Getting While The Getting’s Good

800px-Gluttony
Woodcut depicting the deadly sin of Gluttony, by Sebastian Brandt; Source: Wikipedia

Lately, investors have been gorging themselves on private equity. The Financial Times reports:

“The current speed of fundraising is in my experience unprecedented,” said Jason Glover, a London partner at Simpson Thacher, the law firm. “[Private equity groups] are keen to take advantage of the unusually benign conditions, particularly in anticipation of a change in market conditions when fundraisings may become significantly more difficult.”

But Mr Glover, who has been involved in private equity fundraising for more than 25 years, said investors are eager to park their cash in top-performing funds. “Investors are keen to deploy increasing amounts to private equity and with many of the top funds massively oversubscribed, their only way to secure a commitment is to act quickly before those funds are sold out,” he said.

Private equity funds have also gained traction with investors as other asset classes, like hedge funds, have underperformed, said Warren Hibbert at Asante Capital Group. He said: “The private equity market today provides a unique product which is very difficult to kill, unlike hedge funds. It’s very difficult to lose money in a private equity fund.”

Part of the public service I attempt to provide on this blog is drawing attention to screaming red flags when I see them. As far as screaming red flags go this is a pretty good one.

Private equity is simple in principle and is first and foremost an exercise in financial engineering:

Step 1: Buy cheap company.

Step 2: Add gobs of debt.

Step 3 (optional, if desired): Cut expenses to boost free cash flow.

Step 4: Flip the levered entity at a higher valuation.

The problem private equity investors face today is that they are buying into funds based on past performance that is not likely to persist. The reason? Valuations.

Remember, per the above steps private equity works the same as flipping houses. You need a cheap entry price, low financing costs and stupid willing buyers on the other side. As entry valuations rise, the bar rises on the back end. You need to find progressively dumber more optimistic buyers to exit the investment and earn an attractive return.

Dan Rasmussen of Verdad Capital has written and spoken extensively about his firm’s in-depth research into private equity returns. In a piece written for American Affairs, he discussed the negative impact of higher entry valuations at some length:

This is more troubling than most market observers understand. Private equity is price sensitive because of the use of debt. Higher prices require more debt, leading to higher interest costs and higher risk of bankruptcy. The importance of valuation to returns is controversial but key to understanding the asset class, so it is worth looking at the issue from a few different angles.

The first approach is to look at PE deals and compare returns to purchase price. One PE firm did just such an analysis and found that over 50 percent of deals done at valuations of more than 10x ebitda lost money and that the aggregate multiple of money was barely over 1.0x (i.e., for every dollar invested, only slightly more than one dollar was returned to investors).

The second is to compare the average purchase multiple in a given year to the returns of the funds from that vintage year. There is a –69 percent correlation between purchase price and vintage year return, a strong inverse relationship.

The third is to look at PE-backed companies that IPO. My firm, Verdad, looked at every company taken public in the United States and Canada by a top-100 PE firm since the financial crisis, a data set of 195 IPOs with an aggregate ebitda of $66 billion and an aggregate market capitalization of $728 billion. The average company in this data set went public with $4 billion in market capitalization, traded for 17x ebitda, and was 21 percent leveraged on a net debt/enterprise value basis at IPO. We segmented these IPOs by valuation at IPO. We divided the universe into three buckets: companies that went public at less than 10x ebitda (about 20 percent of companies), 10–15x ebitda (about 20 percent of companies), and more than 15x ebitda (about 60 percent of companies). According to our research, the cheaper IPOs dramatically outperformed the Russell 2000, the moderately priced IPOs matched the Russell 2000’s return, and the expensive IPOs underperformed.

Included in the article is this chart comparing historical valuation multiples:

Verdad_Am_Affairs_Multiples
Source: Verdad Capital via American Affairs

As for Mr. Glover’s assertion that “it’s very difficult to lose money in a private equity fund,” here is a list (not comprehensive) of assets and strategies that wore that mantle at one time or another:

  • Tulips
  • Railroad stocks
  • The Nifty Fifty
  • Tech stocks
  • Hedge funds
  • Mortgage bonds
  • Florida real estate
  • Energy stocks
  • Bitcoin
  • Beanie Babies
  • Tesla stock

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