Private Equity's Not So Golden Age?
Henry Kravis called it private equity’s golden age. From 2005 to 2007, buyout firms paid fat prices to buy about 20 supersized companies, from Hilton Worldwide Holdings Inc. to Hertz Global Holdings Inc.
Now, a decade later, the results of that debt-fueled spree can be tabulated -- and it’s hardly golden. The mega-deals produced mostly mediocre returns, falling well short of the profits that leveraged buyout shops typically seek, according to separate compilations by Bloomberg and asset manager Hamilton Lane Advisors. In more than half the deals -- each valued at more than $10 billion -- the firms would have been better off if they had put their investors’ money into a stock index fund.
Have the Masters of the Universe learned a lesson? They say they have. Caution is now a watchword and less is more. TPG Capital has sworn off buyouts as large as $30 billion, people with knowledge of its thinking said, while other shops will consider enormous deals only if the price is right. But so far none has led a $10 billion or bigger transaction since the financial crisis (click on image).
“The big deals were done more out of ego than economic sense,” said David Fann, chief executive officer of TorreyCove Capital Partners, which advises pension plans that invest in buyout funds. “People paid steep prices and put on too much debt.”
Representatives for Kravis’s KKR & Co. and TPG declined to comment.
Buying Frenzy
Private equity firms make money by charging investors -- pensions and other institutions -- an annual management fee equal to 1.5 percent to 2 percent of the funds they raise. They also keep 20 percent of any profits when a company they acquired is later sold.
The firms typically want to, at least, double investors’ money within three to five years. But a decade ago, a buying frenzy stoked by low borrowing costs saw firms pay sometimes twice as much for companies as dictated by traditional sales and cash flow multiples. That behavior almost guaranteed so-so returns, buyout executives now say.
Private equity firms led 19 purchases worth more than $10 billion from 2005 to 2007, according to data compiled by Bloomberg. As of Dec. 31, the deals earned the firms a median profit of 40 percent above their investment cost -- well below their goals.
Smaller Deals
The results also pale when compared with the 70 percent median return yielded by all private equity transactions during that period, the Hamilton Lane study shows. That group includes thousands of smaller deals.
On an annualized basis, the largest deals generated a median 4 percent return, according to the Hamilton Lane study, which looked at 25 transactions from the era. The Standard and Poor’s 500 Index, by comparison, returned 7.3 percent a year from the start of 2006 through 2015.
“This crop of deals dragged down private equity returns,” said Joe Baratta, global head of private equity at Blackstone Group LP. “The entire industry has become more disciplined.”
The private equity shops justified the high prices at the time by saying big and established companies could weather a possible downturn. But the post-2008 meltdown dashed that conviction, imperiling companies big and small.
KKR was the most active player, leading or joining in nine of the deals valued at more than $10 billion. Its record was mixed. Four of those transactions notched solid returns of 2.2 to 5.1 times the firm’s money. KKR co-led the highest-returning jumbo-deal, that of hospital owner HCA Holdings Inc.
$8.3 Billion Bet
But KKR also participated in four deals posting modest returns of 1.1 to 1.6 times what investors put in. Then there was the record $48 billion buyout of TXU, now called Energy Future Holdings Corp., which was the only total equity wipeout of the 19 mega-deals. The company’s 2014 bankruptcy vaporized an $8.3 billion bet led by KKR, TPG and Goldman Sachs Group Inc.
TPG had a subpar record for its seven buyouts, totaling $160 billion. On top of its Energy Future debacle, TPG suffered a loss in its purchase of casino operator Harrah’s, now Caesars Entertainment Corp., and gained nothing in participating in buying Freescale Semiconductor Ltd. In four other deals, it eked out a profit of half or less what it invested.
Most Profitable
Blackstone and Carlyle Group LP, the two biggest buyout firms, and Bain Capital distinguished themselves among the group by doing multiple deals and dodging any losses. Blackstone led the $26 billion purchase of Hilton, a deal that has morphed into the most profitable leveraged buyout ever in dollar terms -- a $10.8 billion partly realized gain as of Dec. 31, for an annualized return of about 15 percent.
With notable exceptions -- Energy Future, Caesars and Intelsat SA -- the deals clawed their way back to profitability thanks to a resurgent stock market, debt restructurings and streamlining. But that wasn’t enough to produce buoyant returns. One reason is that big public companies tend to trade at higher multiples than smaller firms.
“The fundamental flaw with large public-to-private deals is you pay the full market rate,” said Scott Sperling, co-president of Thomas H. Lee Partners, which ponied up an above-average 16 times cash flow for Univision Communications Inc. “That decreases the odds you can sell the company later for a higher multiple.” He declined to discuss the performance of his firm’s deals.
PE PlaybookIndeed, in this business, memories never last over a decade, but I think it's safe to assume the era of private equity mega deals is over. And that's a good thing for investors and general partners.
Another problem, said Blackstone’s Baratta, was that many of the big companies were well run, leaving less room for operational improvement -- a key element of the private equity playbook.
“You’ve got to know going in that you can drive up growth and margins,” as Blackstone did with Hilton, said Baratta. With Biomet Inc., by contrast, “there was less we could do to transform the business.”
The companies also were too big to sell for cash. That left a public offering or a sale, paid for in stock, to a publicly traded buyer as the only paths to an exit. But unloading shares takes time, eroding annualized returns.
A mega-deal revival is also being deterred by curbs the Federal Reserve has set on loans tied to buyouts, executives said.
While buyout titans are exercising caution, whether they remember the lessons is an open question, said Josh Lerner, a Harvard Business School professor who researches the private equity industry.
“Memories often last a decade” after a crash, Lerner said. “Getting them to last two decades may be over-optimistic.” (click on image)
As far as private equity's (not so) Golden Age, it's long gone and times will get much tougher in the years ahead. In late November, a former Carlyle employee Sebastien Canderle,wrote a guest comment on a bad omen for private equity, highlighting the growing number of inexperienced GPs entering the industry.
As I discussed in that comment:
In 2012, I wrote a comment on the changing of the old private equity guard welcoming new and smaller GPs whose alignment of interests are typically better than the large behemoths looking to gather assets. In fact, at a recent conference in Montreal set up by the U.S. Department of Commerce ("Montreal Trade Mission"), I met a few of these smaller American GPs which actually do what private equity people are supposed to be doing, namely, less financial engineering like dividend recaps and simply rolling up their sleeves to help bolster the operations at private companies.There's a lot more pressure on private equity funds and hedge funds to adhere to the rigorous standards institutions are imposing on them. The best and most experienced private equity investors are grilling their GPs, making sure alignment of interests are there and going over all hidden fees as well as going over how private equity funds are generating their returns.
But I agree with Sebastien's comments, there are many new GPs popping up in recent years and while some are excellent, the majority are questionable. Above and beyond that, this is a brutal environment for even the best private equity funds. Some even think it's time to stick a fork in private equity and that it's the end of PE superheroes. Moreover, I expect more regulations to hit the industry as news breaks of private equity funds stealing from clients.
As far as limited partners (LPs) are concerned, it's high time they wise up too. When I see a CalSTRS pulling a CalPERS on private equity fees, I cringe in disgust. I can write a book on the nonsense that goes on at public pension funds investing in private equity (everything from fees to benchmarks). To be sure, private equity is a very important asset class but the large "brand name" funds have been getting away with murder and it's high time limited partners take their fiduciary responsibilities a lot more seriously and squeeze these funds hard on fees and investments, or better yet, just go Dutch on them like Canadian pension funds have been doing for a long time.
In a nutshell, if you want to raise funds from big institutions, you need to conform to their standards. That goes for everyone, including Blackstone, Carlyle, KKR, TPG and other top PE funds.
What else? The governance of top private equity funds is increasingly being discussed at large limited partners. I had a conversation with a major pension fund investor in private equity who told me if they don't see a solid governance framework where all the senior partners share in the big decisions, they walk away.
Interestingly, he was telling me how he had serious concerns with TPG's governance but liked that of KKR. He even told me: "TPG's governance is all wrong, too much power concentrated in too few hands." This was a couple of years ago. Others like Mark Wiseman think David Bonderman is a private equity god, so it's hard to know who to believe.
The guys that impress me the most are Blackstone. They are a small group of great investors who know how to print money in private equity, real estate, hedge funds, and anything in between. A huge reason behind Blackstone's success is its governance model where power isn't concentrated in one or two hands.
But the landscape in private equity is changing for everyone, including the Blackstones of this world. Record low rates, sluggish growth, strategics flush with cash, pension funds with longer investment horizons competing for deals, and a lot more uncertainty in a world there the risks of deflation are rising and making it a lot more difficult to generate returns of the past.
Still, all these factors haven't stopped the Blackstone machine from garnering ever more assets. In October of last year, it gathered $15.8 billion for the largest fund to invest in global real estate:
The firm collected more than 90 percent of the pool, its eighth fund for global property, from institutions in about four months, a person with knowledge of the matter said in March. The remainder was raised from individual investors, a process that takes longer to complete because of the paperwork involved, the person said.Jonathan Gray is a real estate superstar, one of the best real estate investors in the world. He's also deeply committed to charity and a shoo-in to succeed Steve Schwarzman once he steps down.
Blackstone has already committed 20 percent of the fund to deals, according to a statement Thursday. The New York-based firm in April agreed to a $14 billion transaction to buy real estate assets being divested by General Electric Co., and last month agreed to buy Strategic Hotels & Resorts Inc., the manager of properties including Manhattan’s Essex House and the Ritz-Carlton Half Moon Bay, for about $3.9 billion.
Blackstone has built the largest real estate investing business, overseeing $92 billion in assets as of June 30. Its seven previous global property funds have doubled their invested capital, with annualized returns of 18 percent after fees since 1994, according to the firm’s most recent earnings statement.
The real estate group is led by Jon Gray, 45, considered a possible successor to Chief Executive Officer Steve Schwarzman. Gray’s group also manages an $8.2 billion fund investing in European property and a $5 billion pool for deals in Asia.
“The size of this fund gives us the ability to commit capital in scale with speed and certainty,” Gray said in the statement.
One thing that struck me last week was Schwarzman's comments in Davos stating he was bewildered about why Americans seem so unhappy. With inequality and healthcare costs rising, it doesn't surprise me at all that Donald Trump and Bernie Sanders are rising in the polls and I think a lot of people are underestimating Sanders's gains in the polls (it's making Hillary Clinton very nervous and probably Mike Bloomberg too).
Of course, Schwarzman is one of the world’s richest men, so it doesn't surprise me that he's bewildered by America's growing discontent. He needs to watch an episode of Undercover Boss and maybe try it himself to see how most hard working people are struggling to get by. It's also time he follows Pete Peterson, Blackstone's co-founder, who wisely discovered the meaning of enough after Blackstone went public and signed The Giving Pledge along with a group of billionaires who realize rising inequality has reached extreme and dangerous levels.
As far as large pensions investing in private equity, real estate and hedge funds, they too need to think of the long term imperative and how they're fueling rising inequality, which is extremely deflationary over the long run. Nobody wants to tackle inequality, which is one reason why a guy like Bernie Sanders is rising in the polls (he's actually talking about it and it's resonating with voters).
Lastly, Bruce Flatt, chief executive officer of Brookfield Asset Management Inc., is putting Blackstone Group, Carlyle Group, KKR & Co., and others on notice that his Toronto– based firm is about to make a major push into private equity:
Flatt says his buyout firm will earn comparisons to the largest of Wall Street’s alternative-asset managers.You can actually invest in Brookfield Infrastructure Partners L.P. (BIP), Brookfield Renewable Energy Partners LP (BEP) and of course the flagship firm, Brookfield Asset Management (BAM) which along with other alternative asset management stocks, got hit lately during the market sell-off
“If you don’t mention it today, you should,” Flatt said in an interview at his New York office with Bloomberg Television’s Erik Schatzker.
That may take time. While Brookfield Asset Management oversees a total of more than $225-billion (U.S.) in assets, its private-equity arm, Brookfield Business Partners, has just $7.7-billion. Blackstone’s buyout business has $91-billion, while Carlyle has $63-billion.
Flatt has history on his side. Brookfield, which grew out of the Canadian billionaire Bronfman family’s Brascan Corp. holding company, has increased book value by almost 10-fold since Flatt became CEO in 2002, more than twice as fast as Warren Buffett’s Berkshire Hathaway Inc. Over the same period, Brookfield shares have returned more than 800 per cent versus about 170 per cent for Berkshire.
Owner-Operators
Flatt says Brookfield retains the Brascan approach to investing, and that sets it apart from rivals such as KKR and Blackstone, whose founders were bankers. “They’re all savvy and they’re all excellent organizations,” he said. “We’re owner-operators. We buy businesses we hold for long periods of time. We earn greater multiples of capital. We’re just a little different.”
Until now, Flatt has been content to build his businesses with little fanfare. Brookfield’s personality, he said, is “generally low key, generally conservative, worried about downside protection.”
Flatt says the company’s private-equity arm, which is expected to be spun out from the parent in the next few months, could one day be as big as Brookfield’s other investment units, which run as much as $138-billion.
Commodity Rout
The current turmoil in global markets that has sent stocks and commodities reeling, isn’t a deterrent for long-term investors like Brookfield. The company is intentionally counter– cyclical, and is excited about opportunities in volatile markets like China and Brazil. Flatt said the oil and gas and broader commodity sector present buying opportunities, making them net buyers in those places, along with Europe, Canada and India, and net sellers in the U.S. after strong gains there.
“We’re a net buyer in anything that is out of favour,” he said. “As contrarian investors we’re always trying to find those spots around the world.”
Economic Backbone
That conservative model of investing in “economic backbone assets” has served the parent company well over the years as it amassed $220-billion worth of assets under management. The Canadian company, which was established in 1899 in Brazil as Brascan, is now larger than the biggest pension funds in the country, including Canada Pension Plan Investment Board, taking into consideration currency conversion, which has about $273-billion (Canadian) under management.
The company’s value has soared along with its assets. Brookfield shares have risen fourfold since the end of the financial crisis in 2009, for a market value of more than $28-billion. That’s in line with Blackstone, and more than twice as big as New York-based KKR.
Brookfield is in the midst of raising an additional $25-billion to fund future acquisitions. Flatt said the pace of growth at Brookfield is largely due to its scale and its presence in more than 30 countries across four diverse investment areas including power, infrastructure, real estate and private equity.
China Rebound
Brookfield is devoting “significant” resources and people in China to reap the benefits of long-term growth in the world’s second-biggest economy.
“Five years from now and 10 years from now there will be amazing opportunities to be in the country” Flatt 50, said. “It will be great to be there.”
Flatt has a similar take on Brazil, which he describes as a “mess” right now, with the currency and economy plunging.
“This country is going to come around,” Flatt said. “We’ve continued to put money into the country over the last while.”
Bridge to Canada
One area that is once again showing promise is at home in Canada, where the weak Canadian dollar is creating some buying opportunities, Flatt said. Canada has pledged to double its infrastructure spending over the next decade to $125-billion. Brookfield would consider participating in that, Flatt said.
“Canada is still a great place to invest,” he said. About 10 per cent of Brookfield’s portfolio is in the country, compared with about 50 per cent in the U.S, he said. “It probably ranks as good or better than the United States, in particular because of our heritage.”
“I’d say maybe for the first time in a long time, there may be opportunities for us to put more money into work in Canada,” he added.
These, along with Blackstone (BX), Carlyle Group (CG) and KKR (KKR), are all great stocks to own in any retirement portfolio as they pay out decent dividends and are long term plays. They've all taken a hit lately but private equity and alternative investments are here to stay as underfunded pensions struggle to make their target rate of return.
Before I forget, Aaron Vale of Caledon Capital Management sent me a message to highlight an event the Toronto CFA Society will be hosting on February 11th:
The event is titled Mexican Infrastructure and Energy Opportunities. I think the topic is extremely timely and useful for anyone interested in learning more about the Mexican infrastructure and energy landscape. The panel will include two local participants with relevant government and private sector transactional experience. I personally have worked with both gentlemen and can attest to their knowledge and credibility. The event will also allow for networking and Q&A. Further details are in the link below:Mark the date, February 11th, and if you're interested in Mexican infrastructure and energy opportunities, please support Aaron and attend this conference.
https://www.cfatoronto.ca/cfast/Content/Site_Navigation/Events___Courses/Event_Detail.aspx?title=16MEXICAN
I am organizing so it would mean a lot to me if you were able to pass along to anyone that you think might be interested.
Below, Brookfield Asset Management CEO Bruce Flatt oversees the world's second-largest alternative asset manager. Bloomberg anchor Erik Schatzker sat down with Flatt for an exclusive interview about his firm's investments in real estate, infrastructure, renewable energy and private equity. Great company and a true Canadian and global powerhouse. Listen to Flatt's comments below.
Also, regulators failed banks before the financial crisis, then stifled the industry’s recovery in Europe, according to Blackstone Group LP Chief Executive Officer Steve Schwarzman.
Schwarzman, speaking at the World Economic Forum in Davos, Switzerland, sparred with Dutch Finance Minister Jeroen Dijsselbloem over the effect of rules imposed on financial markets. The panel also featured Brian Moynihan, CEO of Bank of America Corp., Standard Chartered Plc CEO Bill Winters and Min Zhu, the International Monetary Fund’s deputy managing director.
Schwarzman also talked with Bloomberg's Erik Schatzker about the 2016 presidential race, Bernie Sanders, and Donald Trump, stating the rise of Sanders is even more stunning than that of Trump." Not really, Americans are fed up of gross inequality backed by Congress and I think professor Cornel West is right, "brother Bernie" will surprise everyone in 2016.
Lastly, Schwarzman appeared on CNBC and Fox Business stating it would be an overreaction to say the current global economic conditions in China are reminiscent of the financial crisis in 2008. Listen to his comments below, all very interesting.
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