Should I Follow Private Equity Money?
Private Equity Firms rarely fail to make the daily news in financial markets. They are continually on the hunt for new acquisitions and exit companies just as frequently, either to spectacular returns or dismal bankruptcies. This dichotomy creates a certain allure amongst investors, inspiring interrogative thoughts of “could I do that” while simultaneously looking at cases gone wrong, like Toys ‘R’ US. A study of 1400 US buyout funds from 1990 to 2005 showed PE funds outperforming the S&P by 20-27% over the life of the fund, or 3% higher annually, despite the dot-com crash. However, before we can get into the “should I invest like that”, we need to discuss whether or not small investors actually can.
Private Equity Firms set up funds that can range from a few million dollars to billions for the largest firms. The cash comes from pension funds, endowments, and extremely wealthy individuals. This is the primary way to invest in PE: have massive amounts of wealth to invest illiquidly for 10 or more years. However, if you do not have millions in spare cash, you can still imperfectly invest in PE.
The first method is to buy stock in a publicly traded PE firm (or an ETF of many of them), like Blackstone, KKR, Apollo Global Management, and a number of others. However, this isn’t really a synthetic way to invest in all their holdings. PE firms’ stocks tend to co-move with the broader financial services industry rather than on the basis of their deals, which means events that mean nothing to a PE firm can still drag down their stock. The other reason this isn’t the same as investing in their holdings is that a share of stock is a share of earnings. A PE firm’s earnings come from its fees, and while fees are related to the returns on the fund(s), they are not the actual returns. The returns go to the pension funds and wealthy investors. So, a PE firm’s publicly traded stock (or ETF) is not the best way to invest in private equity.
The second method is imperfect as well, but could allow a small investor to “match” private equity returns. PE firms often invest in public companies through private placements or buying public stock. While the firm could buy all of a company, there are many situations wherein they buy some amount greater than 50%, but less than 100%. This way, they have complete control over the company, but can do so with less capital. A small individual investor could then buy stock in the leftover portion of the company and experience the same return the PE firm gets through their management of this company, assuming both parties only own common stock.
Now, PE firms want to create the greatest firm value possible, as this is how large returns are achieved. In order to do this, they often replace management, lay off workers, sell underperforming parts of the business, buy small companies as “add-ons”, etc. These moves all come with substantial risk, and generally tightly couple a company’s financial health (increasing leverage, stretching working capital, etc.) to the PE firm’s projected numbers, wherein a slight miss on top-line revenue or slightly lower margins could put the company into extreme financial difficulty. When successful, these can return obscenely high percentages. However, the variance in individual private equity investments is quite large, meaning that they can also simply lose everything. This would make it very risky for an individual investor to put a lot of weight in one PE-backed public firm. There are many examples of private equity successes and failures, so there isn’t really a need to dissect specific cases. However, this means it is key to talk about the differences between a PE Firm’s investment thesis and an individual investor’s.
Individual investors, generally speaking, invest for retirement. Their plan is to periodically put away portions of annual income, and earn the market risk premium over a long period. This allows them to (ideally) retire comfortably or earlier than if they had only put money in a savings account. A PE firm is very different. Their money comes from “limited partners” (pension funds, wealthy individuals, etc.), and is locked up for a decade or more in a specific fund. Due to the illiquid and risky nature of private equity, these limited partners demand high rates of return on their deposits. To incentivize PE firms to achieve these high returns, limited partners pay a percentage of the total return (in the form of fees) to the firms. The higher the return, the larger the fee, and the happier all the parties are.
In order to maximize the probability of these high returns, PE firms spread their millions or billions of dollars over many investments (depending on the nature of the fund), diversifying their portfolio. Some of these investments will be in private companies, others will be in public companies, and some may be in public companies that PE firms then “take private”. With so much money, PE firms can do many things in business. An individual investor won’t have the ability to follow all of these moves, as they cannot invest in most private companies. They could track several PE firms and attempt to follow their partial investments in public entities. This would diversify their investments, but it would be difficult to implement due to information asymmetries and high capital requirements. It would also incur more trading fees than investing in a single mutual or index fund.
So, while this last strategy is complex yet implementable, it only accounts for part of a PE fund’s returns. The other parts come from sources unavailable to small investors. A study conducted by Carpentier et al. found that private placements in 3000 small to medium sized public firms underperformed the market on average. This means that individual investors would be better off, on average, investing in an index fund than following PE firm private placements. Ultimately, if an investor wants to truly invest in private equity, they’ll need a lot of excess cash and little need for it over a long period of time.
Carpentier, Cécile and L'Her, Jean-Francois and Suret, Jean-Marc, The Return on Private Placement in Small Public Equity (May 4, 2011). Available at SSRN: https://ssrn.com/abstract=1712481 or http://dx.doi.org/10.2139/ssrn.1712481
Harris, Robert S., Jenkinson, Tim, and Kaplan, Steven N. (2013). Private Equity Performance: What Do We Know? Journal of Finance, July 2013. http://faculty.chicagobooth.edu/steven.kaplan/research/HJK.pdf
Huang, Nellie S. (2012). How Small Investors Can Invest in Private-Equity Firms. Kiplinger, January 20, 2012. https://www.kiplinger.com/article/investing/T022-C009-S001-how-small-investors-can-invest-in-private-equity-f.html
Kaplan, Steven N. & Schoar, Antoinette. (2005). Private Equity Performance: Returns, Persistence, and Capital Flows. Journal of Finance, Vol. 60, Issue 4, 12 August 2005. https://onlinelibrary.wiley.com/doi/full/10.1111/j.1540-6261.2005.00780.x