Private equity boom has further to go

Key points

• Private equity is more good than bad for companies and the economy and there is a strong case for its inclusion in diversified investment funds.
• Private equity takeover activity is likely to remain strong for a while to come. This should be positive for shares overall, but it does make stock-picking hard.

Private equity has received a lot of attention lately because it has been involved in several large takeovers. Private equity-funded takeovers are generally good for investors because they push share prices up. But many commentators fret that private equity firms are “Barbarians at the gate” ready to plunder companies of assets, sack workers and push gearing to unsustainable levels and at the same reap exorbitant fees. This note looks at the key issues.

What is private equity?

In essence private equity is just another form of financing and simply involves a group of investors buying, improving and then selling businesses with the hope of achieving a decent return along the way, typically with a three to five-year turnaround. Private equity involves two types of activities: venture capital, which involves financing and developing small high risk start up companies; and buyouts of publicly listed companies, often referred to as leveraged buyouts (LBOs), reflecting the use of debt.

LBO transactions usually involve about 30% equity funding (from a private equity fund or a consortium of such funds) and 70% debt (provided by banks and institutions). Institutional investors account for about 80% of private equity funds both in Australia and globally and these funds are used to provide the equity financing in deals. In Australia superannuation funds are the main investors in private equity. Typical exposures in Australian super funds are about 1–2%, but this ranges from zero up to 6%.

While private equity suffers from being illiquid (with investors usually required to commit for several years) it provides a similar or better return outlook to listed equities without being subject to the same swings in investor sentiment. That means returns, while riskier, are less than perfectly correlated with listed equity markets. With listed equities having run very hard in recent years it’s likely that at some point unlisted equity will outperform. As such, it is easy to justify up to a 5% or so allocation to private equity in a diversified investment mix.

The big development in recent times has been a surge in fund raising by private equity firms and a huge surge in the value of deals, in large part due an increase in the size of deals/companies being targeted. LBOs have driven the recent surge, with deals/bids involving a range of major Australian companies including Qantas, Coles, Seven, PBL, APN News & Media, etc.

Source: Australian Venture Capital Journal, Thomson Financial, RBA

But the surge in LBOs in Australia has followed a similar surge in global LBO activity that began a few years ago. As the next chart shows, there has been an eight-fold increase in the value of LBO deals over the past five years.

Source: UBS, Thomson Financial, AMP Capital Investors

Pros and cons of private equity

The surge in private equity takeovers has led to worries about its impact. The main concerns are:

• Claims it leads to asset stripping and mass layoffs.
• Concern about the fees paid to private equity funds and investment bankers associated with deals.
• Worries about conflicts of interest, with some people concerned that if senior management are involved “they must know something they are not telling us”.
• Concerns about a deterioration in the depth and quality of financial markets as companies are taken private.
• Fears about the increased level of gearing that follows LBOs and what this might mean for the economy.

Against these concerns the following are worth noting.

First, private equity plays a critical role in helping ensure an efficient business sector and that scarce resources are allocated appropriately. The threat of takeover provides a discipline on management, and taking a company private is often a way of making decisions in the long-term interest of the company without having to worry about short-term moves in the share price.

Second, concerns about asset stripping and mass layoffs don’t stack up. Asset stripping would make a profitable exit very difficult. And studies show that employment by firms backed by private equity is actually stronger than for listed firms. Private equity is usually about empowering existing management teams to get it right, not about slash and burn.

Third, while the potential for conflicts of interest needs to be managed carefully, private equity bidders easily run the risk of paying too big a premium for a company.

Fourth, it is worth noting that if fees are too high it will make it hard for private equity funds to provide a decent return for investors. Competition should also help ensure fees are reasonable. While fees for successful deals may sound high there are many deals which never get off the ground but still involve a lot of work.

Fifth, the impact of private equity on the size of the investible universe of publicly listed shares is usually temporary because funds exit after a few years often via re-listing the company. There have been waves of takeover activity over the years and yet sharemarkets in Australia and globally are broader than ever.

Finally, gearing is an issue. But we are coming from a low base in terms of corporate debt levels in Australia and globally so it’s too early to worry about it now.

Source: ABS, Aspect Huntley, RBA, Statex, AMP Capital Investors

The evidence on private equity fund returns tends to support the view that private equity creates more efficient firms, although there is a wide dispersion in returns across private equity funds.

Surging private equity-driven LBOs reflects several drivers:

First, equity capital for private equity funds is readily available, consistent with the favourable liquidity backdrop for investment markets generally. Monetary conditions are generally unrestrictive and investors have been prepared to take on more risk.

Second, corporate balance sheets are under-geared and free cash flow is strong, making companies attractive to private equity funds that rely on strategies which will increase debt levels.
Third, the cost of capital has been driven down by low bond yields and low corporate debt risk spreads, and strong profit growth has helped maintain attractive earnings yields. This is illustrated in the charts below for both the US and Australia.

Source for both charts: Thomson Financial, AMP Capital Investors

Finally, the focus on corporate governance standards in recent years for listed companies may be driving firms to consider that private ownership is an easier option.

Points two and three are perhaps the most important. As long as the cost of capital remains low relative to its return and debt levels are low there is an incentive for private equity funds to mount leveraged buyouts.

Outlook

Our assessment is that the private equity-driven takeover phenomenon has further to go. The relatively benign environment of low inflation and reasonable growth is likely to remain in place for some time and this should ensure that the cost of capital remains low and the return on capital remains high. Corporate gearing is still low, suggesting lots of scope for increased gearing; and the value of global LBO activity as a percentage of global sharemarket capitalisation is still low versus the late 1980s.

Implications for investors

The ongoing boom in private equity takeovers has several implications for investors, including:

• Continuing upward pressure on share prices generally, because private equity funded takeover activity reduces the number of shares on issue and gives cash to investors.
• With price earnings multiples for industrials relatively high, it is likely private equity activity will extend into the resources sector where price/earnings multiples are about 12 times, balance sheets are strong and confidence is growing about the sustainability of high commodity prices.
• Takeover activity is making stock-picking hard, particularly for growth-style investors. Targets tend to be poorly performing stocks that growth investors avoid.
• While private equity funded takeovers may push shares higher, the associated rise in debt levels is negative for corporate debt and may lead to a rise in credit spreads.

Conclusion

The boom in private equity takeover activity is likely to get bigger and this should be positive for shares overall.