Private Equity Generates Big Returns, Big Controversy
So what types of conclusions can we make about private equity? University professors Steven Kaplan and Per Strömberg have recently published a paper on the topic entitled Leveraged Buyouts and Private Equity. In it, the authors take a comprehensive look at the research about private equity. They also make some interesting predictions. Let's take a look.
Big Bucks In It For General Partners
For starters, who benefits? Clearly, the general partners of private equity firms have reaped huge rewards. The typical compensation structure is to get 1% to 2% of the assets under management and 20% to 30% of the profits from the portfolio returns. On mega funds -- such as over $5 billion or so -- the compensation can be enormous.
In some cases, the general partners have turned into billionaires, as seen with KKR's Henry Kravis and George Roberts; Blackstone's Stephen Schwarzman; TPG's David Bonderman and James Coulter; Apollo Management's Leon Black; and the Carlyle Group's Daniel D'Aniello, David Rubenstein and William Conway.
However, besides creating a new class of the super-wealthy, private equity has also generated substantial returns for shareholders. To buy a company, a private equity firm needs to pay a premium over the current stock price, which can range from 15% to 50%. Because of this, it should not be surprising that buyout booms often occur during bull markets, say between 1983 to 1987 and 2003 to 2007.
Finally, if the private equity firms successfully pay down debt and restructure operations of their portfolio companies, there should be high returns for limited partners. These investors are mostly institutions like insurance companies, pensions and endowments.
Getting Harder To 'Flip' Investments
But a key question is, do the portfolio companies benefit?One knock against private equity is that the focus is on getting a quick "flip" on an investment. While there is little doubt the general partners love money, the fact remains that this fast-money strategy is extremely difficult to pull off, especially in light of the fickle debt and equity markets.
According to Kaplan and Strömberg, the general holding periods for investments has actually increased since the 1990s. In fact, only 12% of buyout deals were exited within 24 months.
So to generate strong returns, private-equity firms need to build up their portfolio companies. This is done by allocating hefty equity stakes to key managers, imposing comprehensive monitoring and finding ways to cut costs. Moreover, the high levels of debt may put pressure on management to perform better. The upshot is usually higher cash flows and stronger operational performance.
But doesn't this mean more layoffs? It's true. But as we've seen in the past couple of years, many companies have been aggressive with issuing pink slips. As global competition continues apace and it gets harder to find customers, companies have few options when it comes to maintaining margins.
Returns Likely To Be Meager For A While
Although, Kaplan and Strömberg does have an interesting finding on this topic. After a buyout, hiring tends to slow down -- not fall -- compared to similar firms.
Where do we go from here? If you look back at the history of private equity, there are certainly boom-bust cycles. Of course, the industry is now mired in the bust phase (since about 2008).
How long may this last? It could easily be 10 years. This was the case after the 1980s boom.
The main reason is that returns on funds are likely to be meager for some time because of the high prices paid from 2005 to 2007 as well as the difficulties in exiting investments.
More Deals In India and China Predicted
Despite this, the major private equity funds still have large amounts of cash and have shown an ability to evolve with the times. For example, we are likely to see some new trends emerge. First, expect more deals in emerging markets, especially in China and India.
Next, private equity firms are likely to take minority positions or even form joint ventures. This is in line with doing deals without lots of leverage. What's more, private equity firms may expand into new businesses, such as hedge funds, wealth management and investment banking.
So, as should be no surprise, somehow private equity firms will find a way to make the big bucks.
Tom Taulli is the author of a variety of books, including the including The Complete M&A Handbook. His website is at Taulli.com.