Sunday, November 4, 2012

PE Having a Hard Time Defending Itself?

Kevin Roose of the NYT reports, Private Equity Industry Having a Hard Time Defending Itself:
It's rare to catch a private equity industry lobbyist off-guard. I've met with these guys, and they come bearing massive, Trapper Keeper–sized folders stuffed with charts, bullet points, and news clippings, all touting the merits of the buyout business and its job-creating goodness.

So it's weird that, when a Republican congressman asked a group of private equity lobbyists and industry executives a very basic question about one of the more problematic political elements of their business — namely, the favorable tax treatment given to private equity and hedge fund managers, who are allowed to treat the bulk of their fees as capital gains rather than ordinary income — the question proved to be a stumper.

According to the WSJ:
The meeting was led by Ken Spain, a vice president at the industry association who once worked for the House Republicans' campaign arm where he helped elect Mr. Gowdy, among others.

Mr. Gowdy focused on the primary political problem facing the industry. "When someone stands up at a town hall and asks why private-equity managers are paying a lower tax than them, what do I say?" he asked.

The private-equity executives didn't have a succinct response.

It could be that private equity professionals have a hard time defending the carried-interest loophole because, as industry heavyweights like CalPERS CIO Joe Dear and venture capitalist Marc Andreessen have said, it's basically indefensible. (Essentially, if you want to avoid admitting that it's a gift given through the tax code to wealthy buy-side managers that politicians are afraid to rescind for fear of losing campaign contributions, you have to mumble some stuff about incentivizing investment and putting personal capital at risk and then change the subject quickly.)

But maybe they just got tongue-tied. I e-mailed Ken Spain, the private equity lobby vice-president who ran the ill-fated meeting and asked him if, given a mulligan, he could provide a succinct answer to the carried-interest question. He e-mailed back:
"The message that was relayed to the congressman is the same easy answer that continues to resonate with policymakers on Capitol Hill — dramatically increasing taxes on capital investment such as private equity, venture capital, and real estate, is not going to turn the economy around."

There we go! Much better!
I happen to agree with Joe Dear and Marc Andreesen, the carried-interest loophole is indefensible. Also, lumping hedge funds and private equity with small businesses and allowing these funds to deduct interest on debt makes a farce of the US tax code (watch below).

But leaving that aside, are there reasons to invest in private equity? Michael Nairne, president of Tacita Capital, a private family office and investment-counselling firm in Toronto, recently published an article in the National Post, Private-equity investment has serious merits:
The hard economic reality of the new millennium has pummelled many growth oriented investors. Investors in U.S. stocks, on the receiving end of a “one-two-three punch” from the tech wreck, soaring loonie and global credit crisis, are still in the red. International stocks have struggled and, while Canadian equities have delivered so-so positive returns, you can’t build wealth running on one cylinder.

In contrast, private-equity funds that focus on buying out or providing financing to individual companies, typically privately owned, have achieved stellar returns. The Canadian Venture Capital & Private Equity Association reported that independent private-equity buyout and mezzanine financing funds in Canada returned 16.4% annually for the 10 years ended Dec. 31, 2011. The longer-term numbers in the United States are equally alluring.

A recent study covering the 25 years ended 2008 found that buyout funds achieved a 15.7% annual return, far outpacing stocks. Venture-capital funds that invest in business startups and early-stage growth companies clocked in with a remarkable 19.3% return. It’s no wonder that many wealthy families are looking to hitch their investment wagon to this star.

Private-equity investment has serious merits. It allows ownership participation in a portfolio of growing, private companies without the concentration risk of a single business. It can generate attractive returns while its long-term orientation removes concerns about short-term market swings. Investors can diversify broadly or target particular industries or geographies. It is a “hands-off” investment — the burden of execution falls on the fund managers and the portfolio company executives.

However, investors should always look before they leap since private equity comes with drawbacks. First, it is illiquid. It’s a lot easier to get in than out. Many endowments and pension funds found this out the hard way when they needed to raise cash in the depths of the global credit crisis.

Then there is the “J curve.” In the early years of a fund, the private-equity managers are busy evaluating and structuring acquisitions while investors are writing cheques to satisfy their original investment commitment. It’s a one-way street with cash going out the door. At the same time, the initial fees and expenses of the fund as well as early writeoffs of underperforming acquisitions can result in negative returns. The positive gains and cash flow occur much further down the line as the portfolio of companies matures and is sold or taken public. This pattern of early losses and later gains is shaped like a “J” and hence, its name.
In fact, the typical life of a private-equity fund runs in the order of 10 years. Many private investors accustomed to the liquidity of publicly traded markets find this disconcerting. Like time spent in a bad marriage, it can be chronically painful if a fund isn’t doing well.

Private-equity performance is also cyclical. A recent study found that returns over the past 29 years were much higher for funds started after a recession compared to those started later. Moreover, the trend in returns overall has been downward. Venture capital in particular has struggled over the past decade, registering only a 3.3% annual return, according to the Cambridge Associates LLC U.S. Venture Capital Index.

There is good and bad news about private-equity manager performance. Unlike the realm of publicly traded stocks where there is little evidence of persistence in manager outperformance, some private-equity managers possess unique skills, networks and experience and have been able to deliver excess returns with some consistency. However, access to these star managers is typically restricted.

Also, an investor faces real risk in manager selection. There is considerably more dispersion in the returns achieved by private-equity managers than is the case for investment managers of stocks and bonds. The wrong choice or just plain bad luck can result in abysmal returns, and high minimum investment amounts aggravate this risk. One of the appeals of a fund of private-equity funds is the mediation of this risk through diversification.

Wealthy investors should definitely consider this asset class. But they need to fully understand its “perks and quirks” before pulling out a chequebook.

The Private Equity Growth Capital Council released new infographic highlighting how over 10 years a $1 investment by pension funds in private equity yields a return of $2.30, easily outstripping gains from stocks, bonds and real estate. Take all this industry fluff with a shaker of salt (next ten years will be nothing like past ten years).

I have written many comments on private equity, warning investors to temper their enthusiasm for this illiquid asset class. Just like hedge funds, where most masters are failing the money-making test, there is a changing of the old private equity guard, and some are adapting a lot better than others. The dispersion of returns is considerably higher in PE and hedge funds relative to stocks and bonds.

Top university endowments, which were the first movers into private equity and hedge funds, are facing a hard landing, reassessing their investments in alternatives. Harvard, Princeton and others have scaled back and readjusted their private equity allocations. Harvard is now betting big on farmland and timberland.

Moreover, the environment is changing for private equity funds and many are not adapting properly. Instead of focusing on carve-outs, many private equity funds are feeling the pressure of low returns and are back at their old game of loading companies up with debt, eying dividend recapitalisations.

Does private equity make sense for pension funds? You bet it does but the approach is crucial. Large Canadian pension funds are going direct and co-investing along with top private equity funds. These pension funds use their size, expertise and clout to partner up with the very best managers, lowering fees and gaining access to the best deals all around the world.

Does this approach guarantee results? Of course not. As I've repeatedly warned, a protracted period of debt deflation will hit all asset classes hard, especially illiquid private equity and real estate. Even the David Bondermans, John Graykens and Tom Barracks of this world will have a hard time making money if deflation rears its ugly head.

Finally, I'm still waiting for someone to take IKEA public. Every time I drive by their Montreal store, the huge parking lot is jammed with cars, and let me tell you, it's not the cheap Swedish meatballs and hotdogs that's enticing all these people to shop there. That company has found the secret to long-term success.

Below, Bloomberg’s Cristina Alesci looks at the future of private equity tax breaks in the wake of the 2012 presidential elections and whether it even makes a difference who wins. And KKR Co-CEO George Roberts discusses private equity. He speaks with Jason Kelly on Bloomberg Television's "Money Moves."