Philip Purcell, president of Continental Investors LLC and former chairman and chief executive of Morgan Stanley, argues in the Financial Times that the $45bn buyout of TXU Corporation does not yet, given the nature of markets, signal a downturn for private equity
“Will private equity continue to outperform public markets? Is this good for the economy?”, asks Mr Purcell, “In both cases the answer is yes, because public markets are failing to allocate capital efficiently.”
Mr Purcell believes that “this is not a bubble but a cyclical trend that is likely to end only as public companies become more efficient.”
“Increased regulation of private equity or a radical turn in the credit cycle could affect the current dynamic,” argues Mr Purcell but “until then, private equity firms will continue to offer a classic capitalist response to a public market that is failing to allocate capital efficiently.”
Mr Purcell answers your questions:
Q: Has the intense competition among private equity firms bid up the prices of targets leading to unreasonable prices being paid for mediocre companies?
SK Tan, Hong Kong
Philip Purcell: The prices paid, as a multiple of EBITDA, have steadily increased the last few years as competition among private equity firms and strategic buyers has increased. It’s been fueled by plentiful low cost debt.
History would say that some buyers are over paying for assets which should lead to lower returns than in the past 15 years. Remember though, private equity investments in 2000 and 2001 represented serious “over paying” and they not only survived the down cycle but out performed public equities.
Q: What is the strategy of private equity firms in Africa (Carlyle, Citigroup) and can private equity be a economy driver for the continent?
Serge Massamba, Paris, France
PP: I don’t know how extensive the commitment of private equity firms is to Africa.
Q: If private equity has such a good future, why did you spin-off the private equity operation of Morgan Stanley while you were there, only to have your successor, John Mack, turnaround and get that firm back into private equity?
Kevin Murphy, New York. US
PP: Most investment banks are in the private equity fund business and they’ve done well. But they have to bid against other private equity firms, who are important clients, if they’re successful they have to compete with many of their industrial and financial clients. It is impossible to avoid these conflicts, although they can be managed.
At Morgan Stanley we were committed to a client first strategy and decided to avoid these conflicts. It is interesting to note that in 2004 after we spun off our private equity business we ranked first in global equity underwriting and first in global IPO underwriting for the first time in over 20 years. We also had our highest ranking in global debt underwriting.
Q: Arguably, taxing private equity companies’ interest is right in principle, and if this did happen, how far reaching would the possible consequences be?
John Jose, London, UK
PP: Changes in tax policy can dramatically affect the economics of any business. But without knowing the specific change it is almost impossible to forecast the impact on returns. So I don’t want to speculate on what changes in taxation might be or what impact they might have.
Q: Suggesting that non-executive directors require specific business experience and should not reflect a broad cross-section of society is damaging. Purcell ignores the fact that profitable and breakthrough business ideas are often generated outside narrow industry boundaries. Charles Schwab was a Wall Street outsider yet, he founded one of the fast growing brokerage firms of the past two decades.
Would an industry insider have conceived of the discount broker business model? Private equity and public markets are not either-or institutions. They have a symbiotic relationship, and many private equity companies return to public markets later in life. They can work together, but investors need to be fully aware of the implications of private and listed company investment in terms of their liquidity, transparency, and openness to new viewpoints. Bruce Weber, London Business School
PP: Public and private are two alternative forms of ownership that have important long-term roles in the economy. I agree they have a symbiotic relationship and both have pros and cons. Private ownership uses more financial leverage and is therefore more capital efficient. It is also better at tolerating short-term volatility and focusing on long-term value creation.
Public markets demand consistency and predictability that is difficult to achieve over long periods of time; that in turn places pressure on management to make decisions to meet quarterly numbers that might compromise long-term success. As you indicate, public markets have major advantages for investors in terms of transparency and liquidity. In terms of governance I believe public companies should have non-executive directors of varied experiences - not all business - and they should reflect a cross-section of society. I regret you read my thoughts in a different way.
Q: Your data on the historic returns from private equity does not tie in with academic research. Ludovic Phalippou and colleagues at the University of Amsterdam have conducted the most comprehensive and robust analysis of private equity returns, using the Thomson Venture Economics data but adjusting for a variety of biases. They find that private equity has underperformed the S&P 500 by 3.8 per cent p.a. since 1980.
This is without adjusting for risk. His research has been peer reviewed at industry conferences and by a number of private equity managers without any finding fault to date. Are you aware of this research and if so which aspects do you disagree with?
Mike Brooks, Edinburgh, Scotland
PP: I am not familiar with the research of Ludovic Phalippou and his colleagues. So I have no opinion on the validity of their research. What I do know is in the real world the returns of endowments such as Harvard, Yale, Stanford and Notre Dame all of whom were early investors in alternative products particularly private equity have significantly exceeded the returns of endowments that stayed in traditional public equity markets.
It may be they picked only the good private equity and hedge funds and outperformed by fund selection, but I think it is more likely that they outperformed primarily by allocating more money to private equity and alternative investments.
Q: In financial industry people often believe that history repeats itself. Last time private equity deals reached the same momentum, number of deals and huge premiums, the business was followed by a small correction. One example is Nabisco. What is different this time around?
PP: Nothing is different. In fact, with the tremendous amount of low cost debt available private equity firms are likely to overpay for some assets and there probably will be a correction. But there also will probably be a correction in the public equity markets so I continue to believe that over 5 and 10 year periods private equity returns will exceed those of the public equity markets.
Q: I agree with the fact that public markets are failing to allocate capital efficiently and that public companies lack good management. It seems to me though that pension funds and asset managers could very easily have the companies of their portfolios adopt the sound best practices of PE houses.
Thomas Puetter of Allianz said recently on this web site that the sad thing about PE is that it doesn’t actually do anything that a public company cant do itself. So I guess that if pension funds and asset managers put pressure on the management of the companies in which they invest so that this management start running their companies in the same way as do PE houses, that is to say: focus on the core business, focus on cash, focus on costs, focus management on success through better incentives schemes (focusing on their business performance vs the group share price) and essentially do not tolerate underperformance - have as much leverage as possible then they could internalise the PE practices and squeeze the value given up today to PE houses another way to view this is that basically pension funds and asset managers don’t do well their work today.
Don’t you think that this could happen very quickly and that when it happens, PE practices will dissolve into a widespread better management practice?
Abinal Thomas, London
PP: I don’t believe there’s any lack of good managers at public companies. The problem is the governance process is rightfully broader and therefore more expensive. The broader goals of publicly owned firms make it a more difficult to adopt all of the focused practices of private equity owned companies.
Alan Murray of the Wall Street Journal has described the problem very well, “in the post-Enron world CEOs have been forced to respond to a widening array of shareholder advocates, hedge funds, private-equity deal makers, legislators, regulators, attorneys general, non-governmental organizations and countless others who want a say in how public companies manage their affairs. Today’s CEO, in effect, has to play the role of a politician, answering to varied constituents.”
Q: Can you explain what will be the trigger for radical turn in the credit cycle and how it would undermine the viability of the PE business?
Florent Danset, Singapore
PP: I don’t know what the trigger will be, except that it almost certainly will be something we don’t expect and will not be widely predicted. I don’t think such a turn in the credit cycle will undermine the viability of the private equity business but rather lower the prices they can pay for assets and increase the amount of equity required. This may well lower returns on the equity but I expect it will come at a time when returns on public equity investments are also being adversely affected.
Q: What is the best way to take advantage of the growth prospects of China and India over the long term - 10-20 year horizon - for a private investor? Is it in a specialist managed fund, or a global fund with companies partly exposed to China and India? Connected, do you think these indices are currently overvalued (on a P/E basis)?
PP: I believe China and India have excellent growth prospects over the next 10 to 20 years. However, each of them is unique. Private investors should have experts in these individual markets each managing any investments they make. There will be high volatility in both markets. So I would only invest if I had a long time horizon and could ride out the down swings that are certain to come.
Q: What books or textbooks do you recommend on the subject of hostile takeovers? And secondly, is the current US economic environment conducive to major industrial hostile takeovers?
Antonio Madrid, California
PP: I don’t know of any good books on hostile takeovers.
Q: If the credit cycle were to become less accommodative, what immediate impact will this have on private equity funds? And if debt profiles within private-equity-owned companies become unmanageable, how long a lag time will it be before the wider market knows and impacts are felt within the banking system?
Melinda White, Sydney
PP: As the credit cycle becomes less accommodative, I would expect private equity firms to pay lower prices for companies and use less leverage. This probably will lead to lower returns which will reduce the huge flow of money in the private equity funds, making them a less important source for acquisitions. I don’t know if the debt profiles within private equity firms will become unmanageable, but a business cycle and credit cycle downturn will certainly lower private equity returns. I would expect some negative implications for the lenders but would not expect major effects within the banking system.
Q: Mr. Purcell, in your FT article of Mar 7 (Private equity will stay on a roll) you argued that private equity will continue to outperform public markets because the latter are failing to allocate capital efficiently. As it turns out now, it will be private equity powerhouse Blackstone - an until recently fierce public market opponent reportedly preparing to file for an IPO - who ironically will benefit from exactly that: the inefficiency of the public markets. I dare to doubt that an efficient public market would really value Blackstone at $40 billion - as it is reportedly the case in a conservative valuation scenario according to people familiar with the matter. This is by no means supposed to diminish Blackstone’s extraordinary track record. To the contrary. I also appreciate that Schwarzman’s timing is, once more, impeccable.
I just believe that $40 billion is exaggerated when compared to, say, Goldman Sach’s market cap of $80 billion. Would you say that a market cap of the Blackstone management company north of $40 billion would be (a) plausible and (b) reasonable? And secondly you wrote in your article that the private model and the public model will eventually converge. Given the latest developments (see Blackstone), wouldn’t you agree that we rather are already right in the middle of such convergence?
Thomas Tengler, M&A advisor, Austria
PP: I agree we’re seeing signs of convergence - Blackstone going public is also my favourite example. In addition, Fortress, KKR and Apollo’s BBC have subjected themselves to some of the perils of the public market. Looking ahead, private markets may also suffer from their own popularity resulting in increased regulation too much leverage and other complications. At the same time, public company regulators and markets will inevitably respond to the success of private markets and address the weaknesses in the public model to make it more attractive. I have no view on the Blackstone valuation.
Q: Which asset classes, and in what proportions, would you recommend for a family trust fund with a value of 250m which wants to develop a high return portfolio for the next 10 years? Please provide a brief rationale and explain the risks associated with your proposal.
Nicholas Gavrielides, London
PP: I recommend working with financial advisors who understand your financial goals and risk tolerance.
Q: As a young investor with around 10,000 to invest would you suggest seeking out individual special situations, a fund such as you run or an index tracker?
Ian Gardiner, London
PP: I recommend working with financial advisors who understand your financial goals and risk tolerance.
Q: On the back of the recent active involvement of hedge funds and private equity in the market, which is believed to be the main force in the yen carry trade, how would you capitalise on this investment theme globally?
PP: As an individual investor I would concentrate on longer term trends and opportunities not trading opportunities.