Some PE myths busted

Fascinating article by Daniel Rasmussen that tests some of the claims made about the superior nature of private equity (PE) investments.

PE firms claim that their investments "accelerate growth and more efficient operations due to superior capital structure and PE managers ability to make long-term investment decisions that public companies cannot make". On this, an examination of 390 deals in the US, accounting for over $700 bn in enterprise value representing the majority of the largest deals ever done, for the financials of the portfolio companies reveals,

In 54 percent of the transactions we examined, revenue growth slowed. In 45 percent, margins contracted. And in 55 percent, capex spending as a percentage of sales declined. Most private equity firms are cutting long-term investments, not increasing them, resulting in slower growth, not faster growth... In 70 percent of cases, PE firms are leveraging up the businesses they buy. PE firms typically double the amount of debt on the balance sheet, from 2.5x ebitda to 5x ebitda—the biggest financial change apparent from our study... As an industry, PE firms take control of businesses to increase debt and redirect spending from capital expenditures and other forms of investment toward paying down that debt. As a result, or in tandem, the growth of the business slows. That is a simple, structural change, not a grand shift in strategy or a change that really requires any expertise in management.

The addiction to debt is the Achilles Heel of PE,

There is a big difference—bigger than most realize—between what private equity used to do (buy companies at 6–8x ebitda with a reasonable 3–4x ebitda of debt) and what private equity does today (buy companies at 10–11x ebitda with a dangerous 6–7x unadjusted ebitda of debt). Debt is a double-edged sword. It can provide great benefits if used judiciously, but if regularly applied in large dollops, it can create massive problems... The real reason PE firms want control of the companies they buy is not because of superior strategic insight but because they want to significantly increase debt levels. And while debt magnifies positive returns and enhances the returns of good decision-making, it can also cut the other way, exacerbating negative returns and punishing bad decisions.

 On returns,

From 1990 to 2010, private equity returned 14.4 percent per year, compared to 8.1 percent per year for the S&P 500 index. This 6.3 percent outperformance was net of private equity’s “2 and 20” fee structure, meaning that the gross return of private equity over this period was more like 20 percent per year... since 2010, private equity has, on average, underperformed the public equity market. Cambridge Associates’ U.S. private equity index has lagged the Russell 2000 by 1 percent and the S&P 500 by 1.5 percent per year over the past five years...

The Canadian Pension Plan Investment Board (CPPIB) and the Abu Dhabi Investment Authority (ADIA) did a bottom-up analysis of 3,492 private equity transactions from 1993 to 2014 to understand these dynamics. They found that private equity deals are different on two key quantitative dimensions from public equity investments. First, PE firms buy companies that are significantly smaller than broader public benchmarks. The median market capitalization of a company in the S&P 500 is $41 billion. The median market capitalization of a small-cap company in the Russell 2000 is $2 billion. But the median enterprise value of PE deals is only $250 million. Only about fifteen private equity investments have ever been larger than the maximum market capitalization of the small-cap index. Second, PE deals are significantly more levered than the typical public equity. The CPPIB and ADIA found that the average ratio of net debt to enterprise value at inception has been approximately 65 percent. The typical Russell 2000 small-cap company is levered at about 16 percent while the median large-cap company in the S&P 500 is levered at about 18 percent.

These two factors have been basically constant since the early 1980s. Changes in deal size and deal leverage levels do not explain why performance relative to public equity markets dropped off after 2010. And differences in size and leverage explain only about 50 percent of private equity’s historical outperformance of public equity markets. The factor that has changed is valuation. Private equity firms have historically bought companies at much lower valuations than the broader public markets. Here we see a significant shift from before the financial crisis to after. Since the crisis, the flood of money into private equity has driven up purchase prices significantly, eliminating the formerly large gap between private and public market valuations... 

Private equity is price sensitive because of the use of debt. Higher prices require more debt, leading to higher interest costs and higher risk of bankruptcy... The first approach is to look at PE deals and compare returns to purchase price. One PE firm did just such an analysis and found that over 50 percent of deals done at valuations of more than 10x ebitda lost money and that the aggregate multiple of money was barely over 1.0x (i.e., for every dollar invested, only slightly more than one dollar was returned to investors). The second is to compare the average purchase multiple in a given year to the returns of the funds from that vintage year. There is a –69 percent correlation between purchase price and vintage year return, a strong inverse relationship... The third is to look at PE-backed companies that IPO. My firm, Verdad, looked at every company taken public in the United States and Canada by a top-100 PE firm since the financial crisis, a data set of 195 IPOs with an aggregate ebitda of $66 billion and an aggregate market capitalization of $728 billion... According to our research, the cheaper IPOs dramatically outperformed the Russell 2000, the moderately priced IPOs matched the Russell 2000’s return, and the expensive IPOs underperformed.

In the context of the criticism of short-termism associated with public equity markets and the resultant long-term flexibility that private equity provides, this punchline is delightful,

And it is of course ironic that the same PE firms making these arguments—Blackstone, KKR, Apollo—have themselves gone public.