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?
