Private equity is leveraged capital
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Is anyone reading this? I do not think so. It’s Friday before Labor Day weekend. I love having detective stories and beer and imagining all the readers without a blanket on the beach. But I think today’s letter (another stab at interpreting the mixed performance of private equity funds over the past decade) will still be interesting to read at the end of September.
Monday is a public holiday. Unhedged will be back on Tuesday. Please send me the email: [email protected]
What’s so great about private equity? (part 2)
On Wednesday I wrote about this data from Cliffwater and other similar data. It shows the realized returns of a set of government annuities of different asset classes.
Industry-wide equity and private equity investments have roughly the same annual returns after commissions over the past decade, compared on a similar basis. Everyone seems to agree with this basic point (if you have any evidence of objection, please send it to us).
What should I think of this if I manage a large pension fund? Should I be happy? After all, an increase of 13% per year for 10 years is a good way to get rich. Or should I be disappointed because the reason I entered the EP is to outperform the stock?
A standard A case of disappointment is that PE has not only recently offered returns like stock indices, but has also surprisingly enriched some PE fund managers. But Unhedged doesn’t really care whether the manager gets rich or not, whether it’s worth it or not. What matters is the return to investors.
But there is another debate on the disappointment, the debt. According to Bloomberg, the S&P 600 Small Cap Index (most PE transactions involve SMEs) has an average debt to ebitda ratio of around 3. According to PitchBook, the average debt to ebitda ratio for PE transactions is double. . If my calculations are correct (assuming an enterprise value / ebitda ratio of 13), that means the manager can leverage the equity index at around one-third to create some sort of synthetic PE. This is called “leveraged equity”. This means that you can buy $ 1 in the index with your own 70 cent money and a 30 cent margin. And their yields would have been better than PE over the past decade.
It’s the same as claiming that PE’s risk-adjusted returns are worse than stocks because PE’s leverage is much higher and leverage is risk.
But this argument is at least partially false. Suppose there is a recession and the stock market has fallen 30%. The owners of the leveraged equity portfolio will be charged a margin and be eliminated. However, private equity fund investors benefit from a nice drop in price from the fund’s salary accountant sissy and their investment survives.
The cash flow of companies held by PE funds will also decrease, but the cash flow will not fluctuate as much as the share price, so the possibility of write-off will be low. And if any of the companies in the portfolio are at risk of going bankrupt, the fund dilutes investors with uninvested cash or by injecting new money, but the companies eventually recover. If you do, you can support them by protecting them from larger losses.
To generalize, much of the value created by PE (almost everything?) Comes from the fact that investor money has been trapped for years and the investment itself is not commercialized. This allows PE managers to choose when to buy, when to sell, when to invest money and when to withdraw money. Public companies that are hostage to stock prices do not benefit from this option. This option is valuable in allowing PE funds to use more leverage.
It is real value. I can’t fathom the fact that how much is just optical value, that is, private equity investments are so easy to value that they appear to be less volatile than public equity investments, and how much they really are. And without that understanding, it’s unclear whether or to what extent the returns reported by PE should be risk-adjusted.
However, the apparent volatility of the PE is very low and we know that institutional investors are very concerned about the underlying risk. This is a slide from a PE investing presentation compiled by a very large retirement manager (sent by a reader). Whoever created the slide calculated the volatility of a small cap with leverage (little blue diamond) and compared it to the volatility of a PE (brown square).
Notice the big blue arrow text. The enthusiasm of managers is the low volatility observed in the PE compared to leveraged stocks. Interestingly, the slides don’t show how private equity is leveraged. It is the same for the rest of the presentation. In other words, if the observed volatility is low, the leverage effect is not an associated risk.
Yet leverage clearly contributes significantly to PE returns, and skillful management of leverage is the primary means by which PE fund managers create value. Industry is not always willing to report it. In 2016, KPMG unveiled an excellent report produced Written by Peter Morris, a “value bridge” methodology that breaks down income streams is popular with some in the PE industry. Surprisingly, it almost completely rules out leverage as a source of return.
The mechanism is as follows. The PE fund buys a business for X and sells it for Y a few years later. The Value Bridge breaks down its increase in value (YZ) into three parts. The increase in the company’s earnings, earnings multiples, and the amount of debt added or repaid by the company while it was owned by the private equity firm are adjusted to the dividend paid to the manager.
All of this is true and just as it goes. The problem is, we don’t treat the leverage used to acquire the business as a source of income. Compare that to buying a house. If you buy a house for $ 1 million, get a mortgage for $ 800,000, and later sell your house for $ 1.2 million, your money will double (not including interest payments). But I haven’t doubled the value of the house. Most of the value has been created through leverage. This fact deserves to be mentioned in the evaluation of my genius as a real estate investor.
I know what you are thinking: Value Bridge looks so much like Jae-joong that good companies can no longer use it to explain where the value of private equity funds comes from.
Well, here’s a passage from the IPO prospectus of Bridgepoint, a London-listed private equity firm announced in July.
From 2000 to 2020, it is estimated that 77% of the total profitable investment value creation will be driven by the growth and improved income of Bridgepoint private equity funds, and an additional 25% will be eliminated due to offshoring. . Driven by multiple extensions of. The proportion of portfolio companies for growth and specialization is slightly offset by (2) percent of deleveraging.
It is a value bridge that is acceptable, so the leverage in buying investments is not even mentioned as a source of return. Everything in the paragraph is true. It’s really strange.
Does the massive use of leverage by private equity mean that investors need to discount the industry’s reported returns, or can private equity firms manage the risk of leverage? the sink ? do not know. However, the returns reported in the industry are almost indistinguishable from the returns available in the public market, so investors are right to ask.
A good read
Real estate under the Tokyo Imperial Palace during the 1980s bubble Most valuable of all real estate in California. Now the shoes are on the other leg. Only four US companies are worth more than the entire Japanese stock market.
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