King(s) of Capital
Private equity managers have seen high growth. Should we consider them as investments?
I recently finished the book King of Capital – The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone – by David Carey and John E. Morris. Blackstone is the behemoth of the private equity world (now having $684 billion in assets under management), and Schwarzman has been the company’s CEO since co-founding the firm in 1985. Today, he is 74 years old and the 79th richest person in the world, with a net worth of $33 billion.
The book was first published in 2010 and updated in 2011, but I love older books that stand the test of time, especially when they are filled with all sorts of detail, as this one is. The authors were long-time journalists at the time of writing (at The Deal and Dow Jones, respectively), and therefore were witnessing and reporting on the development of the private equity industry as part of their daily lives while Blackstone grew into a giant. The book’s publisher started with the idea of a primer on private equity, but later agreed with the authors that a history of Blackstone would be more interesting. Nonetheless, the book at times does feel like a history book about the industry, walking through all sorts of big deals and describing many important players. This is ideal for anyone really interested in the private equity industry. The book is incredibly well-researched.
The authors had an immense amount of co-operation from Blackstone, Schwarzman, and other key industry insiders. So much so, they were worried people might see the book as a sponsored biography of the firm. As a result of the co-operation received, the book contains vast amounts of detail such as investment returns, deal clauses, behind the scenes relationships, quotations, and returns data that could not otherwise have been possible. That said, the authors were seemingly able to maintain their independence, and they credit Blackstone and Schwarzman for not trying to unreasonably sway their opinions.
The book outlines how Schwarzman, who was global head of mergers and acquisitions at Lehman Brothers in the early 1980’s, negotiated the sale of Lehman to American Express. Then, together with Peter Peterson, the former CEO of Lehman, Schwarzman started Blackstone as a two-man boutique M&A advisory firm in 1985. Their intention was to emulate the successful KKR and get into the leveraged buyout (LBO) business quickly, but their contacts and experience meant it was much easier to use M&A advice to pay the bills, at least until they could convince some large investor to seed their first LBO fund. Ultimately, they convinced Prudential to be this first investor, after which several Japanese institutions wanted in. At over $600 million, their first fund was big enough to justify hiring big-name experienced deal makers. And the fees generated were also enough to allow Schwarzman to quickly start diversifying Blackstone into other areas, such as fixed income, real estate, stock trading, and hedge funds.
The timing of the fundraising for their first LBO fund was fortunate as it took place during an LBO boom. However, the market for LBO’s turned down at the end of the 1980’s and was at a standstill in the 1990 recession. The book walks through a lot of deals and staff turnover in the 1990’s, including disagreements with Larry Fink, who demanded the sale of his fixed income unit now known as BlackRock. Interestingly, the buyer paid $240 million in 1994 for a business that is now even bigger than Blackstone (BlackRock’s market capitalization today is approximately $128 billion versus $75 billion for Blackstone).
The authors walk through the craziness of the technology boom-bust in the late 90’s, a period that sealed the fate for other firms including the famous Forstmann Little, who you may remember as a bidder for RJR Nabisco in the book Barbarians at the Gate. Schwarzman and Blackstone avoided some of the silly tech excesses, as well as the havoc after September 11th. They had lots of cash available during the early 2000’s, which they put to work helping over-leveraged companies (a.k.a. vulture investing) and starting some reinsurance businesses. These investments led to big profits just in time for the next big LBO boom, in the mid-2000’s.
Around 2002, Schwarzman put a substantial amount of thought and effort into recruiting Tony James from Credit Suisse First Boston to be President and COO of Blackstone. To this point, it had been very rare for any large LBO firm to bring in an outsider to run things. Tony James could see a lot of Blackstone’s success came from opportunistically buying cyclical companies at low points. So, he worked to institutionalize Blackstone’s ability to improve investee operations, rather than just rely on freewheeling personalities.
One of the many deals discussed is the huge takeover of Sam Zell’s Equity Office Properties. Real estate markets were booming, and Blackstone finalized the huge purchase of EOP in February 2007, just before the onset of the subprime credit crisis. Blackstone, which saw unrealized value in the “sum of the parts”, astutely arranged to sell many of EOP’s landmark skyscrapers concurrent with closing the deal. This turned out to be a genius move as otherwise the global financial crisis would have made it a disaster.
Initial Public Offering(s)
Up to this point, the largest LBO firms were private partnerships. There was increasing talk about taking them public. Blackstone was first to strike, with an IPO in June 2007. A Bear Stearns credit fund famously ran into difficulty on the same day as the IPO in a foreshadowing of the carnage to come over the next 20 months. With credit markets faltering, the other three large firms (KKR, Apollo, and Carlyle) were forced to delay their IPO’s until after the crisis. Signed LBO deals started to struggle; banks and private equity firms tried to pull out of deals. The book goes on to outline how the industry worked through the carnage from 2009 through 2011. Blackstone’s investments were marked down, but they were not forced sellers and they could wait out the storm as most debt did not need refinanced until 2012.
One complaint I have read about the book is there is not enough about Steve Schwarzman. However, I would counter that the book makes up for it with countless details about many deals, firms, and other important individuals.
There is enough to show Schwarzman is highly driven and thoughtful. He is a leader, and he brought in high performers right from the beginning of the firm. He was quick to fire underperformers, but also learned to trust people (most importantly, Tony James). His aversion to risk helped him avoid the biggest blow ups in the tech and telecom bubble, as well as the subprime credit crisis. He is clearly opportunistic, stepping in to buy at cyclical bottoms. And he repeatedly leveraged strong relationships with other important businesspeople. He also seems to have great timing – evidenced in selling Lehman, raising funds during LBO booms, and being first to IPO.
In the final chapters, the authors dive into the pros and cons of the private equity industry and compare reality to public perception. They try to answer whether the industry is useful to society. They conclude:
Despite a reputation for greed, extravagance, excess, firings, and leverage, private equity does not harm the economy. Reputable studies show private equity does not kill jobs, strip vital assets, or take a short-sighted view of R&D.
Private equity sometimes adds fundamental economic value through new corporate strategies, mergers and divestitures, and operational fine-tuning, but a good portion of profits are from buying and selling at the right moments and leveraging up to accentuate gains.
Private equity firms are long term, with 58% of companies held five years or more.
The casualty rate for private equity-owned companies is low, with default rates lower than for all companies with bonds outstanding.
Versus public companies, private equity uses management compensation structures that are better aligned with owners and promote longer term thinking. Private equity is also faster to fire underperforming managers.
Private equity funds have beaten returns at major pension funds over the short and long terms. The top firms outpaced the markets handily over the long term. Therefore, private equity is here to stay.
Since 1982, declining interest rates have been a boon for the industry.
Unlike banks, private equity survived the global financial crisis intact, did not need bailouts, and was largely blameless. That said, it was largely due to the responses by governments and central banks that the crisis was not a catastrophe for buyouts.
At lows in the business cycle, buyout capital is used to deleverage struggling or bankrupt businesses or to buy debt at big discounts, because undercapitalized and distressed companies have the most upside for investors in a bad economy. In better times, investment flows to companies that need operational improvements, as well as start-up businesses.
Private equity firms assume the risks of making changes because they control their companies. Their companies can therefore achieve more of their potential. Private equity is best understood as a parallel capital market and an alternative, transitional form of corporate ownership. Its capital comes with an agenda, and the capital provider has the power to see the plan carried out.
Private equity serves as a bridge between two stages of a company’s life. Private equity’s activist ownership style can fill a real need when other forms of capital and ownership have fallen short.
Top private equity firms are becoming global investment emporia catering to the expanding tastes of pensions, endowments, foundations, and high net worth families. They offer an ever-expanding range of alternative assets, including LBO funds, debt investments, lending, real estate funds, hedge funds, corporate finance advisory, funds of funds, and vehicles in all geographic regions including Asia and South America.
When I read these conclusions, I found them balanced and reasonable. I do believe dividends and safe amounts of leverage can lead to more focus on efficiency. Also, despite investment horizons of only 6 to 8-years, private equity often seems more “long term” than many managers overseeing public equities. Their performance through the tech bubble, the global financial crisis, and the Covid pandemic likely does mean they are not as cyclical or prone to bankruptcy as sometimes feared. They do seem good at replacing managers and board members with more efficient people, as well as retaining strong managers. And without quarterly reporting, as Tom Russo might say, private equity-owned companies have “Capacity to Suffer”. In my experience, many companies and subsidiaries sold by private equity go on to perform quite well. Since they are now more efficient, their chances of long-term success are better, which is a benefit to remaining employees, society, and shareholders (the latter often just representing the retirement savings of society).
Despite finding the conclusions reasonable, I could not help noticing that many were diametrically opposed to views in an interesting podcast that came out just last week. Tobias Carlisle in his Acquirers’ Podcast interviewed Professor Jeff Hooke from Johns Hopkins, author of the new book The Myth of Private Equity. Hooke’s arguments include the following:
It is a myth that private equity beats the public market. Some industry players say returns are 20-30% per year. The actual data says that over the last 15 years, the public markets beat the typical LBO fund by ~2% per year.
LBO’s were effective early on (starting roughly 35 years ago) and worked well for about 10-15 years. But the success attracted competition and now there are hundreds of funds chasing targets with the same profile (low-tech money-makers). So, LBO’s didn’t beat the market over the last 10-15 years because their managers are paying higher prices as they compete for the same deals.
LBO’s have been more beneficial for private equity managers than investors. The fees are high (3-4% off the top), which is great for managers, but makes it almost mathematically impossible to beat an index where fees are 3-5bps. If fees were cut to (say) 1% management fees and 10% performance fees (from the standard 2 & 20), then quite a few buyout funds would be beating the market. But out of the top 100, only about the top 25 beat the market.
The actual returns are opaque and often hidden. The industry has convinced legislators in many states to keep fees private. But where numbers are public, the internal rates of return (IRR) for the last 10 years have been around 10-12%.
As a measure of performance, Hooke likes "total value out" versus “total value in” and says 1.5x is the industry average. Yet, industry players brag they are earning 20-30% returns. But 1.5x does not produce those kinds of IRR's over 6-10 years. So, the complexity and opaqueness are allowing people to misstate the true results.
The industry compares its returns to the S&P 500 but should really allow some premium to account for illiquidity.
IRR can be somewhat manipulated. For example:
If a fund sells their good deals first, and holds the dogs for 8 or 9 years, the way the math works, it boosts IRR.
Rates of return are also a little misleading because investors must keep money set aside (likely yielding very little) until they get capital calls from funds they have made commitments to.
The largest 100 private equity firms have grown so big they can borrow money on their own lines of credit. So, they buy companies then hold them for say six months before dropping them into their latest fund. This six-month difference can add a couple of percentage points to the annualized rate of return over 5 years.
Private equity managers are not perpetuating the myth of superior risk-adjusted returns by themselves. They have cooperation, even if some of it’s inadvertent.
Customers are enablers. They could use public markets to implement a private equity-like strategy and get the same returns without the illiquidity and fees (e.g., search Dan Rasmussen). Basically, you buy smaller public companies and leverage them. But big institutional customers will not buy this strategy because they need to justify their existing LBO investments, along with their big job titles, salaries, and staff. It is in their interest for everyone to think their job is complicated. Even though managers are not beating public markets, trustees do not feel qualified to seriously oppose their strategies.
Customers enable the "lower volatility" mantra, too. Public equity markets and markets for private companies are highly correlated. LBO funds are more leveraged, but with the help of 'mark-to-model' accounting they pretend that when the market drops, they drop less. This contradicts financial theory, but nobody questions it. Not the government. And not investors – because it is in their interests to show a smoother ride than the volatile public markets.
Governments are enablers, too. The SEC only has a handful of people looking at the industry. They have not taken issue with 'mark-to-model' or return smoothing despite this being a huge industry.
The business media is also an enabler (and an echo chamber). A lot of reporters do not have the resources or technical knowledge to verify the industry’s returns, and editors are afraid of being ridiculed or contradicted by the industry.
Investment consultants and wealth management firms promote private equity because they get paid for recommending or investigating the funds. If they were to recommend an index fund, clients would say: “Why do I need you?”.
Academics have tended to critique private equity, but a lot of their research studies are 5-10 years old (i.e., from when the LBO funds were performing better). The top universities spend more time on the mechanics of a good deal (how it's evaluated, closed, improved, and re-sold) instead of analyzing returns.
Are there solutions? Not many obvious ones.
High deal pricing due to competition – Eventually, there will likely be fewer funds, which over 10 years could help improve returns.
High fees – Fees have been very stable, and it will take time for investors to realize the private equity firms are not full of geniuses, after which fees might come down.
Gaming returns – Governments should pass legislation requiring more clarity around returns and fees, making comparisons easier. This could lead to eliminating half the funds that can not cut it.
Many of Hooke’s arguments make sense to me, too. I think both perspectives are important. One big difference is King of Capital focuses on 1985-2010, whereas Hooke says LBO’s have underperformed the market over the last 15 years, a period which uniquely ends with a fantastic showing by growth stocks.
It seems the value added by the industry can vary at different points in the business cycle. When LBO funds are booming, fundraising is easy, and intense competition for targets bids prices up, it feels the value added will be much lower. However, the industry is clearly prone to confidence shocks, and when sentiment is jittery or negative in periods of stress and fear it can provide attractive opportunities.
So overall, I enjoyed King of Capital, and I recommend it to anyone interested in private equity (especially if you want to dive into details including deal structure, fundraising, individual personalities, partner compensation, banking, credit markets, economic cycles, competition between firms, etc.). It is not as juicy, thrilling, and dramatic as Barbarians at the Gate. It does have a bit of that (personalities, infighting, negotiation, firings), but you need to want to learn about the details of LBO’s to enjoy this book. While detailed, it is efficient and moves quickly, and does not bog down the reader. Again, it was last updated in 2011, so there is a chance you finish it wishing there was a sequel. Despite this, I believe it is a ‘must-read’ for people entering the private equity industry.
Come back for Part II where I will discuss some of the big public firms in the industry. I will touch on what differentiates them, their current valuations, and whether I think these companies are worth considering as investments by portfolios we manage.
In the meantime, please contact us if you would like to learn more about our current investments. We would be happy to discuss with you how we decide which companies make it into our portfolios. We are always eager to discuss our investment philosophy and how we feel it can help build wealth over time.
Until next time!
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