Would you rather be Philip Green or Stuart Rose? Both men are undoubtedly talented retailers and, by most benchmarks (even the high bar set by Euromoney readers), are wealthy and successful. However, while Philip Green can do exactly what he likes at Arcadia because it is a private company that he owns, poor old Stuart Rose at Marks & Spencer has to seek the approval of pesky shareholders for anything other than mundane decisions.
Complete operational freedom and the ability to pay yourself £1.2 billion, versus regular financial reporting and tiresome meetings with the teenage scribblers that pass for analysts in the City these days? It is a pretty simple choice. So when sharp-elbowed New York private equity firms such as Kohlberg, Kravis, Roberts & Co and Apollo Management LP launch publicly traded funds on the Amsterdam Stock Exchange it is interesting to examine their motivation. After all, private equity firms aren’t exactly famed for openness in their dealings.
KKR Private Equity Investors raised $5 billion and AP Alternative Assets $1.5 billion. Relatively speaking that’s chicken feed for private equity these days. Blackstone Group LP closed the biggest private equity fund ever last month when Blackstone Capital Partners V raised $15.6 billion. Also in July, London-based Permira Advisers raised Europe’s biggest fund when Permira IV closed with $14 billion. That is more than Permira raised in all the previous funds in the course of its 21-year history.
In Europe in 2005, €72 billion was raised for investment into the asset class, according to the European Venture Capital Association. That was more than double the clip of fund raising in 2004. Worryingly, for professional worriers like investment columnists, pension funds were the main source of that capital (24.8%) overtaking banks for the first time since 2001.
Investors are looking for returns and it is true that private equity has been enormously profitable over the past few years. Industry insiders reckon Blackstone has generated an internal rate of return north of 80% since 2002 and firms such as Apollo Management, Carlyle Group and Permira 60%. These are extra-normal profits that coincided with an unprecedented period of monetary accommodation from the world’s central banks. Anyone extrapolating those returns into the future has fallen prey to the alchemists’ fallacy – believing not only that gold can be fashioned from base metal but also that it will maintain its value, allowing its creators to become fabulously wealthy.
Ironically, the mega funds from Blackstone and Permira closed in the same week that the Bank of England warned in its Financial Stability Report that the sinister presence of buyout funds was tempting some companies to increase their gearing. This is a variation on the old rugby ploy of getting your retaliation in first. But the Old Lady is right to voice her concerns. It’s a scary world in which buyout funds are grown so large and menacing that companies choose to re-lever themselves rather than let the barbarians at the gate do it for them.
The Bank of England is not alone. In Sweden the financial supervisory authority, Finasinspektionen, said last month that it was worried about the rising levels of debt used by private equity companies. Because Sweden’s AP Funds have invested A3 billion in private equity, the regulator said it would ask the finance ministry for oversight of private equity unless transparency improves.
Before dismissing the views of regulators, consider the perspective of Wilbur Ross, a veteran investor in distressed debt. He was reported by the Financial Times to be looking forward to a boom in potential investment opportunities. Ross is predicting a sharp rise in bankruptcies, as leveraged buyouts find it hard to meet their interest payments. A man who has built a $1 billion personal fortune by anticipating the swings of the US business cycle is well worth heeding.
So why are KKR and Apollo launching publicly traded vehicles? No doubt they would say they are bringing private equity to the masses out of the kindness of their hearts. More realistically, in the stampede to raise assets, they are probably not fussy about where they get money from and retail investors offer an untapped source of capital. A cynic might go further and conclude that by offering fully public vehicles they are simply passing on all the risk.
If you take that view, it is an interesting commentary on the prospects for the asset class. Whatever the rationale for these particular funds, with the era of easy money coming to an end, private equity is beginning to look like an increasingly speculative investment. The creation of public funds might mark the top of the market.
Anyone contemplating allocating assets to private equity would do well to pause and read the work of the late economist Hyman Minsky. He was inspired by Joseph Schumpeter, who coined the phrase creative destruction. Minsky thought that stability in financial markets engendered instability because it encouraged speculative excesses. He wrote in 1974: “A fundamental characteristic of our economy is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.” Private equity looks like a bubble and smells like a bubble. Caveat emptor.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own.
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