The private equity party is overcrowded
An overheated market intoxicated by cheap credit serves as a warning to investors
by: John Gapper
There are few surer financial warnings than Stephen Schwarzman, co-founder of the private equity group Blackstone, throwing a big party. His 60th celebration a decade ago marked the pre-crisis peak for the industry, so the 70th birthday party he held last month in Palm Beach, Florida, featuring fireworks, camels, and a cake in the shape of a Chinese temple, is worrying.
Private equity entered a slump after his 2007 party, with the huge debt-financed deals struck at the peak looking stupid with hindsight. Ten years later, it is doing extremely well for itself. As hedge funds stumble and public stock markets are increasingly dominated by passive index funds, veterans such as Mr Schwarzman and Leon Black of Apollo are masters of their universe.
It is a safe bet that this will not last, since it never has before. The global industry gathers every year at a conference called SuperReturn, held in Berlin this week. The name is not always merited but this year’s resembles a crowded party that could erupt at any moment. Cocky financiers in expensive suits, intoxicated by cheap credit and high dividends? Run for the exits.
Even this was bearable until Mr Black took to the SuperReturn stage on Monday to declare that, although a correction was probably imminent, it could be postponed by Donald Trump’s pledge of a “revved up” US economy. That could unleash a further three years of “turbocharged” growth for leveraged buyouts backed by the $820bn of capital yet to be invested. Then I really got nervous.
Private equity’s problem is not that it is suffering but the opposite: it has recovered so fully that it is flush with money. As it sells the businesses it bought a few years ago, many at a high profit, and returns cash to the pension funds and institutions that invest through it, more is arriving.
This is a very good period to be selling assets but a hard one to find a bargain.
The industry should still have advantages even in these heady times. Compared with hedge funds, which also charge stiff fees to invest other people’s money, it has performed well.
Warren Buffett wrote harshly of hedge fund managers in his annual letter to Berkshire Hathaway investors, but has partnered with 3G, the Brazilian-led private equity firm.
The classic private equity deal is to borrow money to buy a medium-sized company that is in decent shape but has potential to grow or become more efficient. A fund often puts in new managers, allocating them a hefty incentive to improve the business — private equity chief executives get an average 8 per cent stake, according to one study. It then sells at a higher price five years later.
Having the luxury of privacy and time — not having to worry about quarterly results or investors demanding their money back — helps investments thrive.
The industry consistently outperformed the stock market up to 2006, one study found, and its long-term performance has recovered from a post-2008 dip. But no matter how much leverage and ambition it injects into a company, a private equity fund cannot easily compensate for overpaying. This is the pressing problem: one investor estimates that his fund must pay 15 or 20 per cent more to buy a company with stable earnings than it did two years ago.
Funds prefer to find companies and take time — sometimes years — to size them up and get to know their founders or executives. The new reality is often that, as one partner describes it: “You get a book sent by Goldman Sachs, one dinner with a camera-ready executive team, and then an auction.”
They are not only competing against each other. The most enthusiastic bidders are often companies in the same industry that can obtain cost savings by integrating a smaller rival.
Pension funds are also getting in on the act by co-investing with private equity funds, and sometimes investing directly.
The obvious response to an overheated market is to slow down, and even to take a break from investing until prices fall. In theory, this should be an advantage of private equity funds — they do not have to place funds immediately, and will not benefit their investors by rushing.
Most are pressing ahead anyway. They believe they have a unique formula that will keep their investments safe while others overpay. They do not say, although it is true, that they only get rewarded for action. They charge a 1.5 per cent management fee on their investments.
If you pay a lot, you need to get value somehow. The danger is that they start treating every company like a distressed asset to obtain a return, even if it was originally fine. They may be pushed into acting more like 3G, which one investor calls a “brutal” cost-cutter at companies including Kraft Heinz, where it eliminated 13,000 jobs.
The private equity industry should enjoy the party while it lasts. The fun could soon be over.
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