Institutional asset managers keep flogging more capital to the alternative segments of private equity, private debt and venture capital. For that reason, it might be tempting to invest in the industry’s publicly listed firms.
In recent years, Apollo, Ares, Blackstone, Carlyle and KKR have taken the IPO route. Sweden’s EQT, with €40 billion under management, is rumoured to be preparing a similar move. Prospective investors now have access to a prestigious, high-yielding asset class, traditionally the preserve of institutions and sophisticated high net worth individuals.
Buyouts, leveraged loans and start-ups are high-return assets and should arguably form part of any investor’s portfolio diversification strategy. There is some validity behind this view. If public stock markets deliver 4% to 6% in the long run and alternatives offer 10%-plus, individuals ought to allocate a portion of their capital to the latter.
Mind the reversion to the mean
There are, nevertheless, counterarguments. First, high returns imply high risks. PE and VC fund managers know that a proportion of their portfolio will lose money. On average, a quarter of LBOs fail to return their original equity while up to 70% of VC-backed start-ups fare likewise.
One issue is that people often fail to grasp the most basic laws of averages. In June 1999 Jack Welch, CEO of General Electric at the time, observed: “Last year we made 108 acquisitions for $21 billion. That’s 108 swings. Every one of those acquisitions had a perfect plan, but we know 20 or 30% will blow up in our face. A small company can only make one or two bets or they go out of business. But we can afford to make lots of mistakes.”
Unfortunately, this view does not take into account the fact that the failure rate could shoot up in a downturn, as it did for GE and other punters during the dotcom crash of 2000-03. From 30%, the proportion of acquisitions that unceremoniously bombed reached well above 50%. For dotcom start-ups, it was closer to 90%.
Just like the 1996-99 M&A boom eventually looked decidedly amateurish, the sheer volume of deals completed in recent years will yield its fair share of casualties. Current activity levels are unsustainable: fundraising and investments exceed the 2007-08 heights. Buyouts and start-ups have done well thanks to a bullish economy and cheap credit, but over a full economic cycle, performance is bound to revert to the mean.
Branding is no guarantee of quality
Take the example of Candover Investments plc, a pre-eminent British LBO shop that delisted and went into liquidation last year following a decade of attempted reorganisations to patch up a long list of lacklustre investments completed during the credit bubble. Offering a review of the last ten deals completed by the firm out of its 2005 vintage fund, the table below shows what happens to PE-backed, overleveraged companies in a downturn:
|Transaction||Date of Completion||Enterprise Value (€m)||Cash-on-cash equity return|
|DX Group||September 2006||654||-89%|
|Hilding Anders||October 2006||996||-95%|
|Parques Reunidos||January 2007||935||+25%|
|Capital Safety||June 2007||415||+183%|
|Alma Consulting||December 2007||800||-91%|
Source: Candover Investments plc
What investors craving to back alternative fund managers should understand is that averages also fail to point out how skewed the sector’s performance is. In PE, two-thirds of fund managers do not deliver the hurdle rate of 8% - the minimum annual rate of return that fund managers are usually expected to provide investors in exchange for allocating their capital into high-risk buyouts. Candover was not the only prestigious manager that failed to deliver adequate returns from its pre-crisis vintage: BC Partners, KKR, Providence, Terra Firma and TPG are among the sub-par performers of that era.
Private equity also suffers from a lack of persistence. Firms that were overachievers for one vintage can deliver below-par results from their next fund. Candover’s 1994 fund was top-ranking; its 2005 vintage delivered bottom-quartile returns. In alternatives, as in other asset classes, past performance may not be indicative of future results.
Similarly, strategy execution is heavily dependent on timing within the credit cycle: UK-based 3i Group Plc came within an ace of bankruptcy in 2008 when its senior management chose to lever up the firm’s balance sheet as the economy was heading south - despite yielding stellar returns in the last decade, 3i’s stock is yet to revisit its peak of 2007. And given that, in the past two years, the stock has traded 40% above the underlying net asset value - a situation last encountered in 2007 - it might well be that the markets have once again reached bubble territory.
Whilst the largest, well-diversified PE groups have tried to manufacture steady revenues through management and advisory commissions - in 2018 such fees generated $3 billion for Blackstone from nearly $500 billion in assets - there is no way to completely eradicate cyclicality. Growth in assets under management and portfolio valuations are contingent on the state of the economy, making asset-based fee generation too volatile to deliver predictable cash flows.
With performance-related incentives mostly accruing to staff - over the past two years, Blackstone’s top 3 executives received about $200 million each in capital gains from portfolio realisations - dividend payouts and capital appreciation depend on management and monitoring fees. Because they are to be shared with the fund manager’s personnel and the underlying funds’ limited partners (LPs), such distributable earnings are too uncertain for long-term investors.
To make matters worse, market competition is intensifying and alternatives specialists like Blackstone and KKR could eventually be disintermediated. A growing misalignment of interests between private equity firms and their LPs partly explains why institutional investors have started making direct investments. Following the examples of BlackRock, Canada Pension Plan and Omers, many pension funds have realised that, if they are keen to protect their pensioners’ interest, they cannot allow PE fund managers to keep enriching themselves through a litany of fees. As with many other financial products before it, private equity has become a victim of the principal-agent problem.
Watch out for precedents
Because they know that the good times will not last forever, alternative fund managers are doing their best to attract external shareholders - including by switching from a partnership to a corporate (C-corp) structure - and offer their founders a way out, hopefully before the market topples over.
These newly-listed private capital firms are reminiscent of top-tier investment banks Bear Stearns, Lehman Brothers and Goldman Sachs, which floated in the 1990s before turning into aggressive dealmakers. The logic behind their IPOs was to avoid the fate of privately-owned and undercapitalised Drexel Burnham Lambert and Salomon Brothers, two institutions that went into distress in 1990 following trading scandals.
Eventually, the banks’ listings only served to shift risk exposure from internal managing partners to public backers. As a reminder, Bear Stearns and Lehman lost their shareholders’ money due to mismanagement during the subprime debt bubble.
With the economy experiencing its longest bull run in recent history, these facts are worth keeping in mind. When the tide turns, the overwhelming majority of alternative fund managers will be revealed as what they truly are: opportunistic salesmen. Incidentally, KKR was set up by Bear Stearns bankers; Blackstone by former Lehman partners; Apollo by Drexel alumni. Funny old world. Long-term investors should look elsewhere for sustainable value accretion.
About the Author
Sebastien Canderle is an adviser in private equity and the author of several books on the sector