Are worries about high prices in private equity exaggerated?
Bon French: Prices were high five years ago and are higher today. Inevitably, interest rates will rise significantly, dragging down growth. Then prices measured as a multiple of cash flow will fall. So, concerns are justified. That said, low interest rates have led to high prices for virtually all assets, including public stocks. But there’s a particular risk built into private equity. It’s generated by attempts to keep pricing optically lower. In many instances, cash flow is adjusted upward and multiples downward by incorporating projected synergies and even add-on acquisitions that haven’t yet happened. you can make lots of excellent investments in private equity; you just need to be as knowledgeable as possible about practices and about company prospects across economic cycles. You can’t tell when the cycle will turn, so the most effective defense against high prices for a sophisticated investor is dollar cost averaging, year in, year out.
Francesca Cornelli: Concerns about high prices highlight another issue where general partners need to do a better job. They’ve got to differentiate themselves in a highly competitive environment in order to avoid the winner’s curse of paying too much for assets. Auction theory tells us bidders overpay when everyone has the same viewpoint and the same value creation tools at their disposal. It’s only when you have bidders modeling investment potential differently, relying on differing toolkits and skill sets to leverage it, that you get processes where there’s a surplus of value still left on the table. High prices are leading to greater specialization and differentiation among general partners, but, on average, that evolution is not happening fast enough. Wariness should be the order of the day regarding pricing.
Jagdeep Singh Bachher: Private equity managers are doing what they can to adapt to a more competitive environment. But I believe the fundamental problem today is exaggerated expectations. In a period when interest rates are low and returns from stocks are not likely to meet our requirements, we institutional investors — public pension funds in particular — must take a good amount of the blame for pushing general partners to manufacture scenarios that generate the high returns we need to meet our liabilities. Everyone should be lowering their return expectations.
Can today’s high prices be partly justified by better corporate governance at private equity-backed companies and its possible corollary, increasingly bureaucratic and short-term oriented corporate governance at listed companies?
Francesca Cornelli: Several studies have shown that on average the corporate governance of private equity-backed companies is superior to what you find at listed companies. At private equity-backed companies, boards are way more involved, better informed and incentivized than at public companies, most notably in a way that’s more aligned with long-term profitability and growth. Will that mitigate against the harmful impact of pricing indiscipline? Yes, it probably will, which is why limited partners — who are more sophisticated today than ever — will continue to favor private equity over stocks. Nonetheless, prior to taking the reins at portfolio companies, pricing indiscipline would seem to be a weakness within the management and incentive structures of private equity firms. One way to remedy that may be to give limited partners more information and more ability to question pricing when it comes to acquisitions.
Bon French: We’re facing only the third time in history where private equity-backed acquisition values, expressed as a multiple of cash flow, are higher than publicly-listed valuations. When it happened in the late ‘80’s, and then again prior to the financial crisis, it resulted in subpar annual net returns in the high single digits, versus the 15 percent to 20 percent targeted by private equity. We could be facing similar returns, but given today’s low interest rates, most institutional investors would be backing up the truck and investing even more in private equity if we could guarantee a 9 percent net annualized return versus the approximately 6 percent return expected from stocks. So yes, I think private equity’s better corporate governance, and the higher returns that result from that, do justify pricing that’s higher than in public markets. Still, all prices look inflated today.
Jagdeep Singh Bachher: The fact that the traditional gap between private market valuations and public valuations has disappeared is principally a symptom of the huge amounts of money chasing private equity deals. Another result of the excessive amounts of capital chasing deals are many of these secondary purchases where a firm is sold from one private equity firm to another. I’m concerned that a lot of these deals return money to one pocket and take it from another, leaving investors with more fees and comparatively less upside. High prices and secondary deals are part of the same problem, too much money washing around private equity and too few targets.
Bon French: I’ll jump in here — we did an in-depth analysis of the kind of private-to-private transactions Jagdeep mentions because we shared his concerns. But we found no evidence of systematically diminished returns, whether the private equity purchase was secondary, tertiary or beyond. Each private equity owner tends to bring a new multi-year growth plan, expanding product range and geographic reach. Moreover, we know these companies better than we would listed firms, partly because we’ve been with them a long time, but also thanks to private equity ownership. I’m more wary of being a public markets investor where I have less first-hand knowledge of companies, managements, their plans and debt covenants, than I am of being a private equity investor. The granular, detailed knowledge that leads to the best investment decisions comes from up close, personal contact. That, ironically, isn’t possible in hide-bound public markets.
Jagdeep Singh Bachher: All excellent points — secondary private-to-private deals do make sense in many instances. It’s also undoubtedly very attractive for businesses to stay private thanks to better alignment concerning long-term strategy. Yet many managements, and investors — like us — still believe there’s too much short-termism in private equity, even if the situation is better than in public markets. While managements like the advantages of private equity ownership, a lot are tired of seeing their companies being sold on to other private equity owners after three years or less when there’s still plenty of growth potential left. Each of these transitions is a new burden for management teams. Truly long-term capital, such as the rising number of funds we see with a 15 or 20-year investment horizon, may be the best answer for steering companies through the choppy waters of a marketplace awash with too much capital.
Francesca Cornelli: the desire to deliver money to investors to get momentum going for a new fundraising cycle every three years or so does lead to the premature sale of companies. But even if money is left on the table, it doesn’t fundamentally alter the superior alignment of interest between investors and managements in private equity and the resulting better returns from PE-backed — rather than publicly-listed — companies. The new, longer maturity PE funds we’re seeing would reduce early sales, but it’s too early to say what their impact on incentives will be. There is a danger longer-term funds could destroy the alignment of interests, and the urgency to aggressively grow companies, that makes private equity so attractive and which, to some extent, justifies higher valuations.
What are the implications of high prices when it comes to take-private transactions and the overall size of public markets?
Bon French: Succinctly, the answer is more take-private deals, more private-to-private transactions and fewer initial public offerings. Managements don’t want to go public. Given the huge amounts of committed but unspent capital earmarked for private equity broadly defined — encompassing real assets, credit and venture capital, as well as buyout and growth — they have no need to. Moreover, today’s high private valuations for companies effectively mean little to no penalty for pursuing the bolder and more frequent strategic changes companies increasingly must follow to keep up in an online, data driven world. The radical strategic changes demanded by the technological revolution are easier to handle when companies are private rather than public.
Jagdeep Singh Bachher: Yes, there is a private equity 3.0 model emerging, driven by record high prices. Private equity 1.0 — reliance on cost cutting and leverage to generate profit — worked in less competitive days. Private equity 2.0, operational improvement and buy-and-build strategies became essential as prices rose. But given ever rising prices, 1.0 and 2.0 are increasingly not enough to generate the value-add that private equity needs to produce good returns. Much of the willingness to pay high prices today is based on the amazing efficiencies that private equity managers believe will come with the wider leveraging of data and technology.
Francesca Cornelli: While I think pricing competition from private equity will shrink the public markets, a smaller public market is also the result of technology itself. Companies once had to list not just to raise capital but also in order to build familiarity with their firm. That was brand building for everyone from customers and suppliers to potential lenders and investors. Today the easy availability of online data and media makes it much easier for private companies to do business with all these groups, negating many traditional reasons to go public.
If higher multiples relative to listed equity prove sustainable, what further changes might that provoke?
Jagdeep Singh Bachher: Cancer, neurodegenerative diseases and climate change are seemingly intractable problems. The public markets, because of their structure and short-termism, are exceptionally poor at funding solutions for these kinds of major problems. If private equity managers find themselves in a long-term environment where pricing is higher than in the public markets, they will turn to investment in less crowded specialist fields largely ignored or abandoned by public market investors. Among them, I suspect, will be these areas of major medical and environmental challenge, where the potential return could be mind-boggling for everyone. A dangerous evolution for private equity’s focus and edge would be if higher prices drain activity in public markets to the point where regulators and society feel PE should be opened up to retail investors.
Francesca Cornelli: When private equity investment faces challenges, there are always managers who find a solution — sometimes for the better and sometimes for the worse. One way to potentially neutralize the impact of higher pricing that I do think would gain in popularity would be doubling down on private equity’s advantage of long-term ownership by lengthening fund life, as we discussed. Yet, as I mentioned, that could have unforeseen consequences regarding incentives. If higher pricing in private markets continues to shrink public markets, and PE captures an ever-greater share of investing, we could also easily see more regulation of private equity. The danger is that if regulation is not done intelligently and with a light touch, it could kill private equity’s edge over the public markets.
Bon French: If private multiples stay at a premium to stock multiples, I think we’ll have even bigger mega funds that can step in and buy some of the large cap companies that today only find sufficient financing in public markets. With the contraction of public markets, we’ll also see a much more significant opening up of private equity investment to the mass affluent. This trend is already well underway. JP Morgan, Morgan Stanley, UBS, Vanguard and all the other major traditional money management platforms and investment banks are already working with players like us in private equity to open PE up to individual investors.