve got law firms, accountants, technical consultants, business consultants, environmental consultants, you’ve got the investment bank that’s conducting the sale process and then when you have an exit you’ve got investment banks, you’ve got brokers, you’ve got lawyers, you’ve got accountants… It would be a massive, massive blow to the UK economy. I’m guessing, but you could be talking about taking one or two percent off GDP.
he other argument, which gets lost in the noise, is efficient companies in efficient markets drive prices down. So what we are talking about is lower prices to consumers and ultimately a better standard of living.
Mr Fraser-Sampson thinks it’s the increasing size of the funds, not the principle of buyout, that is at fault. Bigger funds must strike bigger deals, like Sainsbury. Fierce competition bids up prices, something that doesn’t bother private equity managers too much but ought to bother investors, like pension funds who rely on that profit for their return:
…the original idea in the original private equity model was you raised a relatively small fund. The management fee gave you just enough money to run your business on a day-to-day basis and your incentive was in the carried interest. Your share of the profits.
While fund managers grow fat on management fees, the prospect of a big profit for investors is reduced:
You can do the sums for yourself. If you are a $15bn buyout fund and are charging even a 1% management fee it’s rather a lot of money… Whatever they may say to the contrary most buyout managers, for large funds anyway, are probably at least as motivated by management fee as they are by carried interest… So that’s the main driver behind these big buyout funds. You raise as much money as you can to get as much management fee as you can.
The figures suggest a “clear inverse correlation between fund size and returns“, says Mr Fraser-Sampson, but still investors pile in. It’s a classic case of the herd mentality:
The really depressing thing is we’re probably only in the early stages of a bubble in large buyout funds. I think they will continue to get bigger and bigger for years to come as more money seeks to enter the industry.
The smart money is already moving on, he says, but a wall of dumb money, often money from new investors unused to investing in private equity, is entering buyout funds. Mr Fraser Sampson’s fear is that much of that money will be from British pension funds, traditionally minor players in private equity, but now being lured by the promise of super returns.
The problem with say US venture capital in 1997, 1998, 1999 or European big buyout now is that they’re basically investing for the future on the returns of the past, not realising that their own investment automatically changes what those returns are likely to be.
If private equity is to deliver super returns in future, it’s unlikely to be from the 6% of private equity funds over $1bn in size that have attracted 55% of all private equity capital since 2001 (mostly big buyout funds) but from the best of the other 94%, many of them small venture funds. The problem is, nobody’s looking there, he says:
This is the total illogicality of the investor’s position. They’re throwing these enormous amounts of money into large buyout funds when there is this classic contrarian opportunity starting them in the face.
Comments
11 Responses to “The truth about private equity”
Leave a Reply
Candover is a case in point- 20 years of excellent returns, then it suddenly became cash-burdened and appears to have slightly lost its way to smaller and more agile companies, like Hg Capital which appear to concentrate on venture inputs for a diverse range of small companies with great potential eg wind power and health care. Hg has been piling on the pounds recently, but in a more positive sense. Neither have a reputation for negative impacts on employees though.
I have to say article is quite in depth. but leaves me curious to find out more about the remaining 94%. aren’t we talking about hedge funds here?
Thanks for your comments.
Shells; The remaining 94% are venture capital funds typically taking stakes in smaller technology companies - all the rage eight or so years ago but apparently moribund now, in Europe at least. Hedge funds are a different beast again, but since they can do almost anything they’re tricky to define. In his book, Guy Fraser-Sampson starts by defining private equity and points out that the activities of private equity funds, hedge funds and property funds are converging and he can see the time, not far away, when all three combine on the same deal.
One day I’ll make sense of it all
Quality insight but it doesn’t tell me where all this cheap investment money that the big funds have available to go and buy just about anything they fancy is going to end…for good or evil? What you’ve got is not a big (say) retailer buying a smaller one to consolidate and achieve economy of scale etc, rather they’re buying x , presumably leaving a slimmed down management team in place and looking to reap a divi by selling on to yet another private equity group in due course. Is this natural and am I worrying about nothing, because surely Blackstones et al are not in ‘it’ for the long term?
Hi Mike. I think that’s a very good question, so good that I am going to put together a follow-up to this blog that goes some way to answering it. So you’ll forgive me if I play for time - I need to do some research… But I *think* there are examples of good buyouts and evil ones, and I think I know how to tell. My suspicion is - if the Sainsbury one happens it will be an e*v*i*l one!
[...] - Alive, but not as we know it Richard Beddard from Interactive Investor Blog carries an excellent interview with Guy Fraser-Sampson, who wrote the book “Private Equity as an Asset Class“. For me the most interesting [...]
[...] as long as the pension funds that invest in them don’t wake up and smell the falling returns I reported last week. Meanwhile the Treasury is going to review the way private equity finances deals, but on the Today [...]
[...] spent some time on private equity recently, and knowing even the industry has trouble defining itself, I looked it up in his [...]
[...] Original post by Richard Beddard [...]
[...] you’ve been following the private equity story, Alphaville is plugging a ‘Special‘ on the subject. Not all of it’s free to [...]
While the large players will continue to bid up company valuations, I believe it will be the smaller/specialist firms who will consistently find attractive opportunities. Unfortunately, public investors will not be able to enjoy any returns from these players.