Private equity’s reputation has taken a hit, but as with any other investment, the best time to buy is when there is blood on the street. Right now, the streets are pretty bloody.
We have seen a dramatic reversal of fortune for the buyout experts since the credit crunch began in 2007. Financing for their leveraged buyouts has dried up, and their reputations were damaged after they attempted to back out of numerous deals in 2008. One need look no further than the stock price fluctuations of The Blackstone Group (a leader in the private equity industry), from its IPO issuance in June 2007 to its subsequent drop of more than 80 percent, to see how the outlook has changed for private equity.
More than a few privately held companies are likely to default in 2009, wiping out their owners’ equity. Before the credit crunch, private equity funds often had a portfolio company or two fail, but other investments performed so well that the fund’s overall performance was satisfactory, even after fees. We have already seen a number of high-profile defaults of privately held companies, such as Linens ’n Things and Mervyns. With the bonds of so many privately held, highly indebted companies trading for less than 50 cents on the dollar, investors should not be surprised by a wave of additional defaults.
But that’s not to prophesy doom and gloom for anything with the words “private equity” attached to it. There is a major difference between private equity investments made now, and private equity investments made at the peak of the market. That difference is valuation. At the peak, companies were being purchased at high multiples of their earnings, which were made while the economy was expanding and business was good. Now companies are being sold using lower multiples, which are applied to depressed earnings, a double whammy for any potential sellers. There was a financing bubble in the private equity universe (nine of the largest 10 leveraged buyouts of all time were signed in the 18 months leading up to the credit crunch), but that bubble has popped. Opportunities abound these days; unfortunately, it is more difficult for investors and private equity managers to pull the trigger. It is estimated that U.S. private equity fundraising for 2009 will be limited to about $100 billion of equity capital. From 2004 to 2008 the private equity industry raised $1.6 trillion of equity, including an estimated $265 billion last year alone.
Investors clearly are running scared. While privately held companies do not have stock prices that fluctuate from moment to moment as do public companies, investors are still seeing their private investments marked down, often with losses similar to those of their public equity investments. Whether a company is public or private, valuation principles are the same. Cash flow matters. Earnings growth matters. And an abrupt decrease in these can result in a company’s value declining dramatically. Based on this logic, if you are comfortable continuing to invest new funds in the stock market, you should also be comfortable investing new funds in private equity.
History has shown that the best opportunities to make stock investments are when times are lousy. Investors sell their stocks because they fear that recovery may never come. And just when all seems lost … that’s the best time to buy. While there isn’t as much historical data for private equity as there is for public equity, the data that are available show the same thing. A private equity index based on data compiled from 737 U.S private equity funds provided more than 25 percent returns in each of the two years that followed both of the recessions ending in 1991 and 2001. Since private equity investing typically focuses on companies that generate large cash flows, and these companies also were being acquired at beaten-down prices, it should be no surprise that private equity does well when times are tough.
At Palisades Hudson Asset Management, we build highly diversified portfolios for our clients, since diversification reduces risk and increases returns over the long term. With private equity, we believe in diversifying not only by using multiple private equity managers (each holding multiple private companies), but also by “vintage,” spreading out investments over time. Private equity investments made at the same time have shown a fairly high correlation, on average. This is because the change in a company’s value is tied not only to microeconomic factors such as supply and demand for its product or service, but also to macroeconomic factors such as the state of the overall economy and the availability of credit. You see the same thing with public companies: On average, a rising tide tends to lift all boats. By diversifying across vintages, our clients stand to benefit. Palisades Hudson has been investing in private equity on its clients’ behalf since 2000, and we will continue to do so in the future with the expectation that some vintages will do better than others.
At Palisades Hudson, we also confirm that our private equity managers seek to add value to their portfolio companies by improving the way the companies are run, and not simply by employing “financial engineering.” Many private equity managers were able to make a quick buck by loading up their portfolio companies with debt and paying themselves immediate dividends. While this helped generate some return on their investments quickly, they were left holding companies with much greater debt burdens, but virtually the same management and business strategies as before. These strategies do nothing to generate economic value. In 2009 and beyond, these unfortunate companies are most likely to default, wiping out shareholder equity. Going forward, it is unlikely that you will see many buyouts based simply on financial engineering. Lenders are not as willing to lend, and while many of the major buyouts from 2006 and 2007 were accomplished with equity contributions of 25 percent or less, the average equity contribution increased to almost 40 percent in 2008. Private equity managers will have to roll up their sleeves and actually dig into their companies’ businesses and processes to add value. And lenders will demand viable plans from the managers, showing how they will be able to service their increased debt burdens.
In the future, typical private equity acquisitions will be smaller and will employ less borrowing. Debt magnifies returns. Reduced debt will lead to reduced volatility and returns for private equity investments. However, we still expect private equity to outpace public stocks over the long term. Jonathan Bergman’s article “The Growing Benefits Of Private Ownership” in the January 2007 issue of Sentinel discusses the reasons private investments have outperformed, including a focus on cash-flow growth and superior pay-for-performance compensation for executives. In addition, freedom from government regulations such as Sarbanes-Oxley that affect public companies and the ability to avoid a myopic focus on quarterly earnings allow management to spend more time improving their businesses.
While the news for private equity investments made at the peak is not likely to be encouraging, this is not the end of private equity. Rather, the credit crunch will force private equity managers to resume their disciplined ways of the past. This is a return to sanity, and a return to fiscal responsibility that was overdue. The outlook for future private equity investments is still bright, and private equity still deserves a place in the disciplined investor’s long-term asset allocation.