Penetrating to the Core of Private Equity Returns

by: Nadav Manham

I returned, and saw under the sun, that the race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favor to men of skill; but time and chance happeneth to them all. --Ecclestiastes 9:11

Nice guys finish last.--Leo Durocher

The NYT has a long and detailed case study of the Simmons Bedding Company, which was owned by a series of private equity companies in recent years. As a new student of the art and science of private equity manager selection, I read the piece with great relish.

The fundamental message of the article to someone in my position is that anyone evaluating a private equity fund must be able to disaggregate the returns of that fund, to isolate the various components that together form the "35% IRR" or whatever large number a fund uses to advertise its great success.

Not all of these components are created equal, and the private equity manager selector must judge which of these can ultimately be attributed to manager skill, which to luck, and which to simple greed that comes at a social cost. All three seem to have been on display in the Simmons saga.

Starting, like Dante, in private equity hell and moving heavenward, the practice of PE firms paying themselves management fees for running the companies they buy, or success fees for selling them, represents the least "worthy" form of private equity returns, the equivalent of a major stockholder/CEO of a company voting to give himself an enormous raise. I can't morally object to a PE firm, which is after all a fiduciary to its limited partners, engaging in this if it can get away with it, but this component of a PE fund's return should be given the least value when evaluating a PE manager.

(This wouldn't be an Investor's Consigliere post without a Buffett anecdote, so here it is: In 1996 Buffett sat on the board of Gillette when it purchased Duracell, the well-known battery maker. Kohlberg Kravis and Roberts (OTC:KPEQF), the buyout firm that owned 34% of Duracell at the time, demanded an "investment banking" fee of $20 million for its work on the deal, even though it was more properly the seller, not the banker (Morgan Stanley was). Now my adoration of Warren Buffett is second to no one's, but I think even he would confess that throughout his long career as a board member, he's been something of a.. wimp, holding his tongue even when he wanted to object to certain practices. In this case, however, KKR's demand so offended him that even though he favored the merger, he abstained from voting on it as a form of silent protest. End of anecdote.)

The next level up, call it PE Purgatory, are all the practices that come under the general heading of replacing equity with debt, which include the dividend recapitalizations mentioned in the article as well as the initial underwriting of deals. George Orwell, who had a lot to say about capitalism and human nature, pointed out that when the powerful call something X, they're often trying to hide the fact that X is really the X's opposite. Warren Buffett, another student of capitalism and human nature, has written that "private equity" isn't about equity at all, but rather about its opposite: debt.

The common denominator in these types of transactions is that, in exchange for some present benefit for the private equity buyer/owner (either leverage for its equity or, in the case of a dividend recapitalization, cash up front), the burden of the company's future success or failure shifts from owners to debt holders. It's complicated for a manager selector to evaluate the "worthiness" of these transactions, as they can involve manager skill, luck, and pure greed, or some combination of the three. For instance, a PE manager that is able to finance a deal with low-interest PIK bonds at a time when such bonds have willing buyers can be:

a) skillful, in the sense of protecting its equity from future cash flow problems in the business,

b) lucky, in the sense of being in the right place at the right time (e.g. NYC during a credit bubble), and/or

c) egregiously greedy, in the sense of having the chutzpah to sell something (as an insider) that it would never itself buy.

From the perspective of the manager selector, skill is always good. Lucky is good too, certainly better than unlucky, except for two problems: a) a PE fund that can only prosper when conditions are completely favorable won't outperform over the long term, and b) lucky people have a tendency to confuse their good luck with skill. Egregious greed is almost always bad, and not for moral reasons, which each investor must work out for itself. My objection to egregious greed is practical: it creates negative karma--not for the next life, but for the next deals. A PE fund that foists crappy debt on gullible bondholders once won't often get a chance to repeat the feat. A fund that borrows too much and must resort to mass layoffs to avoid bankruptcy will find its union pension fund LPs less than willing to invest in its next fund.

There is also a very subtle psychological downside to playing this game of replacing equity with debt, often in ever increasing proportions as in the case of Simmons. John Maynard Keynes famously described modern securities markets as

so to speak, a game of Snap, of Old Maid, of Musical Chairs--a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.

Modern private equity can be looked at similarly, although in this case the Old Maid being passed around is the inevitable (and it is inevitable) losses that will afflict bondholders and equity holders when rosy business expectations that prevailed on the days securities were sold don't pan out. Many PE players have had great success at this game, but it occurs to me that those who play it may forget that if you choose to play, no matter how good you are one day it will be you holding the Old Maid at the end of the game, or you without a seat when the music stops. In that sense then, to even play the game is to lose it sometimes.

Finally, we come to Private Equity Paradise, the noblest and most worthy components of PE returns, and the purest measures of manager skill. They are the ability to buy assets at bargain prices, and the ability to effect real and lasting operational improvements in the companies purchased. A manager selector fortunate enough to invest in a fund that derives most of its returns from these components will feel as Dante did when he saw Beatrice, either for the first time (take it away, Ridley Scott) or when they reunited in heaven (take it away, Signore Alighieri). Ultimately, nothing justifies the existence of the PE industry (and the fees it charges), either for its investors or as a social institution, but these two factors.

Having rambled at length on this subject, I must confess that I've never known of any PE fund that has tried to disaggregate the components of its returns like this. If someone reading this works in the industry and has seen it done, please let me know. Nor do I think it would be possible for someone from the outside looking in to attempt such a disaggregation with any precision. Therefore, I suppose, we as manager selectors must console ourselves with the various qualitative efforts we can make to penetrate the essence of a given fund's returns.