| Private Equity (PE) investing has grown | | | | invested in private equity, all chasing the same |
| dramatically over the past 5 years, and the | | | | deals, and paying higher prices. Above average |
| private equity funds have produced excellent | | | | returns nearly always get competed away as |
| returns for investors. Private Equity funds have | | | | tons of new supply or capital enters the market. |
| become very popular and trendy "alternative | | | | Acquisitions are now much more competitive and |
| investments" that many large investors (high net | | | | expensive. Private equity companies can't buy |
| worth families and institutional investors) have felt | | | | companies "cheap" any more with all the |
| like that had to be involved with. Private Equity | | | | competitors bidding for the same assets. Many of |
| funds try to acquire companies or businesses | | | | the large hedge funds have also gotten into the |
| cheaply. They use lots of tax-deductible debt to | | | | private equity business over the past several |
| leverage their returns, cut costs to try to | | | | years, making it an even more crowded space. |
| improve the short and long-term profitability, and | | | | More players chasing deals at lower returns just |
| sell assets to take capital out. Sometimes they | | | | to "put money to work"? |
| pay themselves a dividend out of company | | | | 4. Several big private equity firms have recently |
| owned assets, and they eventually (2-5 years | | | | gone public. Why would they do that? That is |
| later) sell out to another buyer or take the | | | | inconsistent and hypocritical with their whole |
| company public at a higher valuation. | | | | philosophy of how much better it is to run |
| The favorable conditions that helped drive the | | | | companies privately. Did they sense a "top" in the |
| recent private equity boom have changed | | | | market for private equity? I think so. The |
| dramatically over the past year. Future private | | | | industry insider "smart money" was selling, so |
| equity returns will be much lower than they were | | | | why should we be buying? The PE companies that |
| over the past 5 years and could prove to be | | | | did go public have seen their stocks drop |
| quite disappointing for many investors. I believe | | | | significantly recently on concerns about the |
| the private equity peak was 2006 and the first | | | | private equity industry. Blackstone (BX) is one of |
| half of 2007. The Private Equity boom was driven | | | | the biggest players in the private equity business. |
| by very cheap debt, a bull market in equities, a | | | | Their stock has fallen by over 40% since they |
| strong global economy, rising corporate profits, | | | | went public (at the peak) and their fourth quarter |
| massive capital inflows into private equity, | | | | earnings (announced March 10th) were down by |
| Sarbanes/Oxley reporting rules for public | | | | 89%. |
| companies, and strong initial returns. Some of the | | | | 5. Some of the private equity firms are recently |
| large private equity companies are Blackstone, | | | | having trouble getting big deals done. Some big |
| Carlyle Group, Kohlberg Kravis Roberts, Texas | | | | buyout deals have fallen apart due to the less |
| Pacific, Thomas H. Lee, Cerberus and Bain Capital. | | | | attractive terms with the new environment, a |
| Private equity historical returns: | | | | slower economy, or the inability to get financing. |
| Past returns in the large private equity funds have | | | | Less big deals getting done and at less attractive |
| been very good, beating equity market returns. | | | | terms means lower future returns for private |
| According to Fortune Magazine over the 10 years | | | | equity investors. |
| to mid-2006 (the likely peak for PE) returns on | | | | 6. The Private Equity firms are going after smaller |
| private equity averaged 11.4% vs. 6.6% for the | | | | and less lucrative deals out of necessity. The |
| SP500 stock market index. Longer-term (20-year) | | | | firms are now doing small investments, making |
| results show that private equity investments | | | | private investments in public companies (PIPE's), |
| have returned about a 4%-5% premium to the | | | | backing small growth companies, and buying |
| public equity markets. Of course these superior | | | | convertible debt. These types of deals are likely |
| returns are achieved with significantly higher risk | | | | to result in lower returns that the traditional big |
| and an investment that is "locked up" for many | | | | LBO deals of the past. Blackstone chief James |
| years. | | | | says "we are looking at deals that don't depend |
| My Concerns About Private Equity Investing and | | | | on leverage". Harvard business professor Joshua |
| Future Returns: | | | | Lerner says the term LBO is a bit obsolete when |
| 1. Debt has become much more expensive for | | | | neither leverage nor a buyout is at hand. Many of |
| leveraged buyouts. Cheap and plentiful debt was | | | | the big PE firms are not able to find good |
| one of the key factors that allowed private | | | | investments so they currently are sitting on lots |
| equity firms to succeed. Private equity is often | | | | of cash, which doesn't produce much of a return |
| just a leverage buyout (LBO's) of companies. | | | | at all. |
| Over the past 5 years high yield or "junk" debt | | | | 7. Fees are very high for investors. The private |
| was very cheap and traded at a very small | | | | equity fees are typically 2% per year, plus 20% |
| premium to treasury debt. Over the past 6 | | | | of any profits earned. That is very expensive, |
| months junk bond debt cost premiums have | | | | especially if they are investing in cash, converts, |
| jumped significantly (from 3% to 8%), and the | | | | PIPE's, smaller less leveraged deals and expected |
| availability of high yield debt has decreased | | | | returns are significantly lower than they were in |
| dramatically due to the credit crisis. Future PE | | | | the past. |
| returns will be hurt because of this higher cost | | | | 8. Access to the best funds and private equity |
| debt, and because they will not be able to use as | | | | companies is restricted. If you are a smaller |
| much leverage. Less leverage means lower | | | | investor with only a few million to invest in private |
| returns for investors. | | | | equity, you are unlikely to get access to the |
| 2. The economy is much weaker now. We may | | | | biggest or best private equity companies and |
| be in a recession right now. Recessions are | | | | funds. Past performance of a particular PE |
| normally very bad for leveraged companies. Given | | | | manager may not be a very great indicator of |
| how much debt these companies layer on to their | | | | future performance. You may have to settle for |
| investments these private equity investments | | | | a less seasoned private equity fund or a "fund of |
| carry a fairly high level of risk. Private equity firm | | | | funds" with an extra layer of fees. |
| Cerberus is struggling with its leveraged ownership | | | | I think there will still be a place for private equity |
| of Chrysler and GMAC (housing and auto loans, | | | | investing among large institutional investors, but |
| 1Q08 loss of $589M) in the current economic | | | | that returns could be somewhat disappointing |
| downturn. | | | | over the next 2-3 years for everyone. In my |
| 3. There has been massive growth in the number | | | | opinion most individual investors should avoid this |
| of private equity firms and the dollars of capital | | | | investment sector for now. |