In Defense of Private Equity?

The only way to create prosperity is to do more with less. In economic terms, an increase in productivity is an increase in the amount or quality of output generated for each unit of input. Jobs do not make society wealthier – productivity does.

The original example of an industry that has learned to do more with less is agriculture. On a medieval farm, an entire family would have to work to eke out a subsistence living for themselves. But today, a small number of farmers produce enough food to feed the entire planet.

Technological innovations and centralization of farming operations – from the green revolution to the present – enabled the agricultural sector to do much more with far less. Between 1930 and 2000, U.S. agricultural output quadrupled, even though material inputs such as land, labor, and capital remained constant.

This enormous productivity boost freed up Americans to specialize in other sectors: building, manufacturing, and creating new goods and services.

The only way to create prosperity is to do more with less. In economic terms, an increase in productivity is an increase in the amount or quality of output generated for each unit of input. Jobs do not make society wealthier – productivity does.

The original example of an industry that has learned to do more with less is agriculture. On a medieval farm, an entire family would have to work to eke out a subsistence living for themselves. But today, a small number of farmers produce enough food to feed the entire planet.

Technological innovations and centralization of farming operations – from the green revolution to the present – enabled the agricultural sector to do much more with far less. Between 1930 and 2000, U.S. agricultural output quadrupled, even though material inputs such as land, labor, and capital remained constant.

This enormous productivity boost freed up Americans to specialize in other sectors: building, manufacturing, and creating new goods and services (click on image).

As the example of agriculture illustrates, there are multiple ways to increase economic productivity. One is to build and finance companies with entirely new innovations, typically the domain of the entrepreneur and the venture capitalist.

Another is to improve the way existing companies work, often by merging many smaller companies to form one large one, or restructuring management goals and employee incentives within a company.

This is typically the domain of the "private equity" firm or a large acquisitive corporation. The two methods sometimes complement each other: when a VC-backed entrepreneur develops a new technology, corporations or PE-like firms often scale the product and quickly spread it throughout the economy.

How private equity works

Today, a private equity or "PE" firm is a company that raises funds from institutions and wealthy individuals and then invests that money in buying and selling businesses. PE firms are usually "activist" investors, which means that rather pursuing a passive buy-and-hold strategy, they are involved in managing (fixing…or screwing up) the internal operations of the businesses they acquire.

Imagine you're an investor who wants to make the economy run more productively by improving as many businesses as you're able to, starting with those with the most potential for improvement. You pore over a map of the economy which shows how different sectors have evolved, which business models have proven effective, where consumer demand is trending, and rafts of other economic data. You want to do more with less – but how?

The leaders of private equity firms find themselves in exactly this position, and employ some of the following strategies:

• Combining back offices of multiple firms to cut redundant costs. Sometimes PE firms will bundle several companies within an industry vertical to reduce supply chain costs. They may also combine an ailing company with a healthy company so that the former can develop better processes and become more productive.
• Aligning incentives by increasing CEOs and operational officers' stake in their business. This technique rewards management for increasing company growth and performing a successful company exit.
• Rescuing and restructuring businesses that are squandering resources. A common target for a PE firm is an older company which lacks financial discipline, perhaps with inefficient middle management, or where executives spend money on private jets and extravagant parties. This kind of firm benefits immensely from the tutelage of private equity firms experienced at leading and running businesses. By aligning rewards with performance (rather than nepotism or tradition), PE firms can make portfolio companies much more productive.
• Locating great sectors and geographies to invest in. PE firms may be able to spot undervalued industrial sectors or localities that others have missed. Capitalizing these areas allows them to develop and thrive at their full potential.
• Using equity capital more efficiently. The capital markets are highly competitive, and securing loans ("leverage") for deals requires finesse. Though the popular press often disparages "financial engineering", reorganizing a company's capital structure can free up money to deploy to other parts of the business or the economy. Of course, irresponsible leverage makes a firm more likely to fail. But the market accounts for this – investors in private equity firms carefully monitor their investments. A PE fund with failed portfolio companies will have trouble raising as much money and freely determining how to allocate it next time around.

A good example is Carlyle's buyout of Hertz Corporation in 2005.

After the buyout, Hertz improved operational efficiency in a variety of ways – for instance locating car cleaning and refueling services in the same parking lots. Not only did these improvements raise Hertz's value by $3B, they forced the entire car rental industry to respond with innovations of their own. During the same period, Avis-Budget and Dollar-Thrifty profit margins and labor productivity increased substantially.

Another example of private equity techniques at work is the brewing industry. The average worker at a North American brewing company is 7x as productive as his counterpart in 1950. (According to "Brewed in North America: Mergers, Efficiency, and Market Power," an academic paper published April 28, 2016, by Paul Grieco, Joris Pinkse and Margaret Slade.)

Private equity groups such as 3G Capital, which merges and restructures brewing operations, have made the industry much more efficient.

Private equity and its discontents

The classic critique of private equity is that it employs financial engineering tricks, such as increasing leverage and minimizing tax liabilities, rather than making real operational improvements.

Venture capitalist Michael Moritz of Sequoia recently claimed, for instance, that PE is akin to "making a small down payment on your neighbors' house; paying for the balance by taking out a mortgage secured by their savings, jewelry, silverware and car; selling off the contents of their property; and then siphoning off some of the loan for yourself."

Similar invectives were hurled around during the 2012 electoral campaign of Mitt Romney, who helped create Bain Capital. Like any industry, PE is occasionally corrupt – as for instance when it charges inmates high rates on interstate phone calls, in partnership with crony state governments.

But the image of private equity as a parasitic form of business completely misses the point.

The primary way to make money in private equity is to make portfolio companies more efficient and healthier in the long run. If a PE firm saddles a portfolio company with such a heavy debt burden that the company is unable to return a profit, it is the PE firm which ultimately suffers. Private equity firms are fundamentally incentivized to improve and strengthen the operations of the companies they control, not to cripple them.

Furthermore, enabling companies to do more with less allows workers to specialize in other areas, and frees up wealth with which investors and management can capitalize internal improvements or ventures in other regions of the economy. PE firms succeed to the extent that their portfolio companies succeed, and to the extent that their portfolio companies succeed, America prospers.

Another conventional critique levelled by Moritz is that PE destroys millions of jobs when cutting costs at portfolio companies. This is empirically false – the private equity industry as a whole is responsible for large job creation as well as destruction, with only modest net job losses.

But the deeper fallacy with this argument is that full, constant employment is falsely seen as the ultimate good in America's economy.

If we wanted to create full employment it would be easy: we could simply ban 20th century agricultural technology, immiserating millions of Americans and forcing them back into farm labor. It's easy to intuit that this would be a bad idea, but it's harder to imagine the economic progress that layoffs and labor migration imply.

In truth, creative destruction of antiquated jobs and invention of new forms of labor drives productivity growth, and PE firms are integral to this process.

Finally, some argue that PE only enriches a select few at the expense of ordinary Americans. In fact, the largest investors in PE are American pension funds, which have committed hundreds of billions of dollars to the American private equity industry.

PE assets make up 9% of CALPERS' portfolio, for instance, and have generated an annualized net return of 12.3% over the last ten years. When private equity firms succeed, every state government pension plan, university endowment, and large philanthropic endowment shares in their profits. It's no stretch to say that the primary beneficiary of the private equity industry is the American public.
Private equity and venture capital

Private equity and venture capital have much in common, and The Economist is partly correct to characterize VC as "private equity for fledglings".

Like their counterparts in PE, VC funds have long lifespans, which allows partners to cultivate long-term growth in portfolio companies rather than focusing on quarterly showings. And like private equity firms, the modern VC is actively involved in coaching and advising its portfolio companies (though ironically, PE is often more hands-on and entrepreneurial than VC because the latter has the more limited discretion of a minority shareholder).

Jim Coulter of TPG noted that whereas VC is in the business of mutation, PE is in the business of evolution. Where VCs fund "mutant" start-ups that offer completely novel technological innovations, private equity firms facilitate the process of natural selection to ensure that only the "fittest" companies survive. This is an important distinction between the two industries, and there are other technical differences. But broadly speaking, you can't believe in the fundamental value proposition of the venture capital industry unless you believe in the basic paradigm of investment, assistance, and economic repair pioneered by PE.

We believe that in the coming decade, segments of the private equity and venture capital industries will converge and adopt similar strategies. Returns will disproportionately accrue to firms that combine the best of each. In the 1980s – the heyday of the private equity industry – firms such as KKR, Blackstone, Carlyle and Apollo tapped the under-deployed resources of banks to purchase, restructure, and resell corporations.

But leveraged buyout (LBO) techniques are now "commoditized," and the industry is extremely saturated: PE backs 23% of America's midsized companies, and 11% of its large companies. The private equity industry remains valuable, but in order to generate unusual returns it must "evolve" itself.

PE firms have always tried to harness new innovations, but a surge of new information technologies has made it increasingly valuable for some private equity firms to partner with leading entrepreneurs and technologists – many of whom are located in Silicon Valley. Commercial data is exploding in volume and variety, and metrics are becoming much more precise. Private investors of the future will use technology platforms to evaluate formerly uninteresting assets as hidden stores of data, which will make their businesses and industries more efficient. New information will allow top investors to better assess consumer demand, supply chain logistics, and industry-level shifts, as well as determine where to open channels of communication and dedicate resources. Data-driven PE firms will save resources, increase their margins, and become more valuable to their partners.

Venture capitalists able to draw on the top networks of talented leaders and builders in Silicon Valley were among the first to develop an armamentarium of data-driven procedural improvements for their portfolio companies. Hybrid groups such as Vista were among the first to pioneer these techniques in the buyout space. Private equity firms working closely with venture capitalists and technologists may be able to unlock assets that others have not leveraged and build technology cultures to iterate on solutions that make these assets more productive. Some may even reclaim 1980s or 1990s-level returns.

At the same time, the best VCs will begin to imitate and adopt PE strategies. Scaling major technological breakthroughs in certain industries requires armies of people and significant resources – private equity's bread and butter. VCs may also begin to increase their return on equity capital of late-stage portfolio companies with debt financing, drawing on the private credit divisions of investment banks, PE firms and more.

There is still a large cultural rift between the two worlds; the culture of Silicon Valley is very different from the "Wall Street" mentality of the American financial establishment.

Fortunately, open-minded individuals in each field are establishing rapport and exchanging insights. We have been lucky to add luminaries including Henry Kravis and Geoff Rehnert as investors and advisors to 8VC, and Sir Deryck Maughan as a board partner. Communication and cooperation between our industries will only continue to improve as the distinction between elite private equity and venture capital investors becomes less meaningful.

Conclusion

Critiques of PE reflect a naïve understanding of what creates economic prosperity. Private equity investors are an integral part of the economy, and should be celebrated for making our country wealthier. The confluence of the venture capital and private equity industries will only make each more productive, strengthening and fine-tuning the economy. Savvy, competitive investors able to build, buy and fix companies will continue to stimulate growth by allowing us to do more with less – the only way to create prosperity.

Are you all ready to take out your American flag, stand up and salute the private equity industry?

I like Joe Lonsdale, think he's a very sharp guy, but he's only showing you the rose-colored portrayal of the private equity industry and obviously has a vested interest talking up this supposed "convergence" between venture capital and private equity.

I'm more skeptical. First, I'm highly skeptical on venture capital ("VC") and wouldn't invest in most of them, even the so-called cream of the crop.

That goes back to my old days at PSP in 2004 when I was helping set up private equity there and called Doug Leone of Sequoia three times to secure a brief meeting with Gordon Fyfe and Derek Murphy. "Listen kid, I like your persistence and will meet your top guys for 15 minutes but we're fighting over whether Harvard or Yale will receive an allocation. We don't want or need pension money. Our last $500 million fund was oversubscribed by $4.5 billion. I'll save your pension a lot of time and money, don't invest in VC, you will lose your shirt."

I remember Gordon and Derek loved that meeting, they both came to see me when they got back and told me it was "awesome". Derek grumbled something like "I've never felt so poor in my life".

Later, during the financial crisis, when I worked at the Business Development Bank of Canada (BDC) for two years, I saw huge losses in the venture capital portfolio. It was a disaster. The guy who hired me, Jérôme Nycz, eventually took over that department and he was appointed Executive Vice President, BDC Capital in 2013. Last I heard, they are doing well.

But make no mistake, VC is very competitive and it's extremely difficult to make money even for the Sequoias of this world. I'm pretty sure they'd gladly jump on pension money these days instead of thumping their chest, bragging about internal disputes over whether Harvard or Yale gets an allocation.

In terms of the overall private equity industry, VC is peanuts and it will always remain peanuts. I foresee a major, MAJOR, shakeout in the VC world over the next three to five years and it will rock Sillicon Valley to its core.

What about private equity? Just like Canada's large pensions, they've been piling on the leverage, as noted in a recent Prequin survey, to the point where leverage on US LBOs is at the highest level since the financial crisis (click on iamge):


You might be wondering why are they piling on the leverage? Why not? Central banks have effectively aided and abated the private equity/ hedge fund/ banking industy to the point where they'd be stupid not to crank up the leverage to squeeze more private equity dividends from their portfolio companies to enrich their payouts (click on image, tweet from 13D Research):


Who else are private equity titans squeezing? They're squeezing pensions on fees, especially chronically underfunded US pensions who are seeing their funded status deteriorate as PE and hedge fund kingpins climb higher on Forbe's list of America's most affluent.

Now, don't get me wrong, private equity is an important asset class for all pensions but as I've reported, these are treacherous times for the industry and there are serious misalignent of interests.

All you institutional private equity investors need to read this comment of mine and then go read Sebastien Canderle's book, The Debt Trap: How leverage impacts private-equity performance, because many of you are totally clueless on all the shenanigans private equity funds do to pull the wool over their investors eyes.

In fact, I highly doubt Joe Lonsdale has read Sebastien's book and unlike him, Sebastien has worked at top private equity funds and has seen first hand all the ways PE funds manipulate data or make decisions in their, not their investors' best interests.

Lonsdae talks about productivity gains and how private equity has helped "unleash" them but it's all nonsense because the truth is the financial sector is heavily subsidized by the Fed and and other central banks. Go read Charles Hugh Smith's comment on the endgame of financialization being stealth nationalization where he posted this chart (click on image):


All this cheap money primarily benefits the "lords of finance" but nobody talks about Wall Street welfarism which is rampant and has totally corrupted capitalism and our social democracy, they only frown upon welfare checks going to the poor and disabled, you know, the "underclass" of society who are only "leaches" according to them even if they need this pittance of money to survive.

What else does Mr. Lonsdale neglect to mention? How about a recent MIT study that found buyout firms regularly exaggerate their performance:

Private equity managers tend to inflate returns when public markets do well, according to research from Massachusetts Institute of Technology’s Sloan School of Management.

A Sloan paper written last month found that buyout fund and venture capital managers, who have some discretion in calculating investment performance, are influenced by public equity gains posted after a quarter has ended. When public markets are subsequently up, private equity managers rate their own performance higher for the quarter gone by, according to the study.

“We make no claim that this behavior is intentional,” Megan Czasonis of State Street Corp.’s research group, Mark Kritzman, a senior finance lecturer at MIT, and David Turkington, a senior vice president at State Street Associates, said in the paper. “It is quite plausible that private equity managers subconsciously produce positively biased valuations merely because they are optimistic.”

[II Deep Dive: Most Private Equity Managers Think Returns Will Fall]

The researchers studied company-level valuation data from State Street Global Exchange’s private equity index, which represents more than half of all global private equity assets. For the first three quarters of the year, they found that private equity valuations were higher if public markets performed well immediately after the quarter ended. But when subsequent public market performance was negative, private equity valuations were not affected.

By contrast, venture capital managers did tend to downgrade their own valuations following several periods of persistent public equity losses.

“Private equity performance is not recorded immediately after the end of the quarter,” the researchers explained. “Instead, it is released over a period of one to three months.”

The reporting delay means private equity managers may be influenced by public equity market performance after the quarter is finished, according to the study. But in the fourth quarter, when private equity valuations are audited, the performance inflation disappeared.

“Private equity managers are less inclined to produce biased valuations when they are faced with audits,” the researchers said in the paper. “As such, we should expect private equity to produce, on average, higher returns relative to the public market in the first three quarters than in the fourth quarters.”

I know Mark Kritzman, met him at PSP years ago. He is a serious researcher who has done great research in finance.

Their findings are right, you need to regularly audit private equity managers who have quite a bit of discretion in calculating their performance.

In fact, my friends over at Phocion Investments here in Montreal just posted this on their website, Private Equity Valuation Shortcomings Can Be Mitigated With Adoption of GIPS:

Private Equity is an asset class that has garnered increased interest from institutional and accredited investors since the Financial Crisis, with Pension Funds and Family Offices demonstrating especial keenness. The driving force for the fervor is that PE investors are attracted to investment premiums for assuming PE’s poor liquidity and reduced degree of single asset transparency. Investors are also attracted to the perception of PE’s lower level of pricing volatility. In this article we explore some of the valuation shortcomings that investors are exposed to when owning Private Equity funds. ‎

GPs Want to Value Assets as High as Possible

When a Private Equity fund is recently established it can contain a large component of portfolio assets whose valuations are unrealized. When placing a quarter-end value on such unrealized assets, the General Partner (“GPs”) typically uses valuation techniques that adhere to certain industry guidelines that offer a great degree of flexibility. This self-assessment practice opens investors up to the possibility that GPs will utilize high comparable multiples that contribute to increasing the fund’s overall valuation. The GP is motivated to do so because the higher the portfolio’s asset size, the greater will be the size of the GP’s compensation that is derived from management fees.

LPs Have Trouble Identifying Source of Performance

When acquiring an investment in a PE Fund, Limited Partners (“LPs”) must accept the lack of transparency in performance. For instance, return calculations are not provided at the investment level. As such, the LP cannot identify the sources of returns, thus rendering the manager evaluation of skill or luck to a mere a guessing exercise. LPs have no way of objectively assessing as to whether GP performance explanations yield truth or fiction. LPs must make certain to assess whether they are being properly compensated in exchange for PE Fund’s investment performance transparency being stacked in the GP’s favor.

GPs Are Often Structured With Poor Valuation Controls

GPs often perform portfolio asset valuation internally which can yield poor policies, procedures and controls. Valuation policies are often structured to allow for too much flexibility, which can lead to artificially high net asset values (NAVs) and misleading internal rates of return (IRRs). The GPs’ valuation discretion can also produce a lack of consistency in valuation among different investments. Furthermore, the absence of an independent, third-party valuation agent makes it difficult to confirm valuation accuracy. Even then, some independent evaluators lack expertise at pricing hard-to-value assets. To top it all off, it is not common practice to have a valuation committee as part of a GP’s corporate governance program.

Concluding Remarks

The first step towards working in investors’ best interest of is to adopt best practices. The CFA Institute has developed standards referred to as he Global Investment Performance Standards (GIPS) that provide guidance to properly value Private Equity investments. It is very unlikely that GPs will adopt GIPS on their own. Moreover, regulators are likely to lack the necessary courage to make GIPS a requirement any time soon. Henceforth, we propose that institutional and accredited investors band together and demand adherence to GIPS. Walking away from non-GIPS PE funds will eventually get the message across. Eventually, GPs will be looking to check the GIPS box to satisfy investor needs. If GIPS is implemented across PE firms and on a broad basis, this enhanced integrity would benefit all stakeholders. That is something worth striving to achieve and there is no better time than the present to set the wheels in motion.

You can read the PDF version here. When it comes to operational and performance risks of your hedge funds and private equity funds and all your investments, you should absolutely consider the team at Phocion Investments who have experience and aren't going to offer you some bogus "cookie cutter" report which is a cut and paste of other reports (I'm shocked at how careless large institutional investors have become when it comes to thorough due diligence on all their external managers).

I agree with my friends at Phocion. If GIPS is implemented across PE firms and on a broad basis, this enhanced integrity would benefit all stakeholders. That is something worth striving to achieve and there is no better time than the present to set the wheels in motion.

It's funny how we have a double standard when it comes to stringent (GIPS compliant) valuation policies in public markets as opposed to private markets.

No doubt, shenanigans happen everywhere and I don't buy for a minute that it was only HSBC which was frontrunning its clients in FX. That nonsense happens all the time everywhere as FX is a license to steal for big banks but what they don't tell you is sometimes the banks eat the losses and sometimes it's the clients who eat the losses (and all the big chiefs at HSBC who knew about this trade are still there enjoying millions in compensation).

My old mentor at McGill University during my undergrad years, Tom Naylor, the combative economist, used to warn us all the time, "the world is a sewer" and "don't believe anything you read until it's officially denied."

I didn't post this comment to attack Joe Lonsdale or the private equity industry. I actually believe private equity plays a critical part in all pensions' portfolios and it deserves to because over a long investment horizon, private equity has offered compelling returns over public markets (even if they're somewhat exaggerated).

I just want institutional investors to be better informed and to realize there are a lot of issues in private equity they absolutely need to be made aware of. It's not always as straightforward as it seems and there are important operational and investment risks that need to be carefully assessed, including valuation risk, liquidity risk and funding risk.

For example, go read this excellent BVCA report on risk in private equity. I note the following on funding risk:

When reflecting on the last financial crisis, some investors faced severe funding issues. The most prominent case was from the university endowment of Harvard Management Corporation who issued a bond of more than USD 1bn to fund their future capital calls and considered selling a private equity portfolio of around USD 1.5bn, when the average discount on the secondary market was between 40% and 50%. Even CalPERS (the largest US pension fund) sold some of their listed stocks in order to be prepared for potentially paying future capital calls for private equity funds according to an article in the Wall Street Journal.

Listed private equity vehicles which ran an over-commitment strategy experienced similar issues. APEN, a Swiss-listed vehicle had to go through significant restructuring, adding a new financial structure as well as selling on the secondary market so as not to lose any of its private equity assets. It should be noted, however, that many pension funds and insurance companies investing in private equity did not have to take drastic measures during this time period and were able to cope with the change in cash flow profile because they managed their risks from the outset by limiting their allocation to private equity. Additional reasons for the limited allocation to private equity have been the possibility for them to match it with their incoming cash flows, the possibility to liquidate other liquid assets beforehand and having more diversified portfolios.

Once again, I don't proclaim to have a monopoly of wisdom on pensions and investments so if you have anything to add, feel free to reach out to me at LKolivakis@gmail.com and I'll post your comments for a small token fee.

I'm kidding, no fee required to email me your thoughts but a lot of you who benefit from reading my thought-provoking comments seriously need to step up to the plate and either donate or subscribe using PayPal on the right-hand side under my picture.

Trust me, I don't figure among Canada's pension overlords, I collect a pittance from my blog but dollar for dollar, I'm probably the most powerful person in Canada's pension industry you never heard of (by default, not by choice). It's too bad I cannot leverage all this knowledge to get compensated properly for all the work that goes into these comments.

Anyway, it's all good, Google makes the big bucks and provides me with a platform to share my knowledge and important insights from pension and other experts. You all get to enjoy it for free but for those who can, please show your financial support. It's greatly appreciated.

Below,  Joe Lonsdale, 8VC founding partner, talks about reinventing the way technology is used to monitor big data problems. Lonsdale is superb when he sticks to things he understands.

And private equity now employs a huge number of employees across the globe, presenting great funding opportunities for firms, says Claudia Zeisberger professor at INSEAD.

Professor Zeisberger is the author of a recently released book,Mastering Private Equity: Transformation via Venture Capital, Minority Investments and Buyouts, and she knows her stuff in private equity.

Unfortunately, as this bubble economy is set to burst, I would be very careful with all risk assets across public and private markets. I foresee a lot of develeraging pain ahead so be careful.