Private Equity Returns: You May Do Better With Treasuries

After my post on private equity boom and bust, one reader has presented a very good example to showcase how strong a return private equity can achieve.

The example: Blackstone (BX) spun off Celanese toward the end of last year. They bought CE in fall of 2004 at almost $4B ($3.9 B) with $2B borrowing. They netted around $1B from the IPO and subsequent sales, achieving 50% of investment in 2 years. This sounds very good. So I decided to do some very simple calculation on both return and leverage, no fuzzy math, only simple math, I promise.

The first is to see the influence of the leverage factor. If without leverage, the talented PE managers will achieve 25% ($1B/$4B) in 2 years. This is still very good, and should be the real alpha if we measure against benchmark. With 50% ($2B borrowing) leverage, the return becomes 50% - thus leverage explains 1/2 of the return without bringing the talent management into the picture.

If the borrowing increases to $3B (75% leverage) as many deals these days, return becomes 100% ($1B/$1B), or 3/4 of the return is explained by leverage, not by real alpha. I do have a little problem on this, since for any stupid money managers, as far as they use large leverage to select companies in random (no alpha achieved), their return could be close to talented managers at BX, or even better if they dare to use higher leverage.

Now let us turn to return calculation. Assuming BX paid 6% on its $2B loan. Then don't forget each year PE firms charging 2% on the asset, 2 year is 4% on $2B. Also don't forget PE firms will take 20% on the $1B profit. So if you are one of the endowment and pension funds invested in BX, as a client, what is your return? Your share of return is: $1B profit - $0.08B fee (2%*$2B*2 yr) - $0.2B PE profit cut - $0.24B interest ($2B*6%*2 yr) = $0.48B, or 24% return ($0.48B/$2B). Suddenly the same deal seems to achieve 50% return on paper, but for clients of PE firms, the actual return is only half of that.

Capital market is a very speculative market. It all depends on people's perception on future economic situation. The higher the leverage, the more accurate PE firms have to get their timing right. They need the timing to borrow to fund their acquisitions during a friendly credit market thus institutions are willing to buy those bonds. Then they need subsequent timing in the future to do IPO in a friendly equity market thus individuals are willing to buy and own stocks so PE firms can cash out to realize profit.

Now use the same example above, but let us say the equity market enters into several years of bear market and takes longer than 2 years to improve and sell. The same deal takes 5 years instead of 2 years to spin off in a IPO (which was typical in those good old days). What would be the return be for BX clients?

The answer is zero. It is: $1B profit - $0.2B fee (2%*$2B*5 yr) - $0.2B PE profit cut - $0.6B interest ($2B*6%*5 yr) = ZERO. 5 years for nothing. The extra 3 years of interest and fee eat all the remaining profit.

For all the corporate pension funds, state and local government retirement funds, endowment and foundation funds rushing into alternative investment these days, do they realize investing in 5% US treasuries per year (27% return in 5 years compounding) could actually be a better return and carry no risk at all?

Comments

[Andrew]

Point well taken. Private equity investment is risky proposition, and no one should invest in private equity (or any other types of investments) without a sound understanding of the fundamental drivers and management competency. However, private equity firms are not all created equal. The consumer retailer analogy would be Target vs. Kmart. They both sell basically the same commodity products, and both management teams understand profitability is driven by pricing, inventory turnover and logistical efficiency. Yet, year after year Target just out performs Kmart (and Wal-Mart).

Recent credit market events will lead to credit tightening, which in turn will hurt many people from individual real estate investors to private equity groups. But, the raised bar will also provide long term opportunities for those that are truely good at their business. Globalization will create more opportunities for knowledge arbitrage....from opening coffee shops to acquisitions.

Private equity gets a lot of bad press, but it creates a source of competition for "strategic" investors (i.e. companies already in the business), which is good for individuals investors and consumers.

For example, Daimler paid $35 billion in 1998 to "merge" with Chrysler. They are now selling Chrysler for $7.4 Billion. I would submit that the individual investors of Daimler got the worst of this one, since senior management are still collecting paychecks and bonuses. Remeber Tyco, MCI? How strategic were those acquisitions?

Another example that is closer to home. Remember the last round of consolidation of oil majors at the turn of the century (always wanted to say that)? How has that worked out for us as consumers? Now most of us are scared to divest from energy stocks because it's our only hedge against inflation.

To come full circle with some irony.... I submit that much of the recent volatility from hedge fund trading and private equity run up came from the petro dollars that left our wallets to the oil exporting nations'.

The bottom line is that capital markets are a double edged sword. Our mantra should not be good vs. evil, but rather "caveat emptor".

I'm not involved with hedge funds or private equity. I have recently started accumulating Blacktone Group.

2007 Aug 03 11:18 PM

[Thomas Tan]

Thank you very much for your comments, I agree with most of your points.

Besides energy stocks, I also feel that precious metals and mining companies will also provide hedge against inflation, probably even better hedge and less overvalued than energy stocks. The upside of this sector is far superior to energy stocks, IMHO. Also I think the consolidation of the mining majors acquiring minors has a long way to go to reach its pinnacle, while the oil sector has been.

2007 Aug 06 02:23 PM