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Bruce W. Kaser, CFA
October 04, 2019

Private Equity and the Eclipse of the Public Markets

  • Michael Jensen’s 1989 article in Harvard Business Review, “The Eclipse of the Public Corporation, was a ground-breaking view of private equity.
  • While historical returns have been very strong, they are diminishing and may be even lower in the future.
  • Private equity will continue to play a major role as a form of company ownership but won’t eclipse public ownership anytime soon.

In 1989, Harvard Business School professor Michael Jensen wrote a ground-breaking article titled “The Eclipse of the Public Corporation1”. In the article, he put forth his belief that a new form of corporate organization, the “LBO Association” (in essence, private equity) would eventually become the dominant form of company ownership. He cited several advantages of private companies, most notably the major reduction in the agency problem, “the conflict between owners and managers over the control and use of corporate resources.” He added that private equity brings greater operational efficiency, tighter strategic focus and better capital allocation.

In many ways, Jensen was right. That quiet corner of the investment world has moved into the mainstream. Remarkable early returns by the pioneering Yale University Endowment fund, whose private equity portfolio recorded a 31.4% annualized return between inception and the end of its 2007 fiscal year2, inspired investors to shift more capital to this asset class. Major pension funds, including California Public Employees’ Retirement System ($356 billion in assets) and the New York State Common Retirement Fund ($211 billion in assets) currently allocate as much as 9.5% of their total assets to private equity. Adding irony to the trend, mutual funds from Fidelity, T. Rowe Price and others are increasingly taking stakes in privately-owned companies, including high-profile unicorns like WeWork.

The high allocations to private equity strategies, as Jensen predicted, have led to its becoming one of the primary forms of corporate ownership. Private equity ownership now accounts for as much as $5.8 trillion3 in equity value, compared to the roughly $30 trillion value of the entire U.S. public stock market. From a different perspective, the private company market is actually larger: according to a recent report by McKinsey & Company,3 there are more private equity backed companies (about 8,000) than U.S. publicly traded companies (about 4,300). While not an exact comparison, as many private equity owned companies are outside the United States, the trend is clear: private equity ownership is widespread and large.

Along with helping address the agency issue, private capital has become so immense that it is diminishing the primary role of public markets – that of a supplier of capital to rapidly growing new companies. The vast growth in private capital, both debt and equity, means growth-stage companies no longer need to “go public” to raise funds. Today, a company could theoretically complete its entire life-cycle, from start-up to market-leading giant to post-growth cash cow, without ever passing through public ownership gates.

Thirty years after Jensen wrote his seminal article, the eclipse of the public corporation appears inevitable.

Private equity: too much money chasing too few good opportunities?

One of Wall Street’s most predictable skills is relentlessly expanding an exceptional idea until it becomes an average idea. Early private equity investors benefitted from the vast, nearly untapped universe of attractive companies ripe for investment – a classic example of too little money chasing many good opportunities. Yet, with the enormous growth in funds, perhaps the opposite is increasingly true: too much money chasing too few good opportunities?

If the private equity market is saturated, the eclipse may only be partial rather than full.

The performance edge over public equities is diminishing

A leading indicator of asset class saturation is investment returns. Returns from private equity have been remarkable steady at about 13% a year over the past 20 years4. Yet, few traits dampen investor enthusiasm more than weak relative performance. Once investors discover and exploit a source of excess returns over public equities, usually measured by the S&P 500 Index, those excess returns tend to diminish. Slowing or even reversing of capital inflows usually soon follows.

In recent years, private equity’s excess returns have diminished. For the 20-year period ending September 2017, private equity’s excess returns were more than six percentage points a year. However, the 10-year excess annual return was only 1.5%, and the 5-year excess annual return was actually negative (-0.4%).4

Returns for Yale University’s $30.3 billion endowment fund have similarly moved toward average. For the fiscal year ending June 30, 2019, its private equity heavy portfolio produced only a 5.7% return. While full data on the components of its 2019 returns aren’t available, the data for last year tell a similar story: the long-term (10-year) returns of its leveraged buyout segment (10.2%) were comparable to the S&P500 return (10.2%), although its venture capital segment return (16.0%) was strong.

Future returns may not be any better?

While it can be tempting to extrapolate past returns, prospective private equity investors will want to focus on future returns. Performance may not match even the steady 13% rate over the past two decades. One problem is the rising prices paid in private company deals. For the trailing 12 months ended June 30, 2019, the average private equity buyout was priced at a 12.3x EV/EBITDA multiple, a remarkably high number in its own right, and up from 10.5x only two years ago.5   Higher purchase prices usually translates into lower returns.

And, those returns are likely to be diluted as private equity firms have increasingly put more equity into their buyouts as debt markets appear less willing to subsidize the higher prices.

Further dampening exit profits is the harsh reality of public equity markets. Private equity funds generally have a limited 7-year life span, after which they are liquidated. This requires the eventual sale of portfolio companies, often by returning them to public ownership. For buyout-related funds, there is no guarantee that public markets will be as accommodating in the future as they have been in the past.

For private equity funds focused on venture capital, which provide capital to start-up companies, the effects of bright sunshine on valuations can be damaging to investment returns.

Some background: by definition, valuations of start-ups companies during funding rounds are set by a small number of believers that literally ‘buy into the concept’. Investors that don’t believe in the company won’t invest, but in a market where capital is abundant, there is plenty of room for other believers to step into their place. This helps drive up valuations, occasionally to unrealistic levels.

Just how unrealistic these valuations can become is illustrated by recent initial public offerings, or IPOs. With prices now determined by a countless number of investors rather than a small group of believers, the returns produced by companies with dubious business models like that of Smile Direct Club, which appears to be a do-it-yourself orthodontics company, won’t likely be flattering. Smile Direct Club’s current $5 billion market cap is down 40% from its IPO valuation. Valuations of other businesses that have a broader appeal, albeit with yet-unproved profit prospects, have similarly shriveled, including tech giants Uber and Lyft, along with not-yet-public WeWork.

Companies still inside private equity funds won’t escape this effect, as their valuations will be suppressed by the weak reception of their newly-public counterparts. Dampened private equity returns will likely follow.

Additional scrutiny of returns and fees seems likely

When private equity returns were strong, few investors questioned the details behind how these returns were calculated. Yet, with weaker performance comes greater scrutiny. Private equity valuations are determined by appraisals, in many cases by the owners themselves. While these appraisals in essentially all cases are done with compete integrity, they inherently lack the objectivity of public equity markets. Importantly, the quarterly appraisals tend to smooth-out the peaks and valleys that are typically experienced in public market prices. It could very well be that, when adjusted for these different treatments, this lower-volatility advantage evaporates.

Lower returns will also likely invite more questions about fees. Private equity firms typically take 20% of the profits on their investments above a 6-10% hurdle rate, along with annual fees that often are 2% of committed capital. While performance numbers are net of these costs, investors may begin to compare those fees to the 0.10% cost of an S&P500 index strategy.

Activist investors play a role

Private equity ownership isn’t the sole solution to Jensen’s agency problem. The rising influence of activist investors is increasingly forcing public companies to improve their operational efficiency, tighten their strategic focus and allocate their capital more wisely. Their efforts further diminish the universe of appealing buyout targets available for private equity investors.

The meaningful chance of lower future returns, combined with higher scrutiny, could very well stall the inflows of capital into private equity funds and the otherwise inevitable dominance over public equities.

Private equity isn’t going away, however

Private equity ownership still provides all of the solid benefits that Jensen outlined. A critical role not mentioned is that of funding nearly all of the remarkable new technologies over the past forty years, and those of the next forty. Without private capital, these innovations simply wouldn’t exist.

To be sure, public ownership suffer many flaws, of which the agency issue is but one. Fundamental analysis and management oversight are often scant, as passive index investing and quant-driven momentum strategies expand their influence. News-driven market volatility can unnecessarily add irrationality to market prices.

Yet, Jensen’s eclipse doesn’t appear likely to happen any time soon.

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