Tuesday, May 8, 2018

Private Equity Going Public?

Thomas Franck of CNBC reports, The stock market is shrinking and that's a good thing, private equity honchos say:
The fact that more public companies are being acquired by large global private equity firms is neither shocking nor problematic, at least according to the titans of private equity.

It's hardly surprising that boards of formerly public companies elect to give private equity a chance, said Jonathan Sokoloff, managing partner of Leonard Green & Partners.

"Our view is that we're a better model. We're a better model for governance. We don't have to deal with all the hassles of the public boards," Sokoloff told CNBC's Leslie Picker at the Milken Global Investment Conference last Tuesday.

"You go to a private company board meeting: we get right down to the meat of the business, and we help the businesses and we're involved," he added. "It's a pretty dramatic shift that's going on, and the public equity markets are really losing share."

Other private equity managers on the panel echoed Sokoloff's comments. The panelists also included Apollo Global Management's Leon Black, Vista Equity Partners' Robert Smith and Brookfield Asset Management's Bruce Flatt.

According to a Credit Suisse report published in 2017, the number of publicly traded U.S. companies has been cut in half over the past 20 years, falling to 3,671 from 7,322 in the two decades ending in 2016.

While private equity buyouts can account for some of the drop in the number of public companies, some executives of companies such as Uber and Airbnb are simply electing to delay their IPOs. Their explanations for the delay have ranged from increased regulation in the public sphere to shareholder lawsuits and activist pressure.

While notable in its own right, the decline in the number of public companies has been accompanied by a mass migration of capital into private equity as some of the world's largest pension funds remain strapped for reliable returns.


Private equity raised a record $453 billion from investors in 2017, bringing the available pool of money to invest to $1 trillion, industry tracker Preqin said earlier this year. The amount of money raised exceeded the previous record of $414 billion set in 2007.

Much of the new capital flow has helped balloon so-called megafunds (those with more than $4.5 billion), with raises for all buyout megafunds up over 90 percent year over year, according to McKinsey, which concluded that had growth in the largest funds stalled in 2017, overall fundraising would have fallen by 4 percent.

At the top of the list of top fundraisers, Apollo took in $24.6 billion last year, and the firm manages a total of $69 billion in private equity assets.

Black said that taking a public company private is a natural step in the business life cycle and gives companies a chance to implement initiatives without increased regulatory or public scrutiny.

"What happens when a company goes private?" Black said. "It is private for a while, it doesn't have to report quarter-to-quarter, things can get done — as John said — more efficiently. And then there's an exit."

The flood of cash into private equity, however, has attracted the criticism of federal regulators, especially as managers look to foreigners for cash.

In its most recent move, the Committee on Foreign Investment in the United States — which monitors and reviews potential national security implications of foreign investments in U.S. companies — warned President Donald Trump against allowing Singapore-based Broadcom's hostile takeover of San Diego-based Qualcomm to go through.

CFIUS, which rarely weighs in publicly on a deal it is scrutinizing, told both companies it was concerned that Broadcom could use a "'private-equity'-style" approach to Qualcomm, slashing investments in research and development as part of a focus on short-term profitability.

Broadcom was forced to abandon the Qualcomm bid.

Private equity executives often say their ownership of private companies creates a better relationship between owners and management compared with publicly traded companies, where managers may hold a very small amount of the company's stock, and so their incentives aren't necessarily aligned with other stakeholders.

"The fact of the matter is, private equity has just, frankly, a better alignment of incentives between stakeholders, stockholders, management and the company," said Smith, founder and chairman of San Francisco-based Vista Equity Partners, which focuses on software and technology companies.

"The challenge, I think, that the public markets have run into is that often the managers of those businesses don't actually have a meaningful stake in the companies any longer," he said. "That fundamental difference in alignment is why I think the private equity model is going to continue to gain momentum."
Clearly, these are good times for private equity titans. They are raising multibillions for their megafunds and most of that money is coming from global pensions and sovereign wealth funds.

Given the amount of money pouring into private equity, it's not surprising to see PE giants increasingly focused on taking public companies private. And there is no doubt that private companies have better alignment of interests with their shareholders who typically focus on long-term added value.

But increasingly playing in public markets raises concerns too. In particular, as Javier Espinoza of the Financial Times reports, Valuations for private and public companies are narrowing:
Valuations for private and public companies are narrowing, data by the Boston Consulting Group show, prompting concerns that investors could be overpaying for privately held assets (click on image).


The narrowing of the gap has been driven partly by private equity investors paying record multiples for assets as they come under pressure to deploy capital, according to industry analysts.

This could eventually lead to investors finding better value and more liquidity in publicly traded companies if economic conditions were to change dramatically, these observers warned.

“Buyout funds have historically valued private companies based on their historical averages,” said the private equity head of a multibillion fund in London. “But private equity investors have raised a lot of capital and to get deals done they are having to pay full price. Many are starting to ignore their traditional metrics.”

The person added: “It’s like 2006 and 2007 all over again.”

Yield-starved investors have been under growing pressure to deploy their capital in a low-interest rates environment. As a result, demand for private equity has risen in recent years, which in return has led buyers to pay record multiples for assets.

In 2017, investors paid on average 12.5 times multiples for private companies compared with 9.5 times multiples a year earlier. This compares with 16.8 times multiples paid for public companies last year versus 19.5 times multiples a year earlier, the data showed.

Industry observers also said that a narrowing of the gap would lead some to reassess their exposure to private equity. “If you want to re-calibrate your portfolio, you can take instant action in the public markets. While you can’t with private equity exposures. You can try and sell your stake in the secondary market but at huge discounts.”

However, Antoon Schneider, senior partner and managing director at the BCG, said that investors were still paying less on average for private companies than for listed companies.

“Private equity investors are not paying more than if they bought shares in the stock exchange and they hopefully get superior governance and better returns,” he said. “The private equity boom is still less than the stock market overall.”
Again, it's confusing but as private equity funds get bigger and bigger, they are forced to take public companies private in order to deploy the capital, so I'm not shocked to see valuations are narrowing between public and private companies.

It's important to note, however, that delistings are primarily the function of cheap capital allowing public companies to strategically acquire other public companies, allowing them to grow by acquisition.

In other words, even though these private equity megafunds are growing and taking public companies private, they're still a pittance relative to the overall global stock market capitalization.

Still, there is no shortage of capital chasing private equity deals but this has put pressure on GPs. Sujeet Indap of the Financial Times reports, Private equity executives discover new backers:
Pity the up-and-coming private equity titan. He (it is almost always a “he”) is around 40 and has spent the previous decade flying every week to the Rust Belt performing due diligence on various metal benders. Finally, the men who hired him are riding off into the sunset and he is ready to step up from junior partner to the inner sanctum.

One small hitch: he is relatively cash poor. It is not so much a hindrance for his day-to-day life of private school tuition and Hamptons beach house as he is still taking home a few million dollars a year. But private equity firms can only raise fresh capital from pensions and endowments if they pony up either their own firm’s balance sheet cash or that of individual partners. These days, that means rustling up perhaps tens of millions of dollars

A solution has emerged for the needy private equity firm. Stepping into this void in recent years has been a new kind of capital provider that nurtures the private equity firm itself. And it has become one of the hottest, if somewhat obscure, ways to take advantage of the global explosion of alternative asset investing.

The development involves the sale of so-called GP, or general partner, stakes. Private equity firms that lack the scale or desire to go public — including Silver Lake, Vista and Providence — have each sold stakes in recent years to one firm, Dyal Capital, a unit of money manager Neuberger Berman. Dyal has become the king of GP deals, having closed 30 such transactions. Its existing three funds total $9bn and it is weeks from closing a $6bn fund, according to people familiar with the matter.

To date, only eight US private equity firms have gone public since Blackstone listed its shares in 2007. Its market value today of $36bn signifies the discounted value of management fees and performance fees known as carry. The public stock can be used for compensation or to buy other asset managers. But of the hundreds of private equity firms out there, only another half dozen are compelling enough to even consider an IPO. This creates an opportunity for GP deals.

GP transactions were once cynically viewed as simply “cash outs” for private equity managers who had accumulated valuable but illiquid wealth. Most nervous were the limited partners, or LPs — pensions, wealth funds and endowments — who contributed to buyout funds and who fretted that Masters of the Universe who just got a pile of cash would suddenly lose their motivation to do the hard work of buying and fixing companies.

However, the majority of capital deployed in stake sales is used for new strategies — credit, real estate and growth equity. Those LPs require the managers to put in their own capital, somewhere between 1 and 5 per cent of the fund size, to ensure interests are aligned. That figure can easily run to more than $100m.

A private equity firm is, at its core, a stream of fees. It takes money from pensions and the like that is locked up for a decade and earns a juicy 2 per cent to buy, manage and sell companies. It then keeps a fifth of the profits it realises. Those numbers alone can create fortunes. But until perhaps the past decade, there was limited thinking about the buying and selling of the capitalised, present value of that fee stream: how much could a lifetime of fees be worth today and who would pay up front for them?

A capital infusion from GP deals provides the power for funds to keep expanding, professionalising and moving beyond the founder generation. “GP transactions take all the creative juices and business-building ideas of rising private equity executives and catalyses them with capital,” says Michael Brandmeyer, co-chief investment officer of the Alternative Investments and Managers group at Goldman Sachs.

For the likes of Dyal and its two chief competitors, Mr Brandmeyer’s Petershill fund at Goldman and the Blackstone Strategic Capital Holdings fund, the attraction of GP ownership is the steady management fees and the chance for big upside in carried interest. Their funds, whose backers also are large pensions and wealth funds, are effectively yield instruments that get steady management fees and then performance fees as those are paid. The stakes they buy are designed to be relatively permanent with no real formal exit planned. Several people familiar with these funds say the ultimate ambition is to float a specific GP stake fund, giving public investors access to a portfolio of private equity managers.

But for now, there is no shortage of capital to help private equity stars get to the next level. One long-time asset manager executive noted that GP transactions have become a branding milestone. “Most good firms will sell a stake at some point.”
Indeed, there is no shortage of capital plowing into private equity, chasing higher yield, and it's only normal that GP transactions increase as the old PE guard retires to make way for new kids on the block.

Are these good times for private equity? I'm very careful in my assessment. The industry is bracing for an inevitable downturn and there's clearly a lot of froth driving valuations higher and prospective returns lower, but there is no doubt that private equity remains a very important asset class for pensions, sovereign wealth funds and other institutional investors.

What is changing, however, is the approach to private equity. There is new competition from large Canadian pensions like the Caisse looking to go direct but direct here means more co-investments to lower overall fees as no pension will ever compete with PE giants head on.

What else? Private equity's dark cloud still hovers over an industry shrouded in secrecy and rightly or wrongly perceived as being nothing more than an asset-stripping machine profitting off the misfortunes of companies. Worse still, there's still the ongoing problem of misalignment of interests with long-term investors.

In other words, private equity still has a huge image problem and truth be told, I don't think it cares.

Lastly, as I recently stated in my comment on BlackRock beefing up its PE team, there is increased competition from traditional asset managers looking to manage more in private market assets. BlackRock has experienced sell-side and buy-side veterans who are not only good operationally but will help large US pensions revamp their private equity portfolio to get better returns and better alignment of interests.

I ended the BlackRock comment by stating this:

You're going to read all sorts of good and bad comments on private equity but the truth is even the industry is bracing for a downturn (which is why I expect activity in secondaries to pick up).

So what is it? Is it the rise and rise of private equity or is it private equity laid bare? I suspect it's somewhere in the middle but one expert shared this with me:
Under conflicts, "Tunnelling" is an extremely serious allegation. He better have some facts to back that up.

IRR's are not meaningless to the investor experience. I would argue everyone should compute IRR for all asset class investment decisions. Right sizes returns for growing programs with higher dollars typically invested over time. Institutions quoting average annual returns while growing dramatically mislead how they are doing.

Fees and transparency is not the problem he makes it out to be. You sign the fee contract, so nothing prevents one from understanding what one is signing. When one understands why the fees are the way they are, the task is to determine if you are getting value for money. But the fee/terms alignment of interest is actually reasonable, or as much as can be to get both general and limited partners to want to be in the business. Those who have never been a general partner, which is most people require a lot of maturity to understand how hard it is to build these businesses to success for all.

PE has become large but is still small relative to global capital markets. It is targeted to sophisticated investors who are supposed to be able to look after themselves. If you dumb it down, you just put huge resources into protecting lazy people. ‎Let the public market take care of those that need it.

There is nothing fundamentally wrong with PE. It can be what its investors want it to be. If there are problems, the investors can fix them. My only issue is that fear mongering favours the goliath LBO focused firms that over resource for all these fears, but end up at way too large a scale. PE is best as a middle market focussed, craft type business, with a tilt to acquisitions and restructurings as the main skill set you are trying to advantage. I also believe growth capital with venture attributes remains under exploited. There are plenty of choices to do it the right way.

‎Trust me, having exposure to the underbelly of the public markets, the shenanigans that go on there‎, with the banks and investment banks, CEO's and the comp consultants, etc. makes the PE business look like an honour society.
He also added this on the rise and rise of private equity:
Being favourable on PE is like saying one is favourable on derivatives or public markets. It is all about execution, and we should all be glad we have so many execution choices. Most assets classes, however defined are not very favourable at the mean level of performance. Of course we all think we are better than average, that's why track record, if true and verifiable, is so valuable.
You need smart people who are able to verify the track record of GPs and make sure they're delivering what they promised to deliver and have proper alignment of interests.

That's what Larry Fink is doing at BlackRock, hiring smart people who can execute and gather assets from institutional investors who need help improving or ramping up their private equity portfolio (like sovereign wealth funds).
So, good times for private equity? Absolutely, the industry is growing and is in great shape but there are many concerns that will test it over the coming years.

One thing I would like to make clear here is private equity remains a great asset class, one that will continue generating important added value for pensions and other investors, but it's also important to recognize that no matter what, private equity's fortunes are intricately tied to those of public markets.

Importantly, if there is a profound dislocation in public markets, it will have an effect on private equity, now more than ever since PE giants are increasingly taking public companies private. The only difference is private equity isn't marked-to-market, something which the Oracle of Omaha referenced over the weekend as he explained Berkshire's losses:




Warren Buffett has made enormous returns in private equity, holding companies for an extended period, far longer than most PE funds hold them. It's a bit surprising to hear him lament over accounting rules which are designed to provide more transparency in pricing across all his holdings.

Anyway, if you have any thoughts on this comment, feel free to reach out to me at LKolivakis@gmail.com. I will be happy to post your thoughts.

Below, Leon Black, CEO of Apollo Global Management, breaks down successful private equity investing. This clip was from the 2016 Milken Insitute Conference. I actually embedded the entire panel discussion with industry titans from two years ago as it was excellent.

Lastly, Bloomberg reports that KKR & Co. will convert to a corporation from a partnership, seeking to capitalize on tax reforms enacted by the Trump administration and win more mutual fund and ETF investors.

KKR's shares (KKR) surged following the announcement but I remain neutral to bearish on all publicly listed US private equity firms. In my opinion, there will be better opportunities to buy them in the future (however, some have great dividends that offer attractive yields to income investors).



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