So you think you want to invest in a private equity fund

Disclaimer: this post is specific to buyout funds -- private equity funds that buy existing businesses, including public companies and divisions of existing companies, usually with leverage -- and not venture capital funds.

Introduction for the uninitiated: A private equity/buyout fund raises hundreds of millions or billions of dollars from institutional and individual investors (collectively called "Limited Partners"), to be invested by a team of investment professionals (collectively called "General Partners"), in the form of ownership stakes in existing operating businesses -- typically public companies and divisions of existing companies. Private equity funds typically use a large amount of debt in order to buy much larger companies than they could normally afford. Returns are realized only one way: by subsequently selling those same businesses -- either to the public via an IPO, or to another company via a sale. The General Partners typically take 20-30% of the investment profit plus 2-3% management fees annually, plus often additional fees, perhaps levied against their companies. After those fees, the Limited Partners still expect to generate returns well in excess of the S&P; 500 index, even though their money is locked up for as long as 10 years in the process. Lately, the amount of money flowing into private equity firms has been exploding, and certain large private equity firms have announced or are considering going public themselves.

15 questions to ask when you are thinking of investing in a private equity fund:

Your fund will use a significant amount of debt when purchasing operating businesses. Interest rates are currently quite low -- in fact, not that far off of 40 year lows, making that debt quite cheap. What happens to your model and projected investment returns if interest rates rise?

The interest rate spread between Treasury bonds and so-called "high yield" bonds is currently near all time lows. The debt that you will be using will fall into the category of "high yield". What happens to your model and projected investment returns if this spread widens?

Price/earnings multiples in the public markets for large and mid cap companies are low relative to 20-year historical norms, making them relatively cheap to buy. What happens to your model and projected investment returns if public P/E multiples expand -- from, say, the current ~16 to not unreasonable levels like 20 or 24?

What part of the excess return over the S&P; 500 index that you are expecting to generate is due to your use of leverage (debt)? Does this indicate that the public companies that you plan to buy are underleveraged? The finance theory of leverage is that a company should take on debt until its cost of that debt is greater than the returns it can generate from that debt -- what happens to your model and projected investment returns if public company shareholders and CEOs figure this out and add more debt before you are able to buy them? Further, if what you are really doing is leverage arbitrage versus the S&P; 500, why can't I just buy an S&P; 500 index position myself and leverage it up by purchasing call options and get the same result for a fraction of the fees?

What part of the excess return over the S&P; 500 index that you are expecting to generate is due to your assumption of higher levels of risk and volatility than the index? What are your internal estimates of the true risk and volatility of your investment portfolios? Will you share those internal estimates with me? If not, why not? And again, why can't I replicate a riskier S&P; 500 index myself via index funds and call options for a fraction of the fees?

What part of the excess return over the S&P; 500 index that you are expecting to generate is due to the fact that you are buying so-called "value" companies and avoiding so-called "growth" companies, thereby taking advantage of the theoretical return premium many finance professionals believe is associated with value companies? Why can't I replicate that effect myself simply by buying a value index for a fraction of the fees?

What part of the return premium that you are expecting to generate is due to the fact that you plan to lock up my money for up to 10 years, thereby extending my investment horizon to 10 years and removing from me the ordinary temptation to sell in a panic when stocks drop? Why can't I replicate that illiquidity premium by simply buying the index, or a leveraged/riskier version of the index, and not selling myself for 10 years? And if there is no illiquidity premium, why am I agreeing to have my money locked up for 10 years?

What part of the return premium that you are expecting to generate is due to the operational improvements that you are implementing in the businesses that you buy? When one of your management consultants or operating partners walks into the tire company you just bought, wearing his $3,000 Zegna suit, $400 Turnbull & Asser shirt, $80 Pantherella cashmere socks, $900 A Testoni alligator loafers, $5,000 Omega watch, $500 Gucci cufflinks, and $150 Hermes tie, what exactly is he telling the general manager of that tire company about running that business that the general manager didn't already know?

You cite high returns generated by your previous funds. Do you still have the same investment team as your previous funds? Are they still as motivated notwithstanding the fact that their net worth is probably at least several hundred million dollars apiece?

Are you still investing in the same sectors as your previous funds?

Are you still buying the same size companies as your previous funds?

There is a much larger amount of capital at work in the private equity world today than there was when you raised and ran your previous funds, and therefore significantly more competition for each deal. What impact do you think this huge influx of money and corresponding greater competition will have on your ability to generate comparable investment returns with your new fund?

Your industry is gearing up mightily to fight the proposed reclassification of so-called "carried interest" -- the 20-30% of investment profits that your General Partners get to keep -- as ordinary income rather than capital gains. The underlying logic of this fight has to be that your General Partners would not be as motivated if they were getting taxed at ordinary income rates, versus their current taxation at capital gains rates. If this proposed reclassification passes Congress and the President signs it into law, are your General Partners going to pick up their marbles and go home in protest?

Given that most of the returns in private equity historically flow to the top 10% -- or even top 10 -- firms, what basis do you have for believing that your fund will be in that top 10% -- or top 10?

Finally, given the extraordinarily high level of demand from really smart institutional and individual investors to invest in high-quality -- top 10% or top 10 -- private equity funds, why exactly am I being given the opportunity to invest in yours?

Comments

[Mukund Mohan]

Marc
Awesome. Simple question: Why not just invest in Art & wine if you are looking at a 10+ year horizon. It a lot more fun.

[David Sklar]

I wonder if Bono has any of those cashmere socks.

[Marc Andreessen]

Yes, but he buys them all in duty-free shops.

[Kuas]

The last point is key.

In this environment, any PE (or venture, or hedge) fund willing to take MY money should be viewed with suspiscion.

[Peter]

Marc,

Great article. One question: in the 10 year horizon question are your trying to make the point that hedge fund needs to beat the S&P; each year? Locking up your money for 10 yrs in the S&P; means you can't out-perform the S&P.; Some clarification on that point would be great.

[John Scholes]

Two other cautionary points. (1) There is increasing competition between buyout funds, which is driving up the prices they have to pay; (2) these things depend upon inside info. So the fund needs the management of the target on side. This is a can of worms and requires legislation to sort out. If that happens, it could put a damper on the whole business.
On the other hand, these things have been doing well for a long time, especially if you regard them as the natural successors of the conglomerates.

[Marc Andreessen]

Hi Peter -- you're right, I need to disentangle a couple of different points there -- am running out to a meeting but will do that this morning.

Interestingly most hedge funds are currently not promising to outperform the S&P; 500 -- instead they are promising to be more reliable than the S&P; 500 at generating regular gains without significant losses. A whole different topic with its own set of questions...

Best,
Marc

[Marc Andreessen]

Hi Peter -- I have reworded that part of the post to be clearer and more accurate.

Research shows that most public market investors flinch in the face of market downdrafts and sell at the wrong time, compromising their long-run returns. Do a Google Scholar search on "myopic loss aversion". So your average investor is not willing to buy and hold for 10 years, and will underperform even the basic index by selling low and buying high for emotional reasons. So simply buying an index and holding it for 10 years will tend to give you better results than typical investor behavior -- this is a so-called "illiquidity premium".

One of the arguments in favor of private equity funds is that they force you to stay locked up and invested for 10 years, hence harvesting this premium -- in essence, saving you from yourself.

Conversely, if there is no illiquidity premium, then there is no reason for you to agree to be locked up for 10 years.

But the fact remains that any individual should be able to harvest that same illiquidity premium simply by buying and not selling. Either to match index returns, or to exceed them by taking on an appropriate (for the investor) level of leverage on the index investment.

Marc

[Brian K]

Good post. I would raise a question about one of your points, however. I think most stock market historians would argue that P/Es are historically high right now rather than low. A state of the world that you will hear any value fund manager worth his salt bemoan daily as there are no seemingly good value investments to be had in any asset class these days. I'm not armed with data at the moment, so perhaps you are right that certain P/Es are below 20-year averages, but I suspect that is because of the crazy P/Es from the bubble years. However, I think the fact that P/Es are currently high underscores your point even more strongly. If P/Es were to trend down to historical levels over the next few years, which they are very likely to do if interest rates rise, Private Equity firms are likely to exit their investments not only below what they pay for them today, but significantly below because of the effect of added leverage (what works wonders on the way up, kicks you on the way down, something home buyers are starting to find out.) Another perspective anyway.

[Julie]

A comment about your question "What happens to your model and projected investment returns if interest rates rise?": It's not higher interest rates that are really going to hurt PE firms. The ratio of the positive change in interest rates to falling IRR's is a little less than 1 to 1, and with available IRR's around 20%, a 1% rise in interest rates isn't going to put a serious dent in them. it would take rates rising more dramatically or the equity risk premium plummeting due to earnings yields falling, and I don't think that's going to happen anytime soon, esp with any hiking action from the Fed being a long way off and corporate earnings not expected to take a serious nose dive. then again, if you're talking about a 10 year horizon, it could change, but nobody has any idea where we'll be then, so the "model" you're talking about isn't very helpful in that case.
What really matters is lenders' willingness to continue to let LBO shops use the same aggressive leverage ratios they've been using over the past few years. Changes in leverage assumptions can change IRR's by as much as 10 percentage points (putting it in your terms, that's the equivalent of a 10+% rise in interest rates from current levels. Barring an exogenous shock of catastrophic proportions, that is not going to happen anytime soon). If banks tighten their standards and don't allow the leverage ratios we're currently seeing, the LBO phenomenon could get hit pretty hard. That's where the biggest risk lies.

[Gary Culliss]

This is a great article and I appreciate your skepticism. I, too, have been wondering where all the money is coming from in private equity buyouts. From my reading of other articles on the subject, it appears that there are some structural changes that can be made when a company is private that are nearly impossible to make when that same company is public. The ability to make these changes without pressure from groups like ISS or other active shareholders allows these value-unlocking changes to take place.

In other words, the PE guys are making money by transitioning across the public-private boundary. Because they're making money outside of the public markets, the idea of replicating their performance with publicly-based index funds and other public financial instruments just isn't possible. I also think there's a bit of market timing going on as well in some of these cyclical industries.

Finally, some of the changes you suggest might hurt the pipeline for deals, but they can strongly support the exit. For example, an increase in the public PE multiple just means that their public exits are at higher valuations. Also, they realize the liquidity premium when selling back into the public markets, so that benefits them as well on the exit. If they've unlocked value during the private phase, then the liquidity premium at the exit will be greater than they suffered when going private. Also, since the securities aren't usually marked-to-market, no one really sees the decrease in value (from the illiquidity discount) they suffer on going private. Keep in mind that the illiquidity discount is offset almost entirely by the control premium they realize, unless they paid too much for control in the bid premium...

Gary

[Marc Andreessen]

Hi Gary -- you are right, the idea that you can make structural changes as a private company that you cannot make as a public company is the foundational "added-value" argument in favor of private equity.

However, I've never understood exactly why that's the case. What exactly is preventing the same management team from making the same changes as a public company? A low stock price? Lots of companies have low stock prices when they aren't changing anything, so that alone doesn't seem to have much to do with it. So ISS and some shareholders complain -- first, ISS and some shareholders complain pretty frequently anyway, and second, the market is pretty efficient in that regard, and new shareholders that value the changes the company is making will step in (either publicly or privately!). And lots of companies DO make huge transformations as public companies.

In addition, many private equity transactions these days are demonstrably simpler than that -- company X is taken private, leveraged up, and taken public or sold again tout de suite. In those cases, and perhaps others, the story of a transformation that could only have been taken place while the company was private is being used as air cover for simply adding leverage.

Please note that I am NOT saying leverage is bad. In fact, the data would seem to indicate that many public companies are significantly underleveraged. It's not totally clear why that's the case, although potential liability from class action shareholder litigation should the company get into trouble from taking more more debt may be a factor. So to the extent that CEOs can only properly leverage their balance sheets by being bought out by private equity, private equity firms are certainly adding true economic value, albeit at a very high price.

Marc

[Marc Andreessen]

Hi Brian -- I appreciate your comments but if you're going to argue that large-cap P/E multiples are high and not low, you're going to need to present some data. All the data I've seen says the opposite -- and certainly private equity firms believe that's the case; that's part of the motivation for raising all that money and buying all those public companies right now.

Marc

[Marc Andreessen]

Gary -- one can plausibly argue that a private equity firm is ALWAYS paying too much when they buy companies in the public market, since they are by definition paying more than a broad and efficient market believes those companies are worth -- which would tend to offset any control premium...

Marc

[Marc Andreessen]

Brian and Gary -- when I ask the question "what happens if P/E multiples expand", I'm primarily suggesting risk to your investment if those multiples expand PRIOR to your new money being invested.

I.e. if you're investing in a private equity fund NOW, your new money will be invested over the next few years -- in large part by purchasing public companies. If the S&P; 500 P/E multiple snaps from 16-ish to 20 or 24 in the next 6 or 9 months -- aka a roaring bull market, which has been known to happen, especially when lots of people believe the market is already too high -- then your new money will buy a lot less buyout value than it would if it were invested today, or four years ago when the last round of private equity funds were at work -- thereby depressing your returns.

On the other hand, to your point, if P/E multiples expand slowly over the next 6-8 years from current 16-ish to 20 or 24, or tread water for 3 years and then explode, then sure, the private equity firm you have invested in will have wind at its back.

On the third hand, if P/E multiples expand from 16-ish to 20 or 24 over the next few years (perhaps driven in part by all this new buyout cash!), public market investors are also going to do very well without paying "2 and 20" -- especially if they are equivalently leveraged.

The core question underneath all this is that the private equity industry has been through several years of nirvana, when public valuations have been quite low, public investors had been recently brutalized and were overly skittish, and interest rates were literally at 40-year lows. They have had great returns for a while, and as a result are now raising WAY more money than ever before, buying much larger companies than ever before, and arguably (arguably!) heading into a potentially very different environment than before.

Far be it from me to predict anything, I'm just saying these are good questions to ask :-).

Marc

[Chris Marino]

Terrific post! The point about '...additional fees, perhaps levied against their companies' is worthy of further discussion.

The cynic in me see this as little more than a shakedown.

What other asset classes have this fee structure? Could you imagine if VCs tried to pull this off on their portfolios? Some have tried, but we know them by a different name: Scammers

[Shane]

Marc,

Your post -- and responses -- have been a great read. One thing to point out about your recent comment, though (7:51pm above) is that, indeed, public market investors may benefit from the same market conditions as the private equity firms.

However, doing so may come at it's own cost. First, we're not talking about an "average" investor since PE firms require an investor to be accredited. Second, a savvy private investor can only spend so much time and go so long with adding more and more companies/funds to their investment list. At some point, if they keep getting spare cash to invest, they may just decide it's worth it to pay someone else to try to invest their money so they can go play on their boat (or, perhaps, run their new startup with full dedication).

Finally, if said savvy private investor does keep spending a lot of time and gets better and better at what they do, eventually they may realize other people may want to pay them to do as much for their own money. And thus, we've come full circle.

Just some thoughts -- I'm certainly no expert.

[Marc Andreessen]

Hi Shane -- mainstream private equity funds were limited to so-called accredited (institutional or high-net-worth) investors up until last week, when Blackstone went public. Now it's a whole new ball game.

Any savvy private investor can buy index funds all day long and get super-cheap market exposure with whatever level of risk and leverage they want... it takes about five minutes. Especially these days, when there are index funds and ETF's for practically any cross-section of any market you want to be exposed to.

Thanks for the comments!

Marc