Private equity - the new kings of capitalism?
"Private equity is a broad term that refers to any type of equity investment in an asset in which the equity is not freely tradable on a public stock market. Categories of private equity investment include leveraged buyouts, venture capital, growth capital, angel investing, mezzanine capital and others"
Investordictionary.com
FT:
"The data is murky, but LBOs and venture capital may account for a fifth of equity capital employed in Europe and the US. JP Morgan thinks it accounts for a similar chunk of current merger and acquisition volume. This activity is now focused on buying quoted companies. (...)This shift from public to private ownership will accelerate. The industry has raised $250bn this year, according to Private Equity Intelligence. Assume this is leveraged up by four times, and it implies almost enough fire-power to take the entire French market private"
"In a perfectly efficient economy, private equity would have only one, modest advantage: legitimate access to privileged information. Since they buy entire companies, private equity buyers can get access to the books. In the real, inefficient world another advantage exists: management. Private equity, it is argued, bypasses the agency problem inherent in public markets. Its managers are incentivised, put under pressure by high gearing, and free from red tape and the quarterly earnings shackle"
"Only some businesses can outperform or be relatively efficient. Talented managers are by definition scarce. (...) That leaves the remaining, claimed, advantage that private equity understands leverage better than public equity. Nobel prize winners Modigliani and Miller showed that, in a zero tax world, a company's enterprise value is not altered by its level of debt. In the real world, debt creates a tax shield, but the value of this is often grossly exaggerated. Moving a typical company's debt from 25 per cent to 75 per cent of EV creates a tax shield worth about only 10 per cent of EV. Similarly the argument that private equity has just been quick to adapt to low real interest rates is, again, overstated. The roughly 200 basis point fall in real sovereign interest rates in the last decade, assuming constant interest cover, justifies a moderate increase in gearing. Furthermore, lower risk-free rates also reduce the cost of equity too"
"Finally, often ignored, are private equity's disadvantages. Illiquidity is one. This is hard to quantify but might add 1 per cent to the cost of capital. Most glaring, however, is the fact that private equity has to pay more for assets than public equity investors: to wrestle a business from the market, it has to pay a premium for control, despite having no industrial synergies in most cases. As an asset class, this is a pretty major drawback"
"So, private equity has soft advantages and some hard disadvantages. Leverage allows it to take more risk, not to generate better returns. It should probably not outperform public markets. Does it?"
"Any private equity firm worth its salt can produce impressive internal rate of return (IRR) statistics. However these lack rigour. The valuations are produced internally. Failing funds may choose not to report. And IRR calculations are flawed. They assume dividends paid out to investors can be reinvested at a fund's overall return rate (rarely the case). This also means they are flattered by paying dividends early"
"Various academics have tried to overcome this. The most famous study by Steve Kaplan and Antoinette Schoar looked at 746 mature or liquidated funds between 1981 and 2001. It concluded that, after fees, some funds do well consistently, but overall returns were in line with the S&P 500. Most other research backs this up. Furthermore, these returns are not risk adjusted. Private equity volatility is not disclosed meaningfully. But with gearing 3-4 times public market levels it would be astonishing if it were not relatively high"
Investordictionary.com
FT:
"The data is murky, but LBOs and venture capital may account for a fifth of equity capital employed in Europe and the US. JP Morgan thinks it accounts for a similar chunk of current merger and acquisition volume. This activity is now focused on buying quoted companies. (...)This shift from public to private ownership will accelerate. The industry has raised $250bn this year, according to Private Equity Intelligence. Assume this is leveraged up by four times, and it implies almost enough fire-power to take the entire French market private"
"In a perfectly efficient economy, private equity would have only one, modest advantage: legitimate access to privileged information. Since they buy entire companies, private equity buyers can get access to the books. In the real, inefficient world another advantage exists: management. Private equity, it is argued, bypasses the agency problem inherent in public markets. Its managers are incentivised, put under pressure by high gearing, and free from red tape and the quarterly earnings shackle"
"Only some businesses can outperform or be relatively efficient. Talented managers are by definition scarce. (...) That leaves the remaining, claimed, advantage that private equity understands leverage better than public equity. Nobel prize winners Modigliani and Miller showed that, in a zero tax world, a company's enterprise value is not altered by its level of debt. In the real world, debt creates a tax shield, but the value of this is often grossly exaggerated. Moving a typical company's debt from 25 per cent to 75 per cent of EV creates a tax shield worth about only 10 per cent of EV. Similarly the argument that private equity has just been quick to adapt to low real interest rates is, again, overstated. The roughly 200 basis point fall in real sovereign interest rates in the last decade, assuming constant interest cover, justifies a moderate increase in gearing. Furthermore, lower risk-free rates also reduce the cost of equity too"
"Finally, often ignored, are private equity's disadvantages. Illiquidity is one. This is hard to quantify but might add 1 per cent to the cost of capital. Most glaring, however, is the fact that private equity has to pay more for assets than public equity investors: to wrestle a business from the market, it has to pay a premium for control, despite having no industrial synergies in most cases. As an asset class, this is a pretty major drawback"
"So, private equity has soft advantages and some hard disadvantages. Leverage allows it to take more risk, not to generate better returns. It should probably not outperform public markets. Does it?"
"Any private equity firm worth its salt can produce impressive internal rate of return (IRR) statistics. However these lack rigour. The valuations are produced internally. Failing funds may choose not to report. And IRR calculations are flawed. They assume dividends paid out to investors can be reinvested at a fund's overall return rate (rarely the case). This also means they are flattered by paying dividends early"
"Various academics have tried to overcome this. The most famous study by Steve Kaplan and Antoinette Schoar looked at 746 mature or liquidated funds between 1981 and 2001. It concluded that, after fees, some funds do well consistently, but overall returns were in line with the S&P 500. Most other research backs this up. Furthermore, these returns are not risk adjusted. Private equity volatility is not disclosed meaningfully. But with gearing 3-4 times public market levels it would be astonishing if it were not relatively high"
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