The barbarian establishment

Private equity has prospered while almost every other approach to business has stumbled. That is both good and disturbing

THIS year Henry Kravis and George Roberts, the second “K” and the “R” of KKR, celebrated their 72nd and 73rd birthdays, respectively. Steve Schwarzman, their equivalent at Blackstone, turned 69; his number two, Hamilton James, 65. In the past few months David Rubenstein, William Conway and Daniel D’Aniello, the trio behind and atop Carlyle, turned 67, 67 and 70. Leon Black, founder and head of Apollo, is just 65.

These men run the world’s four largest private-equity firms. Billionaires all, they are at or well past the age when chief executives of public companies move on, either by choice or force. Apple, founded the same year as KKR (1976), has had seven bosses; Microsoft, founded the year before, has had three. On average, public companies replace their leaders once or twice a decade. In finance executives begin bowing out in their 40s, flush with wealth and drained by stress. 

The professional longevity of the private equiteers—whose trade is the use of pooled money to buy operating companies in whole or in part for later resale—is thus rather remarkable. But do not expect to see a lot of fuss made about it. Since the uproar over a lavish 60th birthday party for Mr Schwarzman on the eve of the financial crisis (guests were entertained by his contemporary, Rod Stewart), such celebrations have become strictly private affairs. At KKR there has been little fuss over the company’s 40th anniversary—a striking milestone, given the fate of the institutions that previously employed the big four’s founders: Bear Stearns (gone), Lehman Brothers (gone), First National Bank of Chicago (gone) and Drexel Burnham Lambert (gone). The company has announced a programme encouraging civic-minded employees to volunteer for 40 hours.

Out of the private eye

There are good reasons for this low profile. The standard operating procedures of private equity—purchasing businesses, adding debt, minimising taxes, cutting costs (and facilities and employment), extracting large fees—are just the sort of things to aggravate popular anger about finance. Investors in private-equity firms (as opposed to investors in the funds run by those firms) have their own reasons to withhold applause. All of the big four have seen their share prices fall over the past year; Blackstone, Carlyle and KKR are all down more than 20%. Apollo, Blackstone and Carlyle trade for less than the prices at which their shares initially went public years ago (see chart 1). First-quarter earnings were bleak, though things have picked up a little since.

A chief executive in any other industry with challenging public relations, poor profits and a depressed share price would have a list of worries. There would be a restive board, a corporate raider, and possibly—ironically enough—a polite inquiry from a private-equity firm. Perhaps in the deep corporate waters such concerns are percolating; there may even have been a redundancy or two. But on the surface, things seem placid. There has been nothing like the rending of garments that would be seen if an investment bank were going through a similarly rough patch. The unusual design of private equity makes it resistant to all but the most protracted turbulence; its record redefines resilience.

It is not just that old private-equity firms persist; new ones continue to spring up at a remarkable rate. According to Preqin, a London-based research house, there were 24 private-equity firms in 1980. In 2015 there were 6,628, of which 620 were founded that year (see chart 2). Such expansion looks all the more striking when you consider what has been happening elsewhere in business and finance. In America, for which there are good data, the number of banks peaked in 1984; of mutual funds in 2001; companies in 2008; and hedge funds, probably, in 2015. Venture-capital companies are still multiplying; but they are effectively just private equity for fledglings.

Private equity’s vitality has seen it replace investment banking as the most sought-after job in finance. This is as true for former secretaries of the treasury (Robert Rubin departed the Clinton Administration for Citigroup; Timothy Geithner the Obama Administration for Warburg Pincus) as it is for business-school students. Some investment banks now pitch themselves to prospective hires as gateways to an eventual private-equity job. If banks resent their lessened status, they respond only with the kind of grovelling deference reserved for the most important clients. The funds made deals worth $400 billion in 2015 (see chart 3). The fees they pay each time they buy or sell a company provide a fifth of the global banking system’s revenues from mergers and acquisitions.

The growth of private equity has been so strong it has a bubblish feel. “The existing number of private-equity funds won’t be topped for 20 years, if at all,” predicts Paul Schulte, head of a research firm in Hong Kong that carries his name. His sentiments are shared, if quietly, by many in the industry as well as outside it, and there is good reason for them. But there is also good reason to believe that the expansion will continue, at least for a while, if only because it is very hard for the money already in the funds to get out.

Private-equity investments are sometimes liquidated and investors repaid. Firms can even be wound down. But investors in private-equity funds are called “limited partners” for good reason, and a key limitation is on access to their money. The standard commitment is for a decade. Getting out in the interim means finding another investor who wants to get in, so that no capital is extracted from the fund. That usually comes with off-puttingly large transaction costs.

Billion-dollar roach motels

The contrast with the alternatives is stark. Clients who want to withdraw money from a bank can do it on demand, from a mutual fund overnight, from a hedge fund monthly, quarterly, annually, or in very rare cases, bi-annually. It is because of the speed with which money can flee them that banks receive government deposit insurance; it shields them from market madness. It is because investors can get out that hedge funds suffering a spell of poor performance can find themselves collapsing even though they have investments that might, given time, pay off handsomely.

The stability that their never-check-out structure provides has enabled private-equity firms to assemble enterprises of enormous scale. Look at the companies themselves and this is not immediately apparent. The market capitalisation of the big four is about $50 billion, which would barely break the top 100 of the Fortune 500; between them they employ only about 6,000 people. But the value and economic importance of the businesses held by their funds (which are owned by the limited partners, rather than being company assets) are far greater. The 275 companies in Carlyle’s portfolios employ 725,000 people; KKR’s 115 companies employ 720,000. That makes both of them bigger employers than any listed American company other than Walmart.

The big four have by far the largest portfolios, but others such as TPG, General Atlantic and Mr Geithner’s Warburg Pincus have a long list of familiar businesses that they either used to own or still do. According to Bain, a management consultancy, in 2013 private-equity-backed companies accounted for 23% of America’s midsized companies and 11% of its large companies.

Not long ago most of those companies were owned by armies of individual stockmarket investors—a system seen as both beneficial to business and befitting a capitalist democracy, and as such one that other countries sought to replicate. Private equity’s deployment of chunks of capital from holders of large pools of money has severely dented that model. And this, too, is being replicated abroad. Only half of the world’s private-equity firms, and 56% of their funds’ assets, are American. A quarter of private-equity assets are in Europe. There are funds in Barbados, Botswana, Namibia, Peru, Sierra Leone and Tunisia.

The rise of private equity has always been subject to scepticism. When KKR launched the first big private-equity takeover, of RJR Nabisco in 1988, it and its cohorts were described in a bestselling book as the “Barbarians at the Gate”. Success, adroit public relations and strategic philanthropy have tempered these concerns, and political donations probably haven’t hurt, either. But the industry’s limitations are still apparent, and current conditions are exacerbating them.

Private equity is structured around a small group of selective investors and managers whose efforts are magnified by the heavy use of leverage in the businesses that the funds control. This is an inherently pricey set-up. Investors need higher returns to offset illiquidity; interest costs are high to offset the risk that comes with leverage; managers who have demonstrated the skills needed to design these arrangements and to maintain strong relationships with providers of capital demand high fees.

During the industry’s growth some of these costs were ameliorated by a long-term decline in interest rates, which enabled deals to be periodically refinanced at lower rates. Today rates can hardly go any lower, and should eventually rise. This is one of the reasons Mr Schulte and others see little growth to come.

Political positions

Another change is that banks which are under orders to curtail the risks that they face are reducing the amounts available for highly leveraged deals. That means borrowing will cost more. To see how that could throw a wrench into the system, look at the brief stretch between September 2015 and this February. The average yield on sub-investment grade, or “junk”, bonds jumped from 7% to 10%. Transactions all but ceased. The value of assets held by private-equity firms with any public stub had to be written down, resulting in those poor first-quarter results. Money was suddenly unavailable for new deals. Carlyle’s purchase of Veritas Technologies, announced just before the crunch, almost failed to close and was saved only after a renegotiation that led to a lower price and lower leverage.

The political environment, too, may be changing. The industry benefits from two perverse aspects of the tax code—the incentive it provides for loading up companies with debt, and the reduced rate of tax the general partners benefit from owing to most of their personal income being taxed at the rate applied to capital gains. There are strong arguments for reform under both heads. In the second of the two cases a change looks quite likely.

There is also a broader political risk, identified in a paper published in January by professors at New York University and the Research Institute of Industrial Economics, a Swedish think-tank, called “Private Equity’s Unintended Dark Side: on the Economic Consequences of Excessive Delistings”. As companies shift from being owned by public shareholders to private-equity funds, direct individual exposure to corporate profits is lost. The public will become disengaged from the capital component of capitalism, and as a consequence will be ever less likely to support business-friendly government policies.

Another far-reaching question to consider is that sometimes the only truly “private” thing about private equity seems to be the compensation structure. The money within the funds is to a large extent either directly tied to public institutions (sovereign-wealth funds and municipal pensions), or, as a matter of public policy, tax-exempt (private foundations and school endowments). This irks both those who yearn for truly private markets and those dismayed at seeing public policy arranged so as to enrich particular groups of private citizens. The implicit tie between the allocation of funds, investments and the state creates a breeding ground for corruption and crony capitalism.

The madding crowd

The largest threat to the industry, though, comes not from its critics but its success, and those who seek to emulate it. According to Bain, the share of America’s midsized companies controlled by private equity tripled between 2000 and 2013; for large companies it increased more than fivefold (see chart 4). That doesn’t mean private equity is running out of road quite yet; but it does suggest that opportunities will get more scarce.

At the same time other kinds of entities with access to cheap and often state-related capital have entered the buy-out market, including Chinese multinationals (financed by state banks), sovereign-wealth funds and pension funds that want to invest directly, such as the Ontario Teachers’ Pension Plan. That means more competition for new deals. In 2007 private-equity firms were responsible for 28% of the purchases of midsized health-care companies, according to Bain. In 2015 their share was only 8%. The trend has been similar, if not so pronounced, in the acquisition of retailers and companies involved in technology and consumer products. It is “the roughest environment for private equity I’ve ever lived in,” Joshua Harris, a co-founder of Apollo, told attendees at a Milken conference in early May.

This may go some way to explaining the amount of money private-equity firms have on hand—their so-called “dry powder”. Preqin puts the current pile at over $1.3 trillion. Adjust for the leverage applied in private-equity deals (say two-to-one) and that sum by itself would account for roughly 70% of the value of acquisitions carried out in 2015. If fertile fields beckoned, the amount of available cash would be shrinking, not rising. A confirmation of tight conditions comes from the willingness of the largest private-equity firms to look further afield for new opportunities. Blackstone now has larger investments in property, $103 billion, than private equity, $100 billion (plus an additional $112 billion in hedge funds and credit). Less than half of Carlyle and KKR’s invested assets are now in corporate equity, and just one-quarter of Apollo’s.

Competition has had an impact on fees, too. A decade ago the standard formula was a 2% annual management fee and 20% of profits. These are still the terms quoted. In reality, though, management fees have fallen to about 1.2%, according to one large firm—similar to what a plebeian mutual fund charges. The 20% slice of profits remains; but some clients are now allowed to “co-invest”, matching the stake in a company they buy through a fund with a stake bought directly. That reduces the fees on the deal.

All good reasons for doubt. But although that mountain of dry powder may betoken a lack of opportunities, it also shows that there is a lot of money still eager to get in. Whether that is wise is not clear. The lack of daily pricing, used to assess mutual funds and, often, hedge funds, introduces doubt into the discussion of private-equity results. The “internal rate of return” measure that private-equity companies tout can be fudged. This makes academic assessments of performance hard.

This July, in an update of a previous study*, business-school professors at the Universities of Chicago, Oxford and Virginia found that, although in recent years buy-out funds had not done much better than stockmarket averages, those raised between 1984 and 2005 had outperformed the S&P 500, or its equivalent benchmarks in Europe, by three to four percentage points annually after fees. That is a lot. Ludovic Phalippou, also of Oxford, is more sceptical; he argues that when you control for the size and type of asset the funds invest in, their long-term results have never looked better than market-tracking indices. That said, getting the same size and type of assets by other means is not easy.

The average return, disputed as it may be, does not tell the whole story. Studies find some evidence that private-equity managers who do well with one fund have been able to replicate their success (though again the effect seems to have decreased in the past decade). The biggest inducement to invest may simply be a lack of alternatives. Private equity’s current appeal rests not on whether it can repeat the absolute returns achieved in the past (which for the big firms were often said to be in excess of 20% annually) but on whether it has a plausible chance of doing better than today’s lacklustre alternatives. This is a particular issue for pension funds, which often need to earn 7% or 8% to meet their obligations.

The standard explanation for why private equity might be expected to outperform the market is that it can ignore the dictates of “quarterly capitalism”—meaning impatient investors. This is not particularly convincing. The people who work for private-equity firms are a caffeinated bunch. During volatile times they oftenrequire constant updates on their portfolio companies’ results, and can intervene to quash even the most trivial use of cash.

What does differ, though, is focus. Private-equity funds, the boards they put in place and the top managers who work for them all tend to concentrate on underlying performance to the exclusion of almost everything else. Public companies face a mountain of often incomprehensible or conflicting regulatory demands that are not relevant to performance; that delisting has risen in step with such demands seems unlikely to be a coincidence.

Disclosure requirements, in many ways the most appealing characteristic of the public company for investors, have come to constitute a legal vulnerability. A sharp drop in a company’s share price can prompt litigation based on the idea that investors caught in the downdraft were unaware of a possible risk. So too could any internal discussion of a potentially controversial issue, as reflected by the New York attorney general’s investigation into ExxonMobil’s lack of disclosure on the risks associated with climate change.

Law is not quite the same sport outside America. But the ways that capital markets operate (or fail to) elsewhere provide other opportunities for private equity to outperform. In China, for example, the term structure for bank loans is only one year, and seeking the longer-term funding offered by a public offering means joining a government-controlled queue. Private-equity financing can be arranged in short order, with money coming in, and out, depending on the needs of the business.

A recent working paper published by Harvard Business School** summarises the possible benefits of private-equity ownership: the substitution of debt for equity, thereby reducing taxes and magnifying profits; compensation structures that provide huge incentives to management for increasing benefits; the addition of new expertise; and transactional dexterity. Perhaps the most compelling point is speed. The upper managements and boards of firms the funds acquire are typically replaced within months. Purchases are done at what are perceived to be opportune moments. So too are sales and refinancings. When the public markets are cool, as has recently been the case, private-equity funds resist relisting holdings or taking on new credit, and may choose to repay some loans. When markets become accommodating, the flows reverse.

Public companies could do much of this, too. They tend not to, perhaps because their inner workings are more open to inspection and criticism. Sometimes they bring in private equity to do what they would not. After acquiring Kraft and Heinz in deals that a Brazilian private-equity firm, 3G Capital, also took part in, Warren Buffett of publicly traded Berkshire Hathaway explained things like this in his annual report: “We share with [3G] a passion to buy, build and hold large businesses that satisfy basic needs and desires. We follow different paths, however, in pursuing this goal. Their method, at which they have been extraordinarily successful, is to buy companies that offer an opportunity for eliminating many unnecessary costs and then—very promptly—to make the moves that will get the job done.” Berkshire, it appears, with its annual meetings featuring happy shareholders applauding a jovial peanut-brittle-munching chief executive, outsourced the hard decisions to a less exposed firm happier to take them.

There are other reasons for public companies and private equity to co-operate. In 2015, when GE undertook a massive reduction in its finance arm, a quarter of the more than 100 transactions that quickly unfolded involved private-equity firms. There were only three public offerings.As well as being speedy, private equity is innovative. When Walgreens Boots, a health-care company, sold a business providing intravenous fluid treatments to Madison Dearborn, a private-equity firm, it was able to retain a significant (if undisclosed) stake. This sort of transaction, which lessens the embarrassment of selling too cheap something which goes on to be a success, is referred to on Wall Street with a pejorative term that can be roughly translated as “sucker insurance”.

They were a kind of solution

Given the flexibility private equity displays, the time may come when there are fewer questions about why a company is held in a private-equity structure rather than a public one. Less taxation, fewer operating constraints and less legal vulnerability are all attractive. There are political risks: structures which skew their benefits to the privileged are always subject to popular backlashes. But that potential vulnerability is also a source of strength. Raise your money from the very wealthy and asset-rich, and from institutions such as the pension funds of state governments and municipal workers, sovereign-wealth funds and universities with large endowments, and you get a certain clout.

In theory, there should be a cost to such privilege. Public markets are inclusive and deep; they should provide capital efficiently (meaning inexpensively and intelligently) and should, as a result, be the best solution for both companies and investors. They should thus outperform the competition. Alas, at the moment it seems that internal and external constraints on public companies are holding that performance in check. The result is that the old lions of private equity, and their many cubs, could be making themselves ever more comfortable for decades to come.