personal finance

Why private equity is eroding the IPO market


Here is an experiment. You are a pension fund investor looking at buying shares in an imaginary company — let’s call it Acme. How might you want to own those shares?

Well, you could simply buy them in an initial public offering. That’s the traditional way. Or, alternatively, you could give the money to a private equity tycoon whose fund would then buy Acme. This is the route ever more pension funds are taking, and one reason why stock markets are shrinking. The number of US IPOs declined from 700 in 1996 to barely 100 in 2017.

Let’s assume Acme has a starting valuation of £1bn, and operating profits of £100m which are growing at 5 per cent. Its operating performance is the same, whichever route it takes, and we apply an identical valuation multiple. The only difference is the capital structure chosen; either a conventional IPO and listing, where 70 per cent of the capital is equity and 30 per cent debt, or a buyout where the position is the reverse, with 70 per cent being debt.

We have to set a few rules, so the listed version (we’ll call it Acme A) pays out all of its cash flow as dividends (reinvested as stock market returns) whereas Acme B (the buyout) uses it all to repay debt.

Acme A has lower running costs for our investor: the pension fund pays half a per cent annually to hire its fund manager and a similar amount to pay the board. Acme B, meanwhile, is paying the full-fat private equity management fee of 2 per cent and profit share of a fifth. There are also one-time IPO (7 per cent) and buyout deal fees (3 per cent).

Lastly, pension funds have long-term liabilities so we’re interested in a 20 year horizon. That means while our fund holds its shares in Acme A throughout, its investment in B goes through five successive four-year buyout deals, investing successively at the same multiple (ie escalating values) in each one.

So, how does the pension fund do out of these two different approaches? Well, in terms of fees, it is no contest. Our investor in Acme B’s buyouts forks out roughly three times the amount paid by the holder of Acme A listed shares.

That’s one reason why the cash flows received over two decades by our Acme A quoted investor are also higher: it receives nearly 50 per cent more in nominal terms than those for investors in buyout Acme B.

And yet Acme B still delivers a higher return than its quoted counterpart, producing roughly one and a half percentage points more annually than the quoted shares (which adds up to quite a wide gap over a 20-year period). Why? Almost entirely because the amount ponied up by our pension fund was just £300m in Acme B, whereas it was £700m in A.

Several conclusions follow from this hypothetical exercise. First, it shows why pension funds are tempted by private equity’s blandishments. If you are struggling to meet your promises to members, you want every pound or dollar to work as hard as it can.

Nonetheless, before getting carried away, it is worth also noting the source of this superior performance, which all comes from financial engineering, not running companies better.

It is far from clear this justifies the three-times higher fees that the pension fund incurs with Acme B.

It is also worth remembering that the extra return is not the free lunch it appears, coming at the cost of additional volatility. Private equity argues that the extra oversight involved in its governance arrangements allow it to deal with the higher financial risks. But its preference for debt can carry heavy societal costs, such as bankruptcy and lost productivity through shirked investment in the business.

And lastly there is a big puzzle surrounding the credit that supports these private equity investments. Most of the gain comes from capital leverage rather than the “tax shield” of deductible debt interest. The scale of the leverage-related bump raises the question of whether banks are really earning a proper return through the cycle on the risks they are bearing on their private equity loans.

If they aren’t, that’s a cost for all citizens (including pension fund scheme members) given the taxpayer support that banks enjoy. The clearest and biggest beneficiaries of lenders’ largesse are the recipients of swollen transaction and private equity fees.

Of course, all this is hypothetical. And in the real world, using fair public market comparisons, private equity hasn’t been delivering vastly superior returns despite its leverage advantage. In more recent vintages of funds, it has basically matched public market performance.

Which begs an important question if private equity is going to buy up the stock market: are buyout companies really better run?



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