It seems like the whole world is now fascinated by a business model that has been around for more than 40 years. In the October 22nd issue of The Economist an editorial panel took a look at Private Equity. Entitled “The Barbarian Establishment” the article is mostly complimentary: “Private Equity has prospered while almost every other approach to business has stumbled. That is both good and disturbing.” It reviews the ingredients for successful economic returns as a layer cake of available leverage, low interest rates, and tax shields from deductible interest, large uncommitted equity pools, long term capital commitments and lack of competition from the public markets. Interestingly, the stock market performance of the big four public PE firms – Blackstone (2007 IPO), KKR (2010), Apollo (2011) and Carlyle (2012) – have all lagged the S&P500. In fact, all four are trading at or below their IPO price. Those lackluster returns only apply to the stream of profits from the management companies, not the returns to the limited partners of the multiple underlying funds. It would be surprising, indeed, for Steve Schwarzman and Leon Black to have made a bad trade in monetizing their own profit stream. When they are sellers, the public should be wary.
The article reviews the paltry returns available today from almost every other asset class and concludes “private equity’s current appeal rests not on whether it can repeat the absolute returns achieved in the past…but on whether it has a plausible chance of doing better than lackluster alternatives”. It takes the authors several thousand words, however, to zero in on PE distinctiveness as being the freedom its managers have to ignore the pressures of “quarterly capitalism” meaning impatient investors.” There is recognition of less taxation, less legal vulnerability and fewer operating constraints that allow private equity managers to focus as owners on managing their assets to provide the greatest returns in a short period of time. By contrast, public companies face a mountain of often incomprehensible or conflicting regulatory demands that are not relevant to performance.
A great example is the agenda for our private equity meetings. We try to start (not end) with an executive session that often includes only the CEO of the portfolio company during which the advisory board members ask the CEO to focus on particular issues that are raised by the volumes of financial and operating statistics included in the board package. This allows the PE owners to prioritize and focus on value creation to the exclusion of all else. My public board experience, especially for the 2-3 years after Sarbanes Oxley was enacted, was exactly the opposite. We usually started with an excruciatingly boring review of Sarbanes Oxley compliance conducted by our general counsel or outside lawyers. Only after 50 pages of PowerPoint persuasion that we were, in fact, complying were we allowed to turn to the purpose of the meeting- creation of shareholder value. By that time you were eating lunch and quickly slipping into carbo overload from the cookies and potato chips. With all your blood in your stomach, the public shareholders often competed with the desperate need for a nap.
The authors are also enamored with an attribute that is lacking in the more constipated public company process, SPEED. Management can be changed quickly. Tuck in acquisitions can be accomplished in a matter of months. Divestitures of non performing units do not need lengthy and cumbersome public disclosure. My experience in the public markets with change in management was illustrative. The Governance Committee of the Board would often have “hypothetical” conversations about changing key managers because regulation FD required immediate disclosure if a serious discussion was joined or a real decision was made. It also always took at least two and sometimes three governance meetings to reach a conclusion that a private equity firm will accomplish in a week.
Speed is also important when a window of opportunity is about to close. I had a discussion with the CEO of a telecom company who feared that the “new economy” telecom bubble was about to burst and telecom valuations would soon crash. He said he knew the end was inevitable when in early 1999 all of his customers had infinity growth plans for their respective markets. He shared his concern with the large PE firm that owned his operation and was told they would have a plane pick him up that afternoon. Two weeks later a “Selling Memorandum” was on the street and eight weeks later the company was sold for cash to a large multi-national telecom company. One year later the telecom market was faltering and two years later industry stalwarts like Global Crossing and WorldCom were filing for bankruptcy. The acquirer is still alive but it never regained its mojo.
You have to love an asset class that can move with this kind of speed in a world of red tape and numbing process.
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Rob McCreary, Chairman
December 7, 2016