Reprinted courtesy of the National Post
by Tom Bradley

I have a friend who’s a private equity manager. He loves to tell me the public markets are broken and investing privately is the only way to go. He argues that CEOs are too focused on quarterly earnings and not enough on long-term value creation. And stock prices are way more volatile than the underlying businesses.

Certainly, managers like him have fewer short-term issues to worry about. They can do deals that public companies can’t do for fear of spooking their shareholders. That may include: buying private companies, tuning them up and taking them public at much higher valuations; rationalizing industries by amalgamating a number of smaller players; and carving out divisions from large companies. And it’s all done using liberal amounts of debt.

I have to admit, he has many good points, but the discussion has another side to it. Private equity also has tradeoffs that investors must be aware of.

Reality Check

As the name connotes, private investing means your assets are illiquid. You’re committed for a number of years and even then, there’s no guarantee you’ll get your money back on schedule.

I’m referring to private equity pools with 10-12 year terms, private lending arrangements and investments closer to home like providing a mortgage to a niece or backing a friend’s company.

Private investing is more labour intensive and as a result, costs more to access. Most funds carry a healthy base fee (usually 2%) and the manager gets 20% of the profits. This is not cheap at a time when you can index public equities for next to nothing.

Private equity managers talk about their freedom to pursue value, but rarely mention their biggest constraint. After capital is raised, they have to spend it within a certain period — a bulk of it in the first two years and the rest within three to five. If that period is characterized by high valuations and an abundance of capital, the results are likely to be disappointing. Like any investment, the most important factor driving returns is the price paid.

And I’d be remiss if I didn’t point out that it’s hard to compare the performance of your privates with your other investments. Managers show how many times your capital has multiplied, but rarely report in public market terms.

It’s been discovered

Now, private equity managers like to tell you about the deal that nobody else saw, but the reality is their opportunity set has been diluted. Skulking in the shadows undetected is harder to do. Industry stats suggest firms have raised a trillion dollars from investors, which triples with leverage. Three trillion dollars to spend means more bidders at the table and higher prices. Purchase multiples are up 25% over the last three years and the amount of leverage is on the rise. Indeed, many deals aren’t private at all, but rather premium bids for public companies, sometimes via an auction.

A veteran manager told me the days of simply buying a company, cutting costs and taking it public are over. Current valuations require growth to make investments work.

In this regard, it’s interesting to watch as private equity firms increasingly “pass the parcel,” which refers to selling an investment to another private equity firm. In other words, a sophisticated seller transacting with a sophisticated buyer. It begs the question — who’s the patsy?

Lingering questions

After years of researching private equity, I’m still wrestling with a number of questions.

How much of my portfolio should be in illiquid investments?

How much extra return do I need to justify the lack of liquidity and higher leverage?

Can I get into the good funds? The leading managers seem to be able to stay on top.

How critical is cheap credit? Lenders have thrown money at private equity firms in recent years. If they get stingier, will returns be impacted?

Does three trillion dollars overwhelm the potential opportunities?

If managers are increasingly bidding for public companies, should I try to be on the other side of the trade?

The debate rages on, at least in my mind. If you’re ready to go private, however, be cognizant of the tradeoffs and ask lots of questions.