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Is anyone reading this? I kind of hope not. It is the Friday before the Labor Day weekend and I prefer to imagine all Unhedged readers on a beach, with a detective novel and a beer. But I suppose today’s letter — another stab at interpreting private equity’s middling performance over the past decade — will still be interesting if read later in September.

Monday is a holiday. Unhedged will be back on Tuesday. Email me:

What’s so great about private equity? (part two)

On Wednesday, I wrote about this data from Cliffwater, and other data like it. It shows the realised returns of a whole bunch of state pension plans from various asset classes:

Stocks investments and private equity investments, industry-wide, have delivered about the same annual returns after fees over the past decade, when compared on a like-for-like basis. Everyone seems to agree on this basic point (if you have evidence to the contrary, please do send it along). 

If I’m running a big pension fund, how should I feel about this? Should I be happy? After all, compounding for 10 years at 13 per cent a year is a good way to get rich. Or should I be disappointed, because the whole reason I got into PE is because it’s supposed to outperform stocks? 

One standard case for disappointment is that PE has delivered equity index-like returns recently, but also made some PE fund managers amazingly rich, and this is dumb and annoying, because the managers didn’t really do much to earn all the treasure. But Unhedged doesn’t really care if managers get rich, whether they deserve it or not. What matters is returns to investors.

But there is another argument for being disappointed, an argument about debt. According to Bloomberg, the average debt/ebitda ratio for companies in the S&P 600 small cap index (most PE deals involve small companies) is about 3. The average debt/ebitda ratios of PE deals, according to PitchBook, is twice that. If my maths is right (assuming an enterprise value/ebitda ratio of 13) that means that a manager could lever the equity index up by about a third and create a sort of synthetic PE — call it “leveraged equity”. That is, they could buy each dollar of the index with 70 cents of their own money, and thirty cents of margin debt. And their returns would have been better than PE over the past decade. 

This is the same as arguing that PE’s risk-adjusted returns were worse than equities, because PE is a lot more leveraged and leverage is risk.

But this argument is at least partly wrong. Say there is a recession and the stock market goes down by 30 per cent. The owner of the leveraged equity portfolio gets a margin call and is wiped out. But the investor in the private equity fund gets a nice gentle markdown from the wimp of an accountant on the fund’s payroll, and their investment survives. 

The cash flows of the companies owned by the PE fund fall too, but cash flows are not as volatile as stock prices, making the chance of a wipeout lower. And if any of the companies in the portfolio do threaten to go bust, the fund can prop them up, either with uninvested cash, or by putting new money in — diluting the investors, but protecting them from bigger losses, if the companies eventually recover. 

Generalising the point, a lot of the value that PE creates (Most? All?) comes from the fact that the investors’ money is locked up for many years and the investments themselves are not marked to market. This gives the PE manager an option of when to buy, when to sell, when to invest cash, and when to pull cash out. Public companies, hostage to the share price, don’t enjoy this optionality. This optionality is valuable because it allows the PE fund to use more leverage. 

It is real value. What I can’t figure out how much of it is merely optical value — the fact that PE investments just look less volatile than public equity investments, because they get easy marks — and how much of it is real. And without figuring that out, it’s hard to know if, or by how much, PEs reported returns should be risk-adjusted.

But we know the apparent volatility of PE is very low, and that institutional investors care about that a lot, whatever the underlying risks are. Here is a slide from a presentation about PE investing put together by a very, very large pension manager (sent to me by a reader). Whoever made the slide has gone through the effort of calculating the volatility of levered small caps (the little blue diamonds), and compared it to that of PE (maroon square):

Note the text in the big blue arrow. What the manager is excited about is the low observed volatility of PE compared to leveraged equities. It’s interesting that the slide does not note how leveraged the private equity is. Neither does the rest of the presentation. In other words, if the observed volatility is low, leverage is not a relevant risk.

Yet leverage is obviously a big contributor to PE returns, and competent management of leverage is the main way PE fund managers provide value. The industry is not always keen to point this out. In 2016, KPMG published an excellent report, written by Peter Morris, about the “value bridge” methodology of decomposing sources of return, popular with some in the PE industry. Amazingly, it leaves out leverage as a source of return almost entirely.

Here’s how it works. A PE fund buys a company for X and sells it some years later for Y. The value bridge breaks down that increase in value (Y-Z) into three parts: the increase in profits of the company while the PE firm owned it, the increase in the multiple of profits, and the amount of debt the company added or repaid, adjusted for any dividends paid to the managers. 

This is all true and fair as far as it goes. The problem is it does not treat the leverage used to buy the company as a source of return. Compare this to a home purchase. If I buy a house for $1m, get an $800,000 mortgage, and later sell the house for $1.2m, I’ve doubled my money (not including interest payments). I did not double the value of the house, though. Most of the value was created by the leverage. In assessing my genius as a real estate investor this fact bears mentioning.

I know what you are thinking: that the value bridge, as a way of describing where value comes from in private equity, sounds so jejune that proper companies can’t possibly use it any more.

Well, here is a passage from the IPO prospectus of the London-listed PE firm Bridgepoint, which came out in July:

From 2000 to 2020, an estimated 77 per cent of value creation across profitable investments has been driven by revenue growth and earnings improvement in the Bridgepoint private equity funds, with a further 25 per cent driven by multiple expansion at exit as a result of the repositioning of portfolio companies for growth and professionalisation, slightly offset by (2) per cent from deleveraging.

That’s the value bridge all right, and as such, leverage in the purchase of the investments is not even mentioned as a source of return. Everything in the paragraph is true. It’s just really weird.

Does the heavy use of leverage by private equity mean that investors should discount the industry’s reported returns, or can PE firms manage the leverage risk away? I’m not sure. But now that the industry’s reported returns are all but indistinguishable from those available in public markets, it’s the right question for investors to ask. 

One good read

Back in the Japan bubble of the 1980s, someone figured out that the real estate under the Imperial Palace in Tokyo was worth more than all the real estate in California. Now the shoe is on the other foot. Just four US companies are worth more than the entire Japanese stock market. 

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