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Private Equity: Real Returns, Real Risks

Private equity has quickly become a global industry.  In the past three decades, private equity has accounted for $2.6 trillion in total assets from all sectors and almost all regions of the world.

 

Private equity’s growth in both size and returns has attracted the interest of many new players, including family offices that represent high net worth individuals and their families.

 

Investments in private equity are not listed in public exchanges, and therefore not subject to the same level of scrutiny as publicly listed companies.  This can make them inherently more risky.  It is also often tempting for private equity managers to sometimes break the rules in ways they would not dare do with publicly traded assets.

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The biggest issue regarding private equity is accountability, for the protection of both direct investors and the general public.  The Dodd-Frank Act provides broad guidelines for monitoring financial activities in the United States, including closing loopholes in transparency for private equity.   The law is more narrow in the United Kingdom, which governs private equity under the Alternative Investment Fund Managers Directive (AIFMD).

 

The Dodd-Frank Act and the AIFMD cover several issues of concern for investors and the general public via monitoring and regulatory measures.  Among them are:

 

 

Concern surfaced around deal pricing and valuation when returns on investment in publicly listed equities, in general, outperformed investment in private equities.

 

From the perspective of private equity managers, however,  this issue is disputable.   Return on investment  is only one of the variables they consider when making investment decisions.  Private and and public equity managers may be using the same parameters but their evaluation criteria may be different.  Public equity managers tend to focus on benchmarks, but benchmarks presume a certain level of certainty not usually found with private equity.

 

 

This was a common practice during the corporate raiding era of the 1970s and -80s.  The raider or buyer would purchase a losing or mediocre company with valuable assets, with the intention of selling these assets at higher price.  The purpose of asset stripping was not for long-term company ownership but windfall profit from the sale of  assets.  Asset stripping is detrimental to creditors and the existing company’s investors and a large portion of profit often wound up in the pockets of equity fund managers.

 

 

 

Another gray line is financial leverage, or using borrowed funds rather than equity to finance acquisition or capital expenditures.  Leverage is an acceptable practice in financial management, but its effects on the return on investment (ROI) and return on equity (ROE) depend on the cost structure of both the debt and equity, including tax consideration.  If debt is abundant and cheap, it is prudent for an investment manager to consider leverage financing in making buyout decisions. However, a moral issue surfaces if the leverage buyout is associated with asset stripping.

 

 

This is a buyout strategy of using other people’s money.  It happens when the seller has plenty of assets, but has fully exhausted the company credit limit.  The person that has the capacity to borrow would arrange a loan using the seller’s assets and then use the proceeds to pay off the  seller.  This practice may become immoral, however,  if the intent of the acquisition is asset stripping.

 

 

The private equity industry is known for risk taking. It follows a generally accepted investment rule: “high risk, high return.”  Thus, it is expected that private equity investment will outperform its public equity counterpart.  As highlighted in  Harvard Business School Report, the “[t]rack record of some endowments in private equity has been spectacular, e.g., annual return for Yale, 1973 to 2006: U.S. venture capital: 34.8 percent, U.S.  buyouts: 22.1 percent, international: 17.1 percent, overall: 30.6 percent.

 

 

The lucrative return of private equity investment is tempting to a family office. A more prudent course of action would be to start as a co-investor in a private equity firm where the family office is already a limited partner, simply to gain experience in the domain while minimizing risk and cost.  Co-investing with one or more family offices is another option.

 

In making choices for a company to invest, working with independent sponsors is also a practical alternative in pre-qualifying potential acquisition or equity investment.

 

However, for those who seriously intend to put up their own private equity fund for greater investment leverage, they should look closely at just how much money it will take to set up and operate a private equity firm.

 

David Drake is an early-stage equity expert and the founder and chairman of LDJ Capital, a New York City-based family office, and The Soho Loft Media Group, a global financial media company with divisions in Corporate Communications, Publications and Conferences. You can reach him directly at David@LDJCapital.com.

 

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