The mantra of the private equiteer is maximum return for minimum risk. However, I can’t stress enough that the empahsis is on minimum risk. You see, the magnitude of badness associated with a poor performing fund significantly exceeds the magnitude of greatness associated with an exceptional fund. Maybe not so in venture capital, but definitely so in private equity.
If I achieve a 10x return on my fund, LPs, other PEs and most others will say “they were lucky”. If I achieve a 0.5x return for the fund, everyone will say “they suck”. Both terms are pejorative (hey, life’s unfair), but in one scenario you get to boast 10x returns and in the other you don’t get to boast at all.
So back to the title of this post, equity returns for debt risk. Private equiteers essentially want all of the upside in a deal and none of the downside. In public markets you can achieve this by buying put options against a portfolio or though investing in call options. But we all know there’s a cost, and even with that cost, you rarely mitigate risk 100%.
To achieve the same in private equity, we invest via preferred stock, demand preferred coupons, have veto rights over many business decisions, take a board majority, have the right to fire senior executives, demand that managers invest, sometimes even demand redeemable preferred stock, etc. We are simply hedging our bets. But, like option strategies in public markets, the hedge isn’t perfect.
Where this idea of equity returns for debt risk really matters, is within a portfolio of assets. Public equity fund managers invest in equity returns for equity risk and that equity risk means that some investments succeed and some fail (and then transaction costs ensure most fund managers achieve sub-market returns).
In a private equity portfolio, our quasi-debt investments don’t incur as much loss from poor performing investments, so portfolio returns can conceivably be above public equity portfolio returns without investee performance being above average. Of course, this doesn’t hold when private equiteers overgear their investments, but think about this one without above-average debt. Especially in current markets, I see private equity characterised more by strict legal terms than mountains of debt. We have made two investments this year that are completely debt-free.
This is just another aberrant thought (following my response to The Economist article) on how private equity can beat public markets.