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Why Long-Vilified Private Equity Does So Well

Several states are the latest to slam the buyout bunch for their high fees. Despite that, PE is flourishing.

Art by Andrea D’Aquino

Private equity has long operated under a cloud of public ill will. But somehow PE has managed to thrive. Why? One big reason: The activity of buying companies and then selling them often delivers on its implicit pledge to do better than the stock market.

That proposition appears to be true, although some disagree with it. A 2016 study by the Center for Economic and Policy Research contended that PE has an edge over the public market during economic downturns, as it can buy good assets cheap and has the financial capacity to weather storms.

Another argument in favor of PE firms is that they offer diversification, best for long-term investing. “They have a longer time horizon” than public companies fixated on the current quarter, pointed out Bruce Monrad, chairman of Northeast Investors Trust. “And they can be more opportunistic.”

But that hasn’t stopped critics from trashing PE. The crux of their complaints: Investing with private equity ain’t cheap. The classic “2 and 20” compensation system—where PE firms get 2% of assets in fees yearly and 20% of the profits upon the portfolio’s sale—is rankling a number of big-name politicians lately. Railing against high fees, the governors of Pennsylvania and New Jersey and the treasurer of North Carolina have all called to eliminate or reduce their state pension plans’ stakes in PE.

PE has had a bad image since the 1980s, when leveraged buyouts and corporate raiders first appeared en masse. This was the day of Michael Milken, who funded the raiders, and ended up doing jail time. The human cost of corporate buyouts made PE suffer most in the court of public opinion. In a well-received 1991 movie, “Other People’s Money,” a villainous raider known as “Larry the Liquidator” (played by Danny DeVito) sets out to buy a small-town company so he can shut it down and fire all the workers.

The standard procedure of private equity is to raise a fund, use the money (often along with debt capital) to buy out a group of companies, improve their performances, and then sell them to another buyer or the public—presumably at a tidy mark-up. “You don’t create value by buying the S&P 500,” Steve Schwarzman, chairman of PE powerhouse Blackstone once remarked. “You actually have to transform the company.”

And this process takes a while, five to seven years typically. For investors, getting out of a PE fund quickly is not easy. The general partners, the managers who run the fund, want to keep capital in place while Schwarzman’s transformation occurs.

So PE operators counsel that they need patience before they sell portfolio companies. Helping their case is a diminished appetite for becoming publicly traded. “People are more comfortable with keeping a company private for longer,” said Rich Nuzum, president of consultant Mercer’s wealth business.

Playing into PE’s hands, volatile stock markets like 2018’s and increased regulation of public companies discourage going public. The 8,000 public companies in the mid-1990s has been more than halved.


What’s so appealing about private equity? Several factors are involved:

Crowd dynamics. It’s basic human nature: Whenever the crowd is running one way, others follow. Institutions and wealthy individuals are scrambling to get into PE. “Now is a sellers’ market” for PE funds, said John Molesphini, eVestment’s global director of insights. “They have no trouble raising capital. Open the door and the line begins on the left.”

The most popular are the mega-funds, those with $1 billion or more, which account for two-thirds of all PE capital, Preqin says. “Most of the largest fund managers say they are routinely oversubscribed,” a report by the firm states.

Certainly, among public pension plans, PE is the clear favorite for new investments, eVestment finds, with 27% of these awards in 2018 going to PE. That surpasses public stock (20%) and direct real estate (14%), and far exceeds hedge funds (11%). Texas Municipal Retirement System began its PE program in late 2015, with a goal of making private equity 5% of total assets (TMRS is at around 2% now, some $550 million).

Fund raising remains robust for PE, although the amount of capital they gathered did slip a bit last year. Investors kept plugging more and more money into PE funds, reaching $566 billion in 2017. Preqin data shows that the money gathering dipped last year to $426 billion. Nevertheless, this is hardly a number to brush aside. In 2018, a new fund from an established firm, Carlyle Partners VII, raised an impressive $18.5 billion.

The promise of superior performance. The chief selling point for PE funds has long been that they will deliver better returns than the boring old stock market. While few general partners will place their hands on a Bible and make such a vow, the underlying idea is that PE funds are peopled with savants who can spot good acquisitions and buff them up.

Giving support to the credo of PE returns’ preeminence was a 2012 paper in the Journal of Finance by University of Virginia professor Robert Harris and two other academics. It found that, starting in 1984, buyout funds consistently outperformed public equities, by 20% to 27% over a fund’s life, more than 3% annually.

More recently, a PitchBook study indicates, through 2017, PE did better than the S&P 500 index over one year and 10 years, but not for five years. The breakdown: 17.8% for PE compared to 13.6% for the index over one year, 12.8% versus 13.7 for five years annually, and 12.9% against 9.1% for 10 years.  And a Preqin study shows that, from the start of the century, PE’s rise was almost double that of the S&P 500.

The Texas Municipal Retirement System got into PE because it realized its bond-heavy portfolio would generate “low expected returns that wouldn’t let us hit our target” for what the pension plan needed over time, said Chris Schelling, the program’s director of PE. Since inception, the PE investments have risen 19% annually, some 5 percentage points better than the S&P 500.

Of course, comparisons like these can be faulted because PE performance is measured differently than the benchmark stock index. The S&P 500’s total return is much simpler, combining price changes and dividends paid. In a bid to approximate standard returns, PE uses internal rates of return, a complex calculation that measures valuations, capital raised, and cash paid out.

Other gripes center on the amount of leverage that PE funds often use, which critics say distorts their returns, artificially improving how they did. That’s the criticism from Larry Swedroe, director of research for the BAM Alliance financial advisory organization. Swedroe also contends that the S&P 500 shouldn’t be used as a PE benchmark because private equity tilts toward small-cap value investments—and those indexes often out-do the S&P 500, making PE look worse by comparison

Going forward, most Wall Street pundits think a recession and a bear market are coming. While that’s not good for any type of investment, bad times should make comparisons to common stocks even more favorable to PE.  “The last 10 years were the greatest for stocks,” observed Neil Blundell, Invesco’s global head of client solutions. “That won’t last forever.”

And private equity, like any investment, fares better in some times than in others. Funds are grouped like wine, into vintages, beginning from the year they launched.

According to Cambridge Associates, funds created before or during the financial crisis didn’t do as well as stocks, because those PE vehicles bought expensive companies that went sour. PE funds hatched after the crisis, helped by low interest rates and bargain purchase prices, have performed better than the S&P 500. (Funds that opened in the last few years are thought to be too young to be judged.)

PE funds have a lot of financial firepower.
The old saw is that it takes money to make money. If so, PE funds are rolling in what they need. And provided that funds choose the right acquisitions and manage them well, fortunes can be made. Or at least that’s the hope.

At this point, the picture is bright for PE. More than 4,800 PE deals were closed in 2018, PitchBook research indicates, the highest ever. And the total deal activity surpassed $700 billion, the second-highest yearly figure, outdone only by 2007’s record. The largest acquisition last year: JAB Holdings’ $21 billion takeover of Dr Pepper Snapple Group.

What’s more, the deals are getting richer: The preferred multiple for PE operators—enterprise value (equity plus debt minus cash) to EBITDA (earnings before interest, taxes, depreciation, and amortization)—exceeded a lofty 10 times for 61.4% of deals, the biggest portion in history.

The amount of capital sitting in PE funds waiting to be committed, so-called “dry powder,” also has set a record, starting 2019 with $1.2 trillion. That’s a lot of firepower, which should keep the buyout market humming throughout the year.

Even the mightiest of PE firms can stumble, however. Apollo Global Management, one of the largest PE enterprises and the rare one that is publicly traded, took a drubbing in 2018’s fourth quarter, when problems at one of its portfolio holdings, annuity seller Athene, put it into the red.

Perhaps the biggest PE fiasco was the 2014 collapse of a portfolio company named Energy Future Holdings, which was bought for a head-turning $45 billion in a joint deal. The buyers included such storied players as Kohlberg Kravis Roberts and TPG Capital. A more high-profile, if lower-cost, PE failure was that of Toys “R” Us last year. KKR and Bain Capital took over the toy chain in 2005, along with Vornado Realty Trust, for $6.6 billion.

Certainly, the current favorable economic cycle will turn at some point. PE suffered from the tech bust of the early 1990s and the 2008-09 financial crisis. Up ahead, noted Nic Millikan, director of research for alternative investments at alt provider CAIS Group, “private equity can’t rely on cheap credit and easy terms” to buy cut-rate companies. “They will have to get creative.”

And by and large, PE firms have shown they can deliver that.