Private Equity

Updated April 2006
PDF April 2006 Journal

Another Public Fund Launched by a Private Equity Firm

In our July, 2005 issue, or see below, we made three observations. First, the work of different researchers led us to conclude that the expected returns from investing in private equity (also known as "leveraged buyout" funds), after manager fees, is about equal to that on the public equity market. Second, that average masks a critical point: the top quartile of funds did much better than the public equity market, while the bottom three quartiles did worse. And third, the decision to invest in a buyout fund therefore critically depends on an investor's confidence in his or her ability to identify superior managers.

We also made the point that, even for top quartile managers, the private equity business was becoming much more difficult. The challenges are well known:

• The wide availability of financial engineering skills and models, together with more demanding shareholders and much greater use of equity compensation by public companies have made it much harder to generate superior private equity returns simply by adding leverage and squeezing out excess costs. Lord Hanson would not find the current environment favorable to the game he once played with such gusto.
  
  
• Market timing (taking companies private when their sector is out of favor, then going public when it becomes popular again) has also become more difficult with the increasing number of hedge funds playing the same game.
  
  
• The ability to buy companies for much less than they are worth has become harder, given the increase in seller sophistication (e.g., more frequent use of auctions).
  
  
• Finally, there is a lot of money chasing deals today, interest rates are rising, and lenders are becoming more cautious.

We also noted that perhaps the best evidence for the increasing challenge of creating value in private equity was the change in the way that buyout funds were realizing the value of their investments. Traditionally this was done through either sales to industry buyers or initial public offerings. However, buyout funds today are increasingly using two other approaches to obtain cash to return to their investors. The first is sales to other buyout funds. If this raises some eyebrows (e.g., "what does the second buyout fund know that the first one didn't?"), the second approach should ring some alarm bells. This is the practice of releveraging a portfolio company to raised funds that are used to pay a special dividend to the buyout fund. As we noted then, the risk involved didn't disappear (and arguably, the higher leverage actually increased it). Rather, it was simply passed on to a different set of buyers (e.g., hedge funds, investors in high yield debt and the "equity" tranches of collateralized debt obligations, and buyers of credit default swaps).

In a recent series of articles, various writers from Financial Times have also had some rather negative things to say about private equity. On April 18^th, the LEX Column noted that "the proliferation of private equity funds, a result of their popularity, is inevitably compressing available returns, making scrutiny of fees even more vital. That these fee structures have not changed in spite of much bigger fund sizes raises a further concern. Managers have a big incentive to outperform [to earn 20% of the profits] when they are charging 2% on a $500 million fund -- less so, perhaps, when they are already taking an annual cut of $200 million on a $10 billion fund. That is at odds with the philosophy of an industry which trumpets [the benefits of] alignment of interests" [between managers and investors]. On April 24^th, John Plender titled his column "The Privileged Existence of Private Equity Funds" and noted "be warned -- it's too good to last." He noted that "the question for [institutional investors] when confronted with a [private] company returning [to the public equity market] is whether the disciplines [of ownership by a private equity fund] have left the company in genuinely better shape, or whether the business has been run for cash at the expense of investment and long-term prospects." He closed with this point: "the paradox of private equity is that it imposes immense discipline on managers of companies, while the discipline on managers of private equity funds is more nebulous. Performance measurement data are suspect, transparency is poor, and the media trumpet successful deals while the dogs go mainly unreported. This encourages the extreme cyclicality of the industry, here money pours in a the top, and panics out at the bottom."

It is in this light that we must evaluate the recent launch by KKR (Kohlberg Kravis Roberts), perhaps the world's most famous LBO firm, of a U.S. $5 billion public offering on the Amsterdam stock exchange of KKR Private Equity Investors L.P. The new LP will invest in deals originated by KKR; the implied promise is that it will deliver exceptional returns. The fact that the deal's original goal was to raise $1.5 billion suggests that there are plenty of investors who agree with this story. Whether they are right will only be known in hindsight.  However, there is a precedent for them to keep in mind. In 2004, another well-known buyout group, Apollo Investors, launched a similar parallel public fund (Apollo Investment Corp, ticker AINV). Its focus was on mid and small cap sized deals, and it now has a market cap of just over $1 billion. When it was launched, we had our doubts about whether it would deliver the exceptional returns investors seemed to expect. After two years, we are right about that; has outperformed the large cap S&P 500, but basically just equaled the performance of a small cap index fund (e.g., NAESX).

However, this example must have been well-known to many of the investors in the KKR LP. This suggests that at least part of their enthusiasm for the KKR offering (apart from the firm's reputation) was driven by a belief that the main future source of high private equity returns lies in taking private much bigger companies than have ever been targeted before, and, to a lesser extent, undertaking these transactions in a wider variety of countries. They may have thought that investing in KKR gave them access to one of the relatively few large funds that will be able to pursue this value creation strategy the future. While this argument seems logical, we have our doubts; we know few large companies that have not, under the pressure of intense global competition, become much more efficient in recent years. Indeed, the recent comments by the FT's John Dizard on the LBO market summarize the argument against investing in public funds sponsored by private equity firms: "it's not as though the original analytics that drove the LBO business from the last 1970s to the early 1990s didn't make sense. It's just that everyone has read the plan by now...[and] most corporations have learnt something about how to manage their business.... After the [restructuring] pain of the past few years, [easy LBO] opportunities no longer exist", and those that do have been made much less attractive in an era of rising interest rates.

Update July , 2005

Most of us have all had a similar experience. Maybe it was back in the 80s, when leveraged buyout funds first made their appearance. Maybe it was back in the 90s, when everyone wanted a piece of the venture capital action. Or maybe it was at a party last weekend, when cousin Charlie was waxing eloquent about how he's in “private equity” today. “And why aren't you?” he's bound to ask. If you've been wondering how to reply to that question, this article is for you.

Let's start with some basic definitions. At the highest level, both a “private equity” fund is usually a privately organized pool of capital run by a professional investment manager. At last count, there 3,000 private equity funds, managing about $700 billion in assets. Of this amount, about $490 billion was invested in “buyout funds”, and $210 billion in “venture capital” funds.

One of the most important features of these funds is that they are not cheap to own. In order to attract the best active managers, a typical private equity fund charges investors an annual fee equal to two percent of assets, and pays twenty percent of all returns (above a certain amount) to the fund manager. In order to justify these fees, hedge and private equity funds often make two promises to their investors. First, that their returns will be high, and second that they will have a low correlation to the returns on other asset classes. Let's begin by taking a closer look at how these funds theoretically generate the high returns they promise.

We'll begin by noting that since private equity funds are actively managed products, their superior returns ultimately must be grounded in the ability of a skilled manager to make a superior forecast, in comparison to his or her competitors. In turn, these forecasts must be based on some combination of superior information and/or a superior model for making sense of the public and private information available to the fund manager.

Broadly speaking, there are two types of private equity funds. Venture capital funds invest in small companies during the early stages of their growth. Buyout funds invest in companies that are larger and have longer track records. Let's look more closely at these two return generating processes.

In their earliest stages, new companies typically obtain their financing from “F, F+F” - founders, families and friends. Venture capital funds only get involved when a company has progressed beyond this stage. Their investments are typically in the form of some type of equity (e.g., convertible preferred shares), and the companies they finance typically do not use much debt. Within our active management framework, venture capital managers hope to earn superior returns through a combination of superior information or a superior model. The former can involve superior insights into the future market for a technology, other investors' future view of companies operating in certain areas, and/or superior access to potential investments (e.g., due to a superior network or a superior brand image in the venture community). A superior model can include the venture capital firm's approach to adding value to an company in which it has invested (e.g., by helping to put together a superior management team, or bringing to bare a superior ability to manage rapid growth) or its superior ability to generate value from all the companies in its portfolio (e.g., by finding ways for them to work together). Venture capital funds realize the value of their investments through two means: by selling them to other companies (“trade sales”) and by selling them to the public (“initial public offerings”). The pricing on these sales obviously depends on prevailing equity market conditions; hence the correlation between venture capital and public equity market returns should theoretically be quite high.

The return generating process for a buyout fund has some similarities with venture capital, but also some important differences. Buyout funds typically invest in three types of deals: divisions being sold by another company; privately owned companies whose owners are cashing out, and public companies that are going private (i.e., where the buyout fund purchases all the target company's publicly traded shares, and de-lists it from a securities exchange). Ideally, buyout fund managers generate value for their investors through proprietary access to potential deals. However, an increasing number of deals are being sold to buyout companies via competitive auctions, so as to maximize the value realized by the seller. This has led many buyout funds to either shift their focus to markets in which they can still generate proprietary deal flow (e.g., Europe and Asia), and toward increased industry specialization, which may also yield reduced competition for deals.

Given this, the theoretical source of buyout funds' superior returns must be either other forms of superior insight and/or superior models. The former can include superior insight into future equity market trends and/or investors' preferences for companies in different sectors, or a superior model for improving an acquired company's business. The nature of the latter has been the subject of much discussion over the years. In the 1980s (when this writer was doing buyouts), the superior model was essentially based on three insights. First, many public companies were run inefficiently, with substantial room to increase cash flow by cutting costs and selling non-core assets. Second, the resulting increase in operating cash flow could be used to add more leverage to the company's balance sheet that had been used in the past, which would magnify the return on its equity. And third, too many managers lacked a sufficient equity stake in their own company.

Today, the buyout business has fundamentally changed, and theoretically become more difficult. The twin pressure of global competition and demanding shareholders have forced many public companies to become much more efficient, and much less reluctant to add leverage to their balance sheets. In addition, most senior managers today are eligible for substantial amounts of incentive linked pay. This has forced buyout funds to identify new ways of improving the operations of the companies they acquire. This logically leads to the question of what obstacles prevented these steps from being taken before these companies were acquired by the buyout fund. To be sure, there are reasonable answers to this question. In some cases, an acquired non-core division of a public company lacked access to the corporate funds needed to execute its strategy. In other cases, a family owned company might have been reluctant to take the risk associated with a more aggressive strategy. The same might have been true of the management of a public company with respect to adoption of a strategy that would have put quarterly earnings targets at risk. Or perhaps being privately owned, with clear demanding leadership from the top, improves overall execution of an already promising strategy. Whatever the logic, one thing seems clear: value creation by buyout funds is more difficult today than it was in the past.

Perhaps the best evidence for this is the change in the way that buyout funds realize the value of their investments. Traditionally this was done through either trade sales or initial public offerings, both of which generated a high correlation with returns on the domestic equity market. Today, however, buyout funds use two additional approaches to obtain cash to return to their investors. The first is sales to other buyout funds. If this raises some eyebrows (e.g., “what does the second buyout fund know that the first one didn't?”), the second approach should ring some alarm bells. This is the practice of releveraging a portfolio company to raised funds that are used to pay a special dividend to the buyout fund.

The obvious question is who is lending the money for these “leveraged recapitalizations?” The answer lies in the way the fundamental operation of debt markets has changed in recent years. In the old days (and you don't know how much it pains me to write that), buyouts were often financed with a combination of bank loans and what were then known as “junk” bonds. These are the same below-investment grade bonds that have since gone upmarket, and are now known as “high yield debt.” In those days, bank loans tended to stay on bank balance sheets. One bank would arrange the loan, and syndicate pieces of it out to other banks, which would share in some of the arrangement fees. The junk bonds would also tend to stay in one place, though for a price some investment banks (e.g., Drexel) make secondary markets in them. Since these credits staid in one place, the people who approved them tended to be a bit more careful with their credit analysis, and reluctant to see deals “leveraged to the moon.” Because we all knew who would end up holding the hot potato if the economy headed south.

Today, nobody is quite sure who is holding that potato. Banks now view “leveraged loans” (i.e., loans to highly indebted companies) as a trading asset. They underwrite them, and then sell them to a variety of new entities that have arrived on the scene. The first is mutual funds that invest in loans. The second is sometimes hedge funds and other institutional loan investors. But the third is the most interesting. These are the special purpose vehicles that use the same basic structure popularized two decades ago in the mortgage market by Salomon's Lou Ranieri. These vehicles buy loans, and then issue different classes of security based on the loan cash flows. These securities are known as “collateralized debt obligations”. Each CDO class has a different risk/return profile. The most senior security might carry a AAA rating. The next class might be subordinated, and carry a below-investment grade rating. And at the bottom there is a so-called “equity tranche” that earns high returns if everything goes right, and gets very badly hurt if things go wrong. In many deals, there is a parallel structure with respect to the bonds issued by the company owned by the buyout fund. When you think it through, the key to these leveraged recapitalizations is the buyer of the CDO equity tranche. Who are they? Who would take this kind of a risk? If you guessed hedge funds, the betting line is that you are right on target. Now why might they so like CDO equity tranche deals?

As we've already mentioned with respect to catastrophe bonds, these deals offer very high returns as long as everything goes right. That's undoubtedly reason number one. But reason number two is probably due to another interesting development: the birth and rapid growth of a derivative market for trading credit risk. Credit default swaps (and options on them) theoretically enable the owner of a CDO equity tranche to manage his or her fund's exposure to the underlying credit risk by purchasing insurance in what is assumed to be a liquid derivative market. So far, so good. Except for one nagging question: who is on the other side of those credit derivative trades? Some people say it's mostly hedge funds. Others say a lot of banks are involved too. One thing is for sure: the credit risk didn't disappear. A lot of people also wonder about how much leverage is being used by those institutions who are holding it, either in the form of CDO equity tranches they have bought or credit derivative contracts they have sold. But the most interesting part is that nobody really knows the answer to these questions. So while few doubt that a lot of heavily leveraged companies that have been “recapitalized” by buyout funds will eventually run into problems, the really interesting question is the nature of the overall impact on the system that will be triggered when they do.

Some very smart people are worried about this. For example, in their recent paper “Systematic Risk and Hedge Funds,” Chan, Getmansky, Haas and Lo conclude that “the hedge fund industry may be heading into a challenging period of lower expected returns, and that systematic risk is currently on the rise.” Similarly, in its March, 2005 Quarterly Review (“Time Varying Risk Exposures and Leverage in Hedge Funds”), the Bank for International Settlements concluded that “painting a comprehensive picture of the hedge fund industry is virtually impossible given the data available.” It also found that “hedge funds that reportedly belong to different style families, and thus presumably follow different investment strategies, have at least some commonality in their risk exposures.” Moreover, “to the extent that hedge funds engage in investments that have payoffs that resemble derivative instruments, their returns will be non-linearly related to the returns on the underlying market risk factors.”

Let's now move on to another point that is too often overlooked in the excitement over the prospective returns from investing in private equity (which remind us of Charles Revson's comment about the cosmetics business: “we're selling hope.”). Most studies show that in the world of buyout, and venture capital funds, the difference between top and bottom quartile managers' returns is quite large. This is taken as evidence of “inefficiency,” or substantial differences in managers' skill and access to information. However, even in inefficient markets, alpha is still a zero sum game. This is an important point that investors too often overlook. Mathematically, there is a weighted-average return from investing in the universe of all hedge, buyout, or venture capital funds, that is ultimately related to the amount of systematic (i.e., beta) risk they bear. In any year, some funds will deliver returns above this average (generating positive alpha) while others will deliver returns below it (negative alpha).

Investors in buyout and venture capital funds face the same challenges as investors in actively managed mutual funds: How to identify truly skilled investment managers? And how to be sure that these managers will not capture (via fees and expenses) all the alpha they create? As you know, this implies a successful forecast on the part of the investor choosing from multiple buyout and venture capital fund managers. And any manager selection forecasting skill necessarily depends on the investor having either superior information and/or a superior model. Paying an investment consultant (or, alternatively, a “fund of fund” manager, which makes sub-investments in a number of hedge, buyout, or venture capital funds) to make this choice only changes the nature of the forecasting problem (while making it more expensive for the investor). However, the forecasting problem does not go away.

If there is any good news, it is that in the world of private equity funds, (and unlike the world of mutual funds), past performance may be a useful guide to future results. In their paper, “Private Equity Performance: Returns, Persistence, and Capital Flows”, Kaplan and Schoar found that managers of previously successful funds were more likely to raise follow-on funds, and to earn above average returns. They hypothesize that this is due to proprietary deal flow and differentiated fund manager skill. They also found that new funds started during cyclical booms were the ones most likely to earn low returns (probably because booms attract marginal or unskilled managers into the hedge and private equity funds business).

To answer the second question - the probability of earning risk adjusted returns (after those hefty manager fees) greater than those available in publicly traded asset classes - we must turn to the thorny question of how to measure private equity fund performance.

The first issue is the level at which the analysis is being done. Conceptually, this can occur at the level of portfolio companies, the individual funds, or the aggregated results for all hedge, buyout, or venture capital funds. Each level of analysis produces its own insights. For example, in his paper “The Reality of IPO Backed Performance”, Yochanan Shachmurove analyzed the returns realized on 2,895 venture-backed public companies between 1968 and 1998. This sample is itself somewhat skewed, because perhaps only 20% of the companies in which venture funds invest ever make it to the public markets. The following table shows average and median nominal returns, as well as return breakpoints and standard deviations for both companies that were still trading in 1998, and those that were inactive (due to bankruptcy or having been acquired).

As Shachmurove notes, “while the media focused on a few big IPO success stories, rather than being typical they were highly unusual in the historical context.” Others have noted that venture capital funds in essence invest in a portfolio of options, since most of their investments fail, while a few deliver sometimes spectacular returns.

The aggregate indexes for private equity fund performance all suffer from substantial shortcomings. The first is the so-called “self-selection bias.” This refers to the fact that funds report their returns voluntarily. Logically, this probably biases the results towards the more successful funds.

The second problem is known as the “backfill bias.” This refers to the fact that when a fund joins an index, it provides a year or two of previous returns. Research has shown that subsequent results are almost always lower. Hence, if backfilled data are included, index average returns will be biased upwards.

The third problem is the “survivorship bias.” This refers to a situation in which funds that merge, close, or stop reporting have their results dropped from the index. Again, this biases returns upward, and risk downward.

The fourth problem is the “stale pricing bias.” When the reported price of an infrequently traded security is determined not by a market transaction, but rather by an appraisal (often by the fund manager), a number of distortions typically result. First, the returns on the security (and of the fund itself) display a higher correlation over time than is the case with most publicly traded securities. Second, this causes reported standard deviations to appear artificially low. It also artificially depresses the reported correlation of return with other asset classes. (For more information on these biases, see “Do Hedge Funds Hedge?” by Asness, Krail, and Liew, and “Asset Allocation Effects of Adjusting Alternative Assets for Stale Pricing” by Andrew Connor).

Many analyses of private equity fund returns have tried to adjust for the aforementioned data problems, to produce a clear picture of the performance of buyout and venture capital funds. Kaplan and Schoar found that between 1980 and 2001, the adjusted return and risk on buyout funds (after manager fees) was essentially equal to that on the public equity market. Their index of venture funds returns delivered about 3.5% more than the public equity market, with about 14% more standard deviation.

Susan Woodward of Sand Hill Econometrics has done a similar analysis, and published her findings in “Measuring Risk and Performance of Private Equity.” She also finds that buyout returns are about as risky as the public equity market, and are also highly correlated with it. In contrast, venture capital was about twice as risky as the public equity market, but its returns were also highly correlated with it, just as theory would suggest. Regarding those returns, the Venture Economics database shows that, over the 20 years ending in December 2004, aggregate venture capital fund investments outperformed the S&P 500 by only 4.0% per year.

This raises an obvious question: Can you invest in a private equity index product? Unfortunately, today you cannot. Most buyout and venture capital funds are organized as limited partnerships, with the investment manager as the general partner. These LP investments are generally only available to “qualified” investors”, who can produce evidence of a minimum level of income or net worth. In addition, the minimum investment in a hedge or private equity partnership has traditionally been quite large. However, in recent years these have been falling. For example, some partnerships now accept minimum investments of $25,000. Even smaller minimums are often available if the investment advisors, who combine different people's contributions to reach the LP's minimum investment.

In addition, a few private equity funds have been organized as either publicly traded closed end funds (e.g., Apollo Investments or Ares Capital in the United States), or individual companies (Onex in Canada, 3i in the U.K., or RHJ International on the Euronext in Brussels).

Finally, in the United States, Standard and Poor's is launching a new private equity index. It is not a great stretch to imagine that we could soon see either a mutual fund or exchange traded fund that tracks it.

However, this still leaves us with the question of whether it makes sense to invest in buyout and/or venture capital funds. When it comes to buyout funds, we think that the answer should be “no.” Absent superior skill in forecasting future buyout manager performance, an investor on average is likely to only earn a risk adjusted rate of return comparable to public market equity. More importantly, given the large difference between the returns on top buyout funds versus all the others, an unskilled investor is likely to do worse than he or she would have with an equity index fund.

Venture capital does not present an equally clear answer. Given the high correlation of venture capital returns with public equity markets, its logical role in a portfolio seems to be that of a return enhancer, rather than a risk reducer. This suggests that it would only be appropriate in portfolios with a high real rate of return target. Moreover, given the large spread between the annual returns earned by top quartile versus bottom quartile venture capital funds (Kaplan and Schoar estimate this gap at 20% over the 1980 - 2001 period), and absent an investable index product, potential venture capital investors face the problem of identifying a skilled fund manager. If you have no confidence you can do this, probability suggests you will be better off not investing in venture capital, at least until an index product comes along.

Excerpt from The Index Investor Guide to Asset Allocation (2003)

As the name implies, this asset class encompasses investments in the equity of companies that are not publicly traded. These investments are usually made through a professionally managed fund, which serves as the intermediary for searching out, evaluating, and monitoring the private equity investments. In general, there are two sub-classes of private equity: venture capital funds and buyout funds. The former tend to make a large number of small investments (relative to the size of the fund) in a large number of companies that are in the early stages of development, and with prospects for high future growth. In contrast, buyout funds typically leverage investors' money with debt, and make a small number of large investments. The classical buyout situation is a fund, in combination with an existing management team, purchasing ("taking private") a division or subsidiary of a public company.