Thursday, October 18, 2012

Private Equity: Too disruptive or not disruptive enough?

From my past blog posts, you should know that I am not a political blogger, but Mitt Romney’s background as a key player at Bain Capital has made private equity a hot topic this political season. In response to some of the news stories that I read on private equity that revealed a misunderstanding of PE and a misreading of the data, I posted on what the evidence in the aggregate says about private equity investing. Reviewing that post, I noted that PE fit neither side’s stereotype. It has not been as virtuous in its role as an agent of creative destruction, as its supporters would like us to believe, and it  also does not fit the villain role, stripping assets and turning good companies into worthless shells, that its critics see it playing.

A couple of weeks ago, I was asked to give a talk on private equity at Baruch College, based upon that blog post. That talk is now available online (in two parts) and you can get it by clicking below:
  1. https://baruch.mediaspace.kaltura.com/media/Private-Equity+Firm%3A+Friend+or+Foe+of+the+U.S.+Economy%3F+%28Part+1%29/1_fjg9aogk
  2. https://baruch.mediaspace.kaltura.com/media/Private-Equity+Firm%3A+Friend+or+Foe+of+the+U.S.+Economy%3F+%28Part+2%29/1_sagki2jm
The session is a little long (with the two parts put together running over an hour and a half). So, feel free to fast forward through entire sections, if you so desire. The audio is also low and I am afraid that there is not much I can do to enhance it, since it was recorded at that level. However, the iTunes U versions of these presentations have better audio and you can get them here:
 https://itunes.apple.com/us/itunes-u/zicklin-graduate-leadership/id556092137?mt=10
I have also put the powerpoint slides that I used for the session for download and you can get to it by clicking here.

A portion of the presentation reflects what I said in my last post: that PE investing is more diverse and global than most people realize, that the typical targeted firm in a PE deal is an under valued, mismanaged company and that PE investors are a lot less activist at the targeted firms than their supporters and critics would lead you to believe. Here are a few of the other points I made during my talk (and feel free to contest them, if you are so inclined):

1. Why private equity? 
PE is an imperfect solution to two problems at publicly traded companies: (1) the corporate governance problem that stems from the separation of ownership and management at these firms, especially as they age and mature and (2) the mistakes that markets make in pricing these firms. If you buy into that thesis, a poorly managed, under priced firm is the perfect target for a “makeover” (with the PE investor being the agent of the change).

2. Who are these PE investors? 
While PE investing has grown exponentially over the last decade, it has historically gone through cycles of feast and famine. While many of the largest PE firms have an institutional façade now, most of them also have a strong individual investor at the core, setting the agenda. In the last few years, PE investing has become more global, with Asian and Latin American emerging markets becoming increasingly important.

3. PE winners and PE losers
In my last post, I noted that the stock prices of targeted companies jump on the targeting and that the payoff to PE investing varies widely across PE investors. Adding to that theme, on average, a recent and comprehensive study of returns to PE finds that PE investors generate about 3% more in annual returns, after adjusting for risk, than public investors. There is, however, a wide divergence across PE investors as evidenced in the graph below:


Thus, the top 10% of PE investors beat public investors by about 36% annually but the bottom 10% of PE investors underperform public investors by about 20% annually. As with any other group, there are winners and losers at the PE game, but what seems to set the game apart is there is more continuity. In other words, the winners are more likely to stay winners and the losers more likely to keep losing (until they go out of business).

4. Is PE a net social good or social bad? 
There are three critiques of PE investing. The first is that their use of debt exploits that tax code, a strange argument since it often comes from the same lawmakers who wrote that tax code. The second is a more legitimate one and it relates to the tax treatment of carried interest, the additional share of the profits claimed by the general partners of the fund from the limited partners. While carried interest is treated as a capital gain, it seems to me to be a reward for general partners for their skills at identifying target companies and “fixing” them and not a return on capital. If so, it should be taxed as ordinary income. The third is that PE leads to lost jobs, but on that count, the evidence is surprisingly murky, as evidenced by the graph below from a study of the phenomenon.



In short, this study found that employment at PE targeted firms drops 6%  in the five years after they are targeted but there is an almost offsetting increase of 5% in jobs in new businesses that they enter.

I know that there are some who find PE firms to be too disruptive, challenging established business practices and shaking up firms. Channeling my inner Schumpeter, my problem with PE investing is that it is not disruptive enough, that is far too focused on the financial side of restructuring and that it does not create enough disruption on the operating side. In short, I want PE investors to be closer to the ruthless, efficient stereotypes that I see in the movies and less like the timid value investors that many of them seem to more resemble. 

21 comments:

kayarkay said...

There is a good piece on this subject by David Stockman in this week's Newsweek.
"Mitt Romney: The Great Deformer"
http://www.thedailybeast.com/newsweek/2012/10/14/david-stockman-mitt-romney-and-the-bain-drain.html


From his forthcoming book:
The Great Deformation: How Crony Capitalism Corrupts Free Markets and Democracy due out, alas, past Nov-6th .. in March 2013.

Jean-Florent Rérolle said...

the link to your presentation does not work

Anonymous said...

What is the relative performance of similarly levered public investors??

Anonymous said...

I cannot hear half of the conference... there seems to be a problem with the microphone

Abhinav Tripathi said...

The link to the presentation is not working.

Jason DaCruz said...
This comment has been removed by the author.
Jason DaCruz said...

Professor,

I would add to your first point on "Why private equity" the information problem. PE shops can really tear through the books of a company. It may be costly (lawyers, accountants, due diligence consultants), but at least it is an available option. This idea ties happily to your previous post on financial disclosure.

As for the treatment of carried interest - the arguments for a break in taxes on capital gains v ordinary income are two fold: 1) it increases the amount of funds available to fund projects and 2) it encourages individuals to save.

I would be inclined to say that 1) is a general market distortion. In theory, the markets should do a fine job in smoothing capital allocations between the present and future. However, 2) may provide evidence that individuals are not always rational in their present v future consumption choices. Or, at the very least, they overestimate their earnings stability - especially for lower income individuals.

That last point - 'especially for lower income individuals' - provides the only justification for social engineering that I can see. A tax break on capital gains up to a certain point would stay true to our beliefs that markets, on average, are right while protecting individuals from a lack of savings.

Unfortunately, the above sounds like a political statement rather than an economic one...

-Jason

Aswath Damodaran said...

Jason,
Like you, I am not a fan of using the tax code for social policy but my point on carried interest is a simple one. Since it is an "excess" payment to general partners, over an above their capital contribution to the buyout, that excess payment has to be for something other than providing capital (which is the basis for your argument that it encourages savings & investment). What do general partners bring in besides capital? They are skilled at targeting the right companies, getting the information about them (as you rightly point out) and turning them around. All of these are very worthy "value added" actions, but they are "income" generating actions that come from skill, not the capital investment. I personally think that PE investors will be well served conceding the carried interest argument and fighting on other fronts.

Anonymous said...

I guess you have to have lived and worked in the PE environment to understand and feel the real difference in leadership under Public and Private financing. Often, ownership is shared between different PE firms and it would have been interesting if you would have digressed on that point. In addition, ownership may change hands between PE firms. It would be interesting to understand how valuation is established when ownership changes under private capital.

Aswath Damodaran said...

Anonymous,
Let's start with your premise. Let's assume that firms under PE experience a change in leadership and that is what accounts for success (I think that PE investors range the spectrum from very effective to completely ineffective). If carried interest is the payoff for leadership, it still does not take away from my point, which is that it is not a return on capital but a return to skills (income).

Anonymous said...

Aswath Damodaran,
A company under PE usually goes through two phases. The first phase is one of restructuring to make it ready for growth, usually taking 2-3 years. The second phase or growth phase is to maximize value to get the company ready for sale. These two phases take different skills and often you see a change in weighting of the owners during the phase transition. In the second phase, the owner with the largest share usually takes the lead in maximizing value to bring the company up for sale, often in an auction but also through an IPO or a sale to another conglomerate of PE’s, and the process starts all over.

I understand your premise that there are good and bad PE’s, like there are good and bad academic environments. What I was interested in learning is how you would think valuation works in the second phase of a company under private rather than public capital. So, when a company is ready to change hands from one group of PE to another group of PE, a price is negotiated for the sale. How does the underlying valuation work in that sale?

Jan Dil
The Netherlands

Jason DaCruz said...

Professor -

Sorry I didn't check in for your reply; I hope you get a chance to see this.

I think I misspoke when I left my commment - I meant to say that the carried interest tax treatment doesn't fall into either of my reasons for general preferential treatment of capital gains under the tax code. I am in agreement that PE should throw in the towel on their favorable tax status.

Jan Dil and a couple others were interested in learning more about these company valuations. I've worked with a few PE shops and have a basic understanding of how they forecast revenue and expenditure growth (usually through discussion with management and a rigorous analysis of their assumptions) for the holding period. Most of them then use earnings multiples -- usually the lesser of their own acquisition multiple or multiples of comparable companies -- to calculate a divestiture value.

I am very interested in understanding the capital structure analysis that goes into valuing these companies, though. What makes a good 'distressed' investment? Are these mostly management turn-arounds or is there a financial component?

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Financial Directory said...

Private equity is nothing more than a blood sucking way to drain the life and vitality out of a company in order to make a fast buck. Buy a company using lots of leverage. Along with some dirty little tricks like buying quietly a majority stake in a company behind everyones back without making a tender offer along with and including buying the shares at a big discount to what they are actually worth without declaring your intentions' to deceive investors. Than declare that your taking the company private and offer as little as possible for the remaining shares which are worth twice as much money as your offering for them and than say your saving the company what a bad bad joke. These private equity firms will do anything to come out ahead on the bottom line. Like sell all the real estate a company owns' sell or loan out patients and copyrights' tradmarks' pit one state against another threatening to move a division of their company to another state if they do not receive a subsidy or some generous tax breaks. Sell off divisions of the company that are undervalued. Fire as many workers as they possibly can' along with cutting the wages and benifits of the remaining employees to increase the bottom line. Squeeze price concessions from loyal vendors that are heavely dependent on a large part of their sales to your company. Tell your unions its take drastic cuts in wages and benifits or else risk having your plant shut down. And finally when you bring your company public again hire that so ethical investment banking firm goldman sachs to overhype the value of your public offering to increase the amount of money you will receive when the company becomes a public company again and at that point you bail out of the stock leaving a company torn into pieces from what it originally was.

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