Stick a Fork in Private Equity?

Earlier this week, Andy Kessler, a former hedge-fund manager and author of “Eat People”, wrote an op-ed for the Wall Street Journal, The Glory Days of Private Equity Are Over:

Private equity is done. Stick a fork in it. With Kraft singles and Heinz ketchup as toppings, there are many signs that private equity has peaked as an asset class.

Sure, private equity is pervasive, which is one of its problems. According to Dow Jones LP Source, 765 funds raised $266 billion in 2014, up 11.7% over 2013. Ever since David Swensen, the investment manager of the Yale University endowment, almost 30 years ago began successfully allocating outsize portions of the portfolio to “alternate” assets, especially private equity, the so-called Swensen model has been widely duplicated. Last week the Stanford endowment named Swensen-disciple Robert Wallace as CEO. There is a lot of capital chasing similar deals.

When it comes down to it, private equity is pretty simple. You buy a company, putting up some cash and borrowing the rest, sometimes from banks but often via exotic instruments that Wall Street is happy to sell. Then you manage the company for cash flow, making sure you can make interest payments with enough left over for fees and investor dividends. With enough cash flow, you either take the company public or sell it to someone else. And how do you generate cash flow? You can expand the company, but more likely you slash costs, close divisions, cut staff, curtail marketing, eliminate research and development and more. In other words, cutting to the bone.

The Swenson model has worked for the past three decades. But it’s a bull-market investment vehicle whose time is done. Here are the main reasons private equity has peaked—the first four are reasonably obvious, but the last one is the killer.

First, interest rates are going up. As they say on “Game of Thrones,” winter is coming. The Federal Reserve will no longer be “patient” on raising rates. This year? Next year? It doesn’t matter. Rising interest rates mean private equity will see higher costs of capital, wreaking havoc on Excel spreadsheets justifying future returns.

Second, as The Wall Street Journal pointed out last week, banks are slowing lending for leveraged deals. Since 2013, regulators have been discouraging leverage above six times earnings before interest, taxes, depreciation and amortization, or Ebitda, a measure of cash flow. Leveraged loans are the lifeblood of private equity; limits are already crimping the ability to do deals.

Third, tax reform is in the air, and interest-rate deductions are on the chopping block. The Lee-Rubio tax reform plan introduced in March “eliminates the deductibility of new debt.” We all pay taxes on interest income, yet companies get tax deductions on interest payments, which only encourages debt. These tax writeoffs are the air that has filled the private-equity balloon for decades. Lee-Rubio may not get anywhere, but the interest-tax symmetry is long overdue and makes enough sense that it could end up in future tax reform. As an aside, this won’t be pretty for debt-laden cable and telecom companies.

Fourth, private equity has been holding back the economy. When you buy out a drugstore chain or car-rental company and load it with debt, you aren’t investing in the productivity of the economy. More often, by cutting back on new products and services, you are removing productivity from the economy. While generating wealth for endowments and pension funds, private equity can destroy wealth in the economy—my guess is 0.5%-1% lower gross domestic product in an already subpar recovery.

And, by the way, of that $266 billion raised last year by private equity, only $33 billion was for venture capital. Venture investments rarely involve debt—they are productivity creators on steroids. With so many billion-dollar-valued startups, it is hard to argue for more venture capital, but instead expect capital allocated to debt-backed investment to peak and decline.

The final reason private equity is done: It is fresh out of fat targets. In October 2007, KKR and TPG and Goldman Sachs bought the utility TXU Corp. for $48 billion. Bowing to the green gods and regulators, who put so many restrictions on electric generation, the deal now known as Energy Future Holdings Corp. has been a bust, filing for bankruptcy last year. So no more utilities.

Earlier this month, Dutch semiconductor firm NXP bought Freescale for $11.8 billion. Freescale, the old semiconductor arm of Motorola, was bought by Blackstone, Carlyle, TPG and Permira in 2006 for $17.6 billion. Firms that are R&D-intensive aren’t great candidates for buyouts, as interest payments squeeze the research needed for innovation. Dell’s buyout two years ago notwithstanding (Dell is more of a packager and distributor), don’t expect many technology buyouts down the road.

So what’s left? Mattress companies seem to change hands regularly. There are a few more food companies beyond Kraft. General Electric is selling off international-lending divisions. But these are too small to soak up hundreds of billions in private-equity capital that the Swenson model now demands.

The reality is that the best companies with high-enough cash flow to pay down interest can’t be bought. No one is buying Apple or Google. But this is also true of cash machines Uber and Airbnb or high-growth companies like Snapchat and Pinterest. Private equity can’t afford them. And with the Dow bobbing around 18,000, public companies are increasingly off the table. Maybe the oil patch? Good luck with that.

Capital will still chase increasingly expensive deals. That won’t end well. So it’s back to basics—creating companies rather than squeezing the last life out of old ones. Just like Wall Street shrinking and curtailing once-profitable businesses, private equity will begin a slow decline. Yes, we’ll see more deals and even a few successes. But the returns from private equity won’t match those of the past 30 years. And capital will flow elsewhere—let’s hope to productive and wealth-creating segments of the economy.

Whether or not you agree with Mr. Kessler -- and clearly some don't -- he's absolutely right on one front, the glory years of private equity are long gone. By the way, I can say the same thing about hedge funds, his former industry, where the squeeze on fees is just getting underway.

Importantly, and quite ironically, the institutionalization of private equity and hedge funds is the biggest reason why the glory years of these alternative asset classes are long gone. As more and more money chasing yield keeps piling into them, it's dimming prospective returns of private equity giants competing against themselves and strategics flush with cash and great balance sheets.

How is private equity responding? PE giants are now trying to emulate the Oracle of Omaha, talking to their biggest investors to create a “coalition of the willing” that can buy control of large companies outside of their existing funds in an attempt to hold assets for a longer period but with lower returns typical of their traditional funds (but they still charge fees over a longer period).

Of course, as Dan Primack of Fortune reports, Private equity is changing slower than you've heard:

Private equity may have Buffett envy, but it isn’t rushing to copy him.

There is a burgeoning narrative about how private equity is reconsidering its traditional model, with eyes toward raising long-dated funds that would allow them to hold portfolio companies for 20 years or more. Basically moving closer toward a Berkshire Hathaway structure, albeit not always with publicly-traded shares.

Some of this talk is based on reported experimentation with such funds by large private equity incumbents like The Blackstone Group (BX) and CVC Capital Partners. Some was prompted by a February speech by TPG Capital co-founder James Coulter, in which he talked about the private equity industry experiencing “titanic shifts.”

In general, however, this “evolution” is overblown.

The reason for interest in long-dated private equity funds is that certain institutional investors believe that private equity fees are too high relative to performance. This is largely because private equity charges fees up-front on uncommitted capital, slowly ratcheting down the fees (in terms of hard dollars) as capital is called down (and then often paying them back once investment returns are generated). Or, as Coulter put it in his speech: “That fee drag in the early years of a fund actually becomes difficult.”

But if you create a long-dated fund, you can charge lower annual fees. Not only because fees would be charged for more years, but also because overhead can be reduced. After all, it should be cheaper to run a fund that has 20 years to invest its money than one that only has five years to invest. And the same goes for hold periods (i.e., longer to turn companies around).

The only problem, of course, is that private equity firms already have begun to lower fund fees. Not only “sticker prices,” but many firms are abandoning old rules that said any cost break enjoyed by one limited partner would be enjoyed by all. Today, larger investors can get added discounts for buying “in bulk” — plus are being encouraged to participate in co-investment vehicles that often do not include any management fees on uncalled capital.

And the reductions have proved success, with U.S. private equity fundraising having rebounded from its 2009-2012 lull (average of $95 billion raised annually) to average nearly $180 billion over the past two calendar years. I can think of only a couple of long-dated funds being raised in that more recent crop, and those were for firms that implemented such models long before they became rhetorically trendy.

Even Coulter’s TPG is in the midst of raising a new flagship fund that has… you guessed it, a traditional time structure.

To be sure, private equity firms will try to innovate in their quest for better performance. But when it comes to fundamental structure, few firms will deviate sharply from what has worked for them for decades. If there is movement, it will be glacial.

Things move slowly in private equity but there's no denying larger, more sophisticated investors are putting the squeeze on funds as they look for better alignment of interests.

Interestingly, Jennifer Bollen of the Wall Street Journal reports the average life span of a private equity fund now exceeds 13 years, but this is mostly due to the hostile market environment and the increase in the number of 'zombie' investments:

The average life span of a private equity fund has reached “an unprecedented” 13 years amid concerns about the high fees charged on tail-end funds.

Palico SAS, which operates an online marketplace, said in a report this week that the median life span of a private equity fund—across all regions and sectors—had hit 13.2 years. The figure, which is based on 200 funds dissolved last year, has increased from an average life span of 11.5 years in 2008.

Private equity funds typically aim to return capital to investors within 10 years. About 12% of funds liquidated last year had wound up by their tenth year. A further 29% had liquidated within 12 years, 33% by the 14th year, 14% by year 16, 7% by year 18 and 5% by year 19.

Palico said it meant investors faced lower-than-expected annual returns and potentially serious liquidity problems.

It attributed the longer life spans to drops in asset valuations in the wake of the dot-com bubble of 2000 and the financial crisis in 2008.

“Typical fund life would be even longer without the good exit environment of the past couple of years,” Palico said. “High asset prices, driven by exceptionally low interest rates and widely available credit, have allowed private equity funds to realize a large volume of investments, but they’ve also made it more expensive to acquire companies.”

Jos van Gisbergen, a senior portfolio manager at investment manager Syntrus Achmea, said private equity firms which continued to charge high fees on tail-end funds had caused concern but that longer life spans in general did not necessarily pose significant problems.

“Since funds have common 10-year life spans and up to a three-year extension it is nothing to worry about,” he said. “From experience, I do know the average for [venture capital funds] runs from 15 to 20 years. Also funds of funds as standard run above 15 years.”

Mark Nicolson, a partner at fund-of-funds firm SL Capital Partners, said while strong performing funds that make decent investments early on in the life of the fund will have good internal rates of return regardless of how long the tail continues, the number of funds with one, two or three zombie investments at the end of the life does appear to be increasing.

“It is our job as investors to encourage the managers to realize these,” said Mr. Nicolson. “Certainly we push for them to be realized and for the managers to charge no fees [beyond the agreed extension period] so there is no increased drag in fees.”

I agree with Nicolson, it's the job of investors to push managers to realize on their investments, mitigating the drag on fees, especially when it comes to funds of funds that charge an extra layer of fees to pensions and other institutional investors.

On that note, Yves Smith (aka Susan Webber) of naked capitalism continues her anti-PE rants noting that many private equity investors, known in the trade as limited partners, enter into agreements with private equity firms that do a terrible job of protecting the investors’ interests.

On Wednesday, Yves Smith blasted the head of SEC’s examination unit, Andrew Bowden, for gushing about the private equity industry at a conference at Stanford Law School, including joking about how he’s told his son to work in the industry. (Update: See her latest comment on Adam Levine, an ex-TPG employees countersuing his former employer charging them of cheating and misleading investors).

And she laced into LACERS for giving up approval of its private equity investments to its "hopelessly conflicted" private equity consultant Hamilton Lane, which also manages close to $30 billion private equity fund of funds:

For Hamilton Lane, performing advisory work for funds like LACERS is a nice, reputation-burnishing side activity to their big money marker, running various private fund of funds.

Consider what Hamilton Lane’s incentives are. Pursuing their fiduciary duty vigorously would put Hamilton Lane in conflict with their general partners. Since pension fund consultants are typically paid a flat fee to review all prospective investments for funds like LACERS, playing collegial with the general partners minimizes hassle and effort.

But it’s even worse than that. If pension fund consultants became more rigorous on the advisory side of their business and did real due diligence, those same firms acting on the advisory side of the business would wind up asking managers like Hamilton Lane on the fund of fund side of their business much tougher questions.

Moreover, remember that until recently, the Holy Grail of private equity investing was to get into top quartile funds. Never mind that nearly 80% of the industry could cut its results in a way to claim to be top quartile, and that top quartile performance no longer persists. The reason for hiring a firm like Hamilton Lane is supposedly to make better fund selection. Peculiarly, these same investors understand that trying to outcompete other investors is a fool’s errand as far as stock and bond investing is concerned. As a result, the overwhelming majority are index investors. But rather than save money and hassle and try to act like an index investor in private equity, limited partners work hard at fund-picking.

Given that Hamilton Lane has a large number of pension fund clients it advises, as well as running its own fund of funds, which compete on results, where do you think Hamilton Lane ought to deploy its investment expertise, on the charitable assumption it has any? Pension consultants who are also running funds would be much better served to use it in their fund management activities. Thus it should hardly be surprising that low-information-content reports are the norm. It’s what you’d expect to see from an industry that wanted to keep its best cooking for itself.

Hamilton Lane is an Investor in a Widely-Used Program That Allows Private Equity Firms to Cook the Books of Portfolio Companies. One of the worst ways in which private equity is a non-transparent, “trust me” business is that the limited partner do not have any right to see the financial statements of the companies the private equity fund has bought on their behalf. That is also, as Andrew Bowden pointed out in his speech last year describing widespread misconduct, why so much chicanery is possible: they can have the portfolio companies pay all sorts of fees and costs that may not have been authorized by the governing agreements and the limited partners have no will clue.

Hamilton Lane, as both a fiduciary through operating fund of funds of its own, and as an advisor to major investors like LACERS, should be particularly cognizant of financial reporting risks at the portfolio company level and should strive to reduce exposure to them. Instead, Hamilton Lane is a shareholder in iLevel Solutions, a venture that allows general partners to tamper with portfolio company financials. Since Hamilton Lane clear does know, or could easily know, which general partners use this system, one would imagine that its responsibility to the investors would require it to avoid committing client funds to any general partner that used iLevel Solutions. If you think that’s what Hamilton Lane actually does, I have a bridge I’d like to sell you.

I'll let you read the rest of her comment here, it's a doozy. I'm actually appalled at the lousy job the SEC is doing regulating many useless investment consultants with inherent conflicts of interests, recommending funds to their clients they're investing in. It's an absolute scandal but when you buy off politicians, you can basically do whatever you want to charge fees even if it's chicanery at its worst.

I remember meeting a senior representative of Hamilton Lane when I was working at PSP Investments, helping Derek Murphy set up private equity there. We weren't particularly impressed nor did we want to invest in a large private equity fund of funds, paying an extra layer of fees for no good reason. But the meeting opened our eyes to the nonsensical approach many smaller U.S. pension funds that practice cover-your-ass investing take to invest in private equity. It's an absolute travesty. Murph stated it bluntly: "These guys are f*cked!".

Unfortunately, the reality is most mid sized and even larger U.S. pensions don't have the right governance model, making them easy meal tickets for greedy consultants and funds of funds. It's crazy but this is one area that still doesn't receive the scrutiny it deserves from regulators busy watching porn or touting how great private equity is.

As far as private equity, however, I wouldn't stick a fork in it, at least not yet. Why? As long as there are dumb U.S. public pension funds chasing what Andy Kessler aptly called the pension rate-of-return fantasy, you can bet private equity will continue to thrive, figuring out new ways to profit off their small and large investors.

Once again, if you have any thoughts you want to share, feel free to contact me directly at LKolivakis@gmail.com. I don't pretend to have the monopoly of wisdom on these topics but my job is to make all of you think critically on an industry that is dominated by far too many brainless advisers.

Also, please don't forget to contribute to my blog via PayPal at the top right-hand side under the click my ads picture. I thank those of you who support my tireless efforts to bring you the very best insights on pensions and investments and I ask more of you to contribute or subscribe to my blog.

Below, as private equity giants submit bids for Quebec's Cirque du Soleil, Warren Buffett discusses if other acquisitions are in the works and why 3G Capital is different than other private equity firms. In an environment where deals are cooling, clearly 3G is doing a lot of things right (just don't mess with Tims, eh!!).

I also embedded a small showcase of comic genius Michael Richards, aka Cosmo Kramer. I love Seinfeld and wish they'd do another reunion for those of us who miss great TV comedies. Enjoy your long weekend, I'll circle back next week to discuss Ontario Teachers' 2014 results.