C&B Notes

Some Perspective on Private Equity

Dan Rasmussen and his team at Verdad Capital took a hard look at the performance of private equity and what its investors can expect in the future.  Their findings suggest leverage and rising exit multiples have driven much of the returns in the last two decades plus with little evidence of operational improvements as a source of value.  Will the capital market conditions that produced these mutually beneficial outcomes persist for the next 20 years?

A recent survey of institutional investors found that 49 percent expect private equity (PE) to outperform the public equity market by a whopping 4 percent per year or more.  Another 45 percent believe PE will outperform by 2–4 percent per year.  Only 6 percent think returns will be comparable.  The survey did not even bother to ask if investors thought PE might underperform…

This consensus has led institutional investors to flood private markets with capital, about $200 billion per year of new commitments.  The result is soaring prices for private companies of all shapes and sizes.  Just before the financial crisis, in 2007, the average purchase price for a PE deal was 8.9x EBITDA (earnings before interest, taxes, depreciation, and amortization — a commonly used measure of cash profitability).  Deal prices reached 8.9x again in 2013 and are now up to nearly 11x EBITDA.

But asset prices are going up everywhere.  What makes private equity dangerous is the use of debt — and the use of phony accounting to conceal the riskiness of these leveraged bets.  The average PE deal is 65 percent debt financed, and whereas the valuations of public equities are determined by transparent, liquid public markets, PE firms determine the valuations of their own portfolio companies.  Unsurprisingly, they report far lower volatility than public markets.

This appraisal accounting also encourages lenders to take risks.  After the financial crisis, the Federal Reserve warned banks that most companies could not bear debt above 6x EBITDA.  Lenders now tend to stop at 6x EBITDA in keeping with that rule, but they allow PE firms to play with the definition of EBITDA.  Whereas regulators require public companies to use GAAP financials, lenders allow PE firms to remove various “one-time” costs to get to “pro forma” EBITDA or to take a particularly positive recent quarter and extrapolate from that short time period to an optimistic “run-rate” calculation.  Such optimistic metrics are at their most extreme in software, where lenders will finance companies based on neologisms like “annual recurring revenue” and “cash EBITDA,” which, having no fixed definition, allow debt levels to be picked from the air.

In 2007, private equity debt levels reached 5.2x EBITDA.  Today, they are at 5.8x EBITDA, and they have been above 5.2x every year since 2013.  The 2007 vintage deals did not end well for investors.  Today’s higher-priced and more leveraged deals could end even worse.

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My firm, Verdad, compiled a comprehensive database of 390 deals, accounting for over $700 billion in enterprise value (EV), a substantial set of data representing the majority of the largest deals ever done.  We then analyzed it to understand what has actually been going on in the PE industry…

In 54 percent of the transactions we examined, revenue growth slowed.  In 45 percent, margins contracted.  And in 55 percent, capex spending as a percentage of sales declined.  Most private equity firms are cutting long-term investments, not increasing them, resulting in slower growth, not faster growth.  If PE firms are not growing businesses faster, investing more in growth, or gaining much operational efficiency, just what are they doing?  In 70 percent of cases, PE firms are leveraging up the businesses they buy.  PE firms typically double the amount of debt on the balance sheet, from 2.5x EBITDA to 5x EBITDA — the biggest financial change apparent from our study.

The industry mythology of savvy and efficient managers streamlining operations and directing strategy to increase growth just isn’t supported by data.  Instead, there is a new paradigm for understanding the PE model — and it is very, very simple.  As an industry, PE firms take control of businesses to increase debt and redirect spending from capital expenditures and other forms of investment toward paying down that debt.  As a result, or in tandem, the growth of the business slows.  That is a simple, structural change, not a grand shift in strategy or a change that really requires any expertise in management.

That is not to say that debt is always bad, or that rerouting capital to debt paydown is necessarily a negative thing.  There is an optimal capital structure for every company that maximizes the value of the interest tax shield while minimizing the risks of financial distress.  Many companies have too little leverage.  The effective use of leverage was key to private equity’s historical success.  In the 1980s and early 1990s, private equity firms helped rein in the impulses of would-be empire builders and bad capital allocators (Japan today could probably use a healthy dose of this, for example).  Investors were right to demand earnings not be kept in the business but instead returned to investors through debt paydown and dividends.

But there is a big difference — bigger than most realize — between what private equity used to do (buy companies at 6–8x EBITDA with a reasonable 3–4x EBITDA of debt) and what private equity does today (buy companies at 10–11x EBITDA with a dangerous 6–7x unadjusted EBITDA of debt).  Debt is a double-edged sword.  It can provide great benefits if used judiciously, but if regularly applied in large dollops, it can create massive problems.

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