If we compare the economy to a car, then we can say that private equity is like oil for this car. It is necessary to keep the economy running well but many dislike it. If you do not have oil in your car or private equity in the economy, your car engine as well the economy are likely to incur significant damage. Put too much oil in your car and the crankshaft will turn it into a froth, which is not good for lubrication. Similarly, too much private equity may not be as beneficial for the economy as excessive capital is chasing a limited number of opportunities, thus reducing everyone's return. Finally, similar to oil, a private equity fund has a limited life and after a certain time-period the fund returns the capital (hopefully appreciated) to the investors. The private equity firm has to start a new fund and the cycle repeats.
In this article, I will discuss three leading private equity firms: Blackstone (BX), Kohlberg Kravis and Roberts (KKR), and Fortress Investment Group (FIG). These three investment titans have gone public fairly recently. The article will list several reasons why their publicly traded shares (or common units) offer good entry point at current prices and especially after declining significantly from their IPO valuations (for Blackstone and Fortress). In addition, these three companies pay a decent dividend yield, which is something unavailable to direct investors in private equity funds. Finally, the article will look at the overall investment management industry and into the relatively strong position of these three firms.
Based on a price to earnings ratio, Blackstone, KKR, and Fortress shares trade at 9.6, 5.5, and 9.6 times their 2012 estimated earnings, respectively, which is favorable to the S&P 500, which trades at 13.7 times the 2012 earnings. Based on price to book value the shares of Blackstone, KKR, and Fortress are also attractive having a price to tangible book value of 5.1, 5.8, and 3.9, respectively, compared to 4.5 for the market. Numbers here can be misleading as private equity firms usually exit their investments at significantly higher values than they are kept on their books even in the current economic environment.
Since Blackstone, KKR, and Fortress went public in June of 2007, July of 2010, and February of 2007, respectively, only KKR's shares have had a positive return of 47% compared to a gain of about 20% for the S&P 500. One of the the reasons for this performance is that the company went public after the financial meltdown of 2008-9. Blackstone and Fortress shares are down 61% and 87%, respectively, compared to single digit losses for the S&P 500 during these periods. Clearly, private equity firms shares and valuations continue to be affected from the financial crisis.
In addition, their shares trading at multiples that are still lower from the pre-financial crisis. For example, Blackstone's price to book value in 2007 was 7.8 in 2007, more than 50% higher than its current levels. This valuation dropped to 2.3 for Blackstone, only to recover partially to its current level of 5.1. While there has been a slow-down in private equity activity, performance numbers for private equity funds have continued to outperform the general market as indicated in the Dealmaker's Journal.
It seems like the market has overreacted and a return to pre-crisis valuations should cause shares of Blackstone, KKR, and Fortress to rise. If anything, the crisis presented an opportunity for private equity to take advantage of the financial distress and negative public opinion many firms were experiencing during and after the crisis. Two recent articles described how Blackstone and Fortress are taking advantage of investments that banks and other investment institutions are avoiding - residential mortgages in the case of Blackstone and personal loans in the case of Fortress.
Investors in private equity funds have to wait years before they receive any of their investments back from the private equity firms. However, investors in the shares of Blackstone, KKR, and Fortress receive a quarterly dividend of $0.10, $0.13, and $0.05 per share, respectively, for an annualized yield of 2.9%, 3.6%, and 4.8%, respectively. Many financial firms that compete with pure-play private equity firms, such as the major investment banks, have to get approval from the Fed whether they can issue dividends and the amount of the dividend. In the case of private equity firms, the dividend amount is decided solely by the company. In addition, these three companies are able to pay dividends even though their net income is far less than the shareholder distributions.
The asset management business is very competitive and the demand for investment funds and key employees is fierce. Private equity firms have a clear advantage over other investment firms as they accept mostly long-term institutional investors and their strong profitability has allowed them to retain the best investment minds in the world.
While a mutual fund has to deal daily with inflows and outflows, once a private equity fund is established it can distribute money only after the fund expires or under special circumstances. This allows managers of private equity firms to have a long-term investment horizon and wait for their investments to pay out. A mutual fund that underperforms its benchmark for a few quarters in a row would likely see large outflows. Private equity funds have a longer-term investment horizon and managers have the flexibility to invest for the long-term ignoring short-term trends.
Since private equity funds deal with fewer but larger investors, they can partner more easily with their investors. In fact, many alternative managers are entering such partnership. Since Blackstone, KKR, and Fortress are some of the largest and best known alternative managers, they can enter into these strategic alliances even more easily than other smaller and less established private equity companies.
At current valuation levels, the publicly traded shares of Blackstone, KKR, and Fortress appear to be a good investment choice. The case for investing in these three companies is sweetened by a generous dividend yield that can compete with the yields of most long-term bonds. In addition, private equity firms appear to be more flexible than traditional investment mangers in taking advantage of market imbalances, enter into strategic and working partnerships with their investors, and retain the best possible investment talent. Despite their recent underperformance, investors should consider buying shares of Blackstone, KKR, and Fortress. Even though cars may not need oil in the future due to technological innovations, private equity's role in the economy should only increase from current levels.