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October 31, 2007

Private Equity's Boom Now Busting?
by Thomas Tan

There has been a great boom for the private equity (PE) sector last several years. And there are many discussions on what this sector as alternative investment have done to the financial market. For example, both Business Week and WSJ have cover articles recently discuss how PE firm Blackstone has got their full money back while lots of people at Travelport were being laid off after Blackstone's purchase. I don't think it is exaggerating to say that the public has reached a high level of negativity toward private equity industry. There are several factors contributing to this worth mentioning:

1) PE firms are getting more and more short term lately. In the good old days, PE firms more focused on improving the acquired firms in a long term basis. They took a long time to aim (improve) then fire (sell). These days, PE firms fire first before aiming, seeking very quick cash out. In such short term, there is no way to improve the company materially, and they basically jack up both sides of the balance sheet, increasing asset and liability, then cashing out on the asset and dumping the liability to the public. The problem on this is during an unfriendly credit tightening market like now, the public is holding the bag of those severely downgraded, low quality and risky bonds while the PE partners are cashing out with vast wealth in hand.

2) There is a very wide disparity between tax rates. A normal business, such as tobacco manufacturers, at least they are paying normal and full tax by buying and selling companies. However, due to the partnership structure, the tax rate of 15% is not even half of the typical corporation rate. What makes it worse, according to a recent Fortune article "More Sugar for Schwarzman", due to a tax loophole, PE partners are not even paying the 15% dividend tax rate as we thought they were paying, but 7% tax rate on their IPO cash out profit. The trick is to get paid back by 85% of Goodwill which is tax deductible and as a result effectively lowers tax rate from 15% to 7% on PE partners such as Blackstone. No wonder we see in the US that income distribution has become more skewed toward the top few rich and tax burden has heavily shifted to the average middle and working class.

3) The current tax system encourage higher debt since interest on debt is tax deductible, which encourages PE firms to increase debt thus interest deductible until little or no corporate tax is paid. This approach actually adds no value to the business and society but only risk to the public who is holding the debt. When many of these bonds are being downgraded from double A to double B a couple months ago, with credit tightening, spread widening and PE fund shrinking, suddenly the public such as the pension funds, the endowment funds and foundations have suffered large paper losses and taken a lot more risk now.

4) The recent PE boom reminds me about the junk bond boom in the 80s. With the junk bond market crashing, Savings & Loans under crisis, liquidity suddenly drying up, refinancing becoming a pipe dream, we saw major defaults on loans and many highly leveraged corporations financed by the junk bonds. Currently with the quick widening of credit spread (rating agencies from risk taking to risk averse), drying up of PE funding, lowering corporate profit margin, declining revenue and P/E trend, we can see not only many potential highly leveraged deals being dead, but also more importantly many complete deals will suffer heavy losses in the near future. Several months ago, all the computer models on this kind of PE deals built in the most optimistic assumptions, not sure they want to show off their models with the new assumptions now. A few months ago every institution was lining up to buy those PE financing rated AA, but now can't wait to dump these bonds to avoid any junks in their portfolio. It is noted that in the 80s one large bank (Drexel) failed and was used to be blamed on the whole junk bond and S&L crisis while public and tax payers were holding the bag and lost billions. This time, it will be very interesting to see whether any major bank and large PE firm would fail. No wonder why partners at major PE firms are competing with time to IPO and cashing out now.

I would also like to debate the common perception that the PE deal generates great return for investors. How good is their return really?

Let us study a hypothetical deal that a PE Firm A purchased Company B at $4B with $2B borrowing, a very typical deal these days. They netted around $1B from the IPO and subsequent sales, roughly 50% return of investment in 2 years. This sounds great. So let us do some very simple calculations on both return and leverage, no fuzzy math, only simple math, I promise.

The 1st is to see the influence of the leverage factor. If without leverage, the talented PE Firm A would achieve 25% ($1B/$4B) in 2 years, still very good, and I think this should be the real alpha we measure against benchmark. With 50% ($2B borrowing) leverage, the return becomes 50%, thus leverage explains 50% of the return without brining the talent management into the picture. If the borrowing increases to $3B (75% leverage), return becomes 100% ($1B/$1B), or 75% of the return is explained by leverage, not by real alpha. I do have a little problem on this, since for any money managers, as far as they use large leverage to select companies in random (no alpha achieved), their return could be close to talented mangers, or even better as far as they dare to use higher leverage.

Now let us turn to return calculation. Assuming PE Firm A paid 6% on its $2B financing. Then don't forget each year PE firm charges 2% on the asset, 2 year is 4% on $2B. Also don't forget PE firm takes 20% on the $1B profit, the typical 2+20 fee structure. If you are one of the foundations, endowment and pension funds invested in this PE deal, as a client, what is your return?

Your share of return is: $1B profit - $0.08B fee (2%*$2B*2 yr) - $0.2B PE profit cut - $0.24B interest ($2B*6%*2 yr) = $0.48B, or 24% return ($0.48B/$2B). Suddenly the same deal seems to achieve 50% return, the real return for clients is only half of it.

Capital market is a very speculative market. It all depends on people's perception on future economic situation. The higher the leverage, the more accurate PE firms have to get their timing correct. They need the timing for borrowing to fund acquisitions during a friendly credit market so the public is willing to purchase and hold those bonds. Then they need subsequent timing in the future for spin-off IPO in a friendly equity market so individual investors are willing to buy their stocks so they can cash out to realize profit.

Now use the same example above but let us say the equity market enters into a couple years of bear market in the future. The same deal now takes 5 years instead of 2 years to spin off in an IPO. What would the return for PE clients be?

The answer is ZERO. It is: $1B profit - $0.2B fee (2%*$2B*5 yr) - $0.2B PE profit cut - $0.6B interest ($2B*6%*5 yr) = 0. 5 years for nothing. The extra 3 years of interest payments and excessive 2+20 fee structure eat all the remaining profit. For all the corporate pension funds, state and local government retirement funds, endowment funds and foundations rushing to invest 10-20% of their investments into private equity these days, do they realize investing in 5% US treasury per year (27% for 5 years compounding) would actually offer better return and carry no risk at all (except the risk of holding US dollar)?

Even better, if the public and all these funds can invest only 5-15% in precious metals and mining companies, it will offer even better diversification, probably better return in the future, and better protection from inflation, especially better security from devaluation of US dollar.

Thomas Tan, CFA, MBA
www.investorwalk.com

Disclaimer: The contents of this article represent the opinion and analysis of Thomas Tan, who cannot accept responsibility for any trading losses you may incur as a result of your reliance on this opinion and analysis and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Do your own due diligence regarding personal investment decisions.

Copyright © 2006-2009 Thomas Z. Tan

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