In the Andy Kessler writes an obituary for private equity funds or, at least, for their “glory days”:
Private equity is done. Stick a fork in it. With Kraft singles and Heinz ketchup as toppings, there are many signs that private equity has peaked as an asset class.
Here’s his description of the sector:
When it comes down to it, private equity is pretty simple. You buy a company, putting up some cash and borrowing the rest, sometimes from banks but often via exotic instruments that Wall Street is happy to sell. Then you manage the company for cash flow, making sure you can make interest payments with enough left over for fees and investor dividends. With enough cash flow, you either take the company public or sell it to someone else. And how do you generate cash flow? You can expand the company, but more likely you slash costs, close divisions, cut staff, curtail marketing, eliminate research and development and more. In other words, cutting to the bone.
While that may be a fair characterization of some private equity funds does it apply to all of them? Here are his reasons for predicting the “decline of the asset class”:
- Interest rates are going up.
- Banks are less eager to lend for leveraged buyouts.
- Tax reform may make it less profitable.
- Private equity funds are bad for the economy.
- It’s already picked the low-hanging fruit.
I think there’s some reason to question his claims. For one thing private equity investment today as a proportion of GDP is substantially below its pre-recession level. Since interest rates have gone down even as private equity investment has decline it suggests that either a) the dynamics are somewhat different than he’s suggesting or b) the “glory days” of private equity ended some time ago. It may be that he’s predicting the past, a somewhat easier chore than predicting the future.
What is a highly leveraged buyout? Is 6:1 typical or is it at the margins? That would make quite a bit of difference in his analysis.
OK, I’ll bite.
Oddly, he may be correct about PE’s “glory days” (depending on what you mean by that) being past, but his observations are largely inane.
A back of napkin history first: Private Equity really means venture (early stage) and LBO’s (late stage) “Venture capital” was once solely the province of wealthy families. Think JH Whitney. And think early stage investment/start-ups. Circa the 40’s and 50’s really. Institutional capital invested by PE firms (think KKR, Clayton Dubilier, Bain) came later, as did a change in the investment profile. “Bootstraps,” mature companies using leverage to make returns (as opposed to profit growth) were in vogue. You might put $1 of equity in to an enterprise valuation. Do the math. You can make a tidy investment return with very little profit growth with that type of leverage. Then came, pretty much in the 80’s, the asset strips. Mr. Kessler is stuck in that model based on his comments. But that was a brief period and really a creature of the market for corporate control and poorly run old line industrials. Think Carl Ichan, bust ups, turnarounds, ESOP’s etc. But that is rare today; only a few dinosaur’s still live. Then came the “growth buyout” era, (from early to mid-1990’s on) which persists to this day. The model changed to making returns through a balance – stylized – as : 50% profit growth, 30% leverage and 20% multiple arbitrage, a portion of that being market timing, a portion size, and a portion a better company on exit. This model has a “ride the thoroughbred” wing, and a “polish up an untapped potential gem” wing. The former is kind of like finding Apple in the private market. The latter requires investment in people, facilities and equipment, proper strategies and marketplace/competitive assessment, and most importantly, management stewardship. Its very hands on. You might eliminate or scrap certain aspects of the business, but cutting to the bone is Kessler’s tormented and misinformed mind at work.
Observations.
Rising interest rates – PE has persisted through a number of rate cycles, and barring a Jimmy Carter-like environment will not be a dominating factor.
Banks less willing. Is Kessler nuts? Its a very profitable business for lenders who have few good rate spread opportunities these days. Just don’t let the non-leveraged lender crowd into the leveraged game. They don’t know what they are doing, apparently like Kessler.
Taxes; bad for the economy. – Both a change in deductibility of interest and carried interest rules would throttle down PE activity. Why someone would want to do that in a growth challenged economy is beyond me. Only if you were a petty person, or college professor, stuck in a “they are all just rich corporate raiders” mindset would you advocate a throttling of risk capital. Kind of like Dodd-Frank.
Which brings us to low hanging fruit and the glory days.
Its become a very, very competitive business. In large companies, just because of the population pool, there are fewer at bats. But in small to medium sized, there are plenty of opportunities. On the flip side, all those underfunded pensions sure do like that yield in “alternatives,” as opposed to over-priced public equities and vulnerable to rate hikes bonds. When did those glory days really exist? Probably 1986-1995. In best “Get Smart” mode, Kessler “missed it by that much.”
And lastly, what is highly leveraged? It varies, and it depends. Ultra-large company buyouts (see Blackstone) might have 8-9 times cash flow leverage. But those are really bond financings, with no amortization of principal and simple covenant packages. In the lions share of middle market deals, the cap structure might look like this: Enterprise Value: 7.5x financed by 2.5x equity and 5x debt. The debt would be whacked up 3.5x senior and 1.5x mezzanine. It varies by company size, sponsor, industry etc. But that’s a plain vanilla structure these days.
You read the code. I wanted to get your take on it.
I think this:
is about right and it’s also what I meant by predicting the past.
Also, if he’s talking about mega-buyouts (like the Kraft-Heinz “merger”), it’s sort of circular, isn’t it? How many $50 billion potential acquisitions are out there? Practically by definition we’re not going to see a lot of those because there just aren’t that many companies in that size range.
Yes, that’s correct. Those giant buyouts are a different world. Rare, different terms, and driven more by inflection points in grand strategy than being a business doctor and really laying your hands on the company.
To his original point, more damage has been done by Dodd-Frank than all the other factors Kessler might site, and he missed that one. For 70 years the industry did fine with Rule 144 and not SEC babysitting. People confuse giant hedge funds and their shenanigans, with the main stream buyout business and its characteristics.
Now, back to selling one of our businesses to an ultra-large corporate buyer and THEIR shenanigans. Where’s the regulators when you really need them? Probably off putting the coal industry out of business……….