The Eclipse of the Public Corporation or of the Private Equity Partnership? Klion Forum Columbia Business School January 29, 2008

Transcription

1 The Eclipse of the Public Corporation or of the Private Equity Partnership? Klion Forum Columbia Business School January 29, 2008

2 The last share of publicly traded common stock owned by an individual will be sold in the year 2003, if current trends persist. Jay O. Light (current Dean of HBS) HBR,

3 In fact, Columbia University has been allocating more capital to private equity than to public equity (Allocation of Columbia University s Endowment, 2006, (fair market value, $1000s) US public equities and mutual funds $ 541,494 Foreign public equities and mutual funds $ 763,103 Private equity $ 1,635,273 Hedge funds $ 2,731,938 Fixed income and fixed income mutual funds $ 294,834 Cash held for re-investment $ 235,939 Other $ 897 TOTAL $6,203,483 Source: The Trustees of Columbia University in the City of New York, Financial Statements 3

4 As we know today, however, the death of the public equity market has proved to be an exaggeration, and ironically private equity firms themselves are going public May 3, 2006: KKR Private Equity Investors is listed on the Euronext exchange. The market capitalization is $5bn. June : Apollo raises $1.5bn in an IPO of a private equity fund listed on Euronext December 27, 2006: Nomura acquires 15% stake in Fortress for $888mn. February 8, 2007: Fortress announces that they sold 34,286,000 class A shares priced at $18.50 in an IPO. May 20, 2007: China s newly established State Investment Company takes a $3bn non-voting minority stake (9.4%) in Blackstone s management group. June 21, 2007: Blackstone announces that they raised $4.133bn in an IPO November 7, 2007: Apollo announces that it sold 9% of the firm to ADIA, the world s largest sovereign wealth fund. September 22, 2007: Mubadala takes a 7.5% stake in Carlyle for $1.35 billion in cash. The deal represents a 10% liquidity discount to the parties agreed-upon $20 billion firm valuation. The minority investment includes no associated voting rights and is subject to value-related protective rights. January, 9, 2008: Silver Lake Partners sells 9.9% stake for $275mn to CalPERS. According to press reports, other important GPs, such as KKR and Apax, contemplate IPOs or selling minority stakes to outside investors 4

5 Agenda What are the Advantages of Private versus Public Ownership? How Important is the Role of Private Equity in Financial Intermediation? Does Private Equity Really Outperform? Why Do Private Equity Firms Go Public? Why Now? And what are the Implications? What Next? 5

6 What are the Advantages of Private Equity? Private Equity is a powerful model of general management Private equity enables the capture of value destroyed by agency problems in public firms especially failures in governance (M. Jensen) Superior governance prevents incumbent managers from using free cash flow for wasteful purposes Board of Directors are small in size CEO function separate from Chairman CEO generally only manager on the board GPs are genuinely active investors involved in strategic decisions and committed through substantial equity No cross-subsidization between PE divisions Compensation: CEO and other top managers have more equity interest that typical public company managers Far fewer undiscussables in board meetings Management shifts from growing the business to growing the equity 6

7 What are the Advantages of Private Equity? Jensen s Strategic Value Accountability Managers want to be measured on results they can control, say, numbers of new products or sales Virtually no manager wants to be measured on how the market values the firm SVA often gets assigned by default to CFO and Investor Relations Manager but has to be either the CEO and/or group of senior managers In PE, SVA is effectively assigned to and exercised by the GP on the board and the CEO Those involved are rewarded based on the market value of the results Historically, PE has accomplished this through carry and/or equity interests 7

8 What are the Advantages of Private Equity? Private equity is based on a fundamentally different form of financial strategy Higher debt/equity in PE than in public companies because of tax advantages control function of debt: servicing your debt obligations is critical and much more important than meeting your budget in a public firm (bankruptcy, restructuring, loss of equity). Management focus on cash flow to pay the debt Debt and equity of PE divisions are at the divisional level (portfolio companies) Very few LBOs have actually gone into bankruptcy even though leveraged to 95% in the 1980s and 70% more recently. 8

9 What are the Advantages of Private Equity? How does private equity create value? And why don t public firms apply the same tools? Five key areas where private equity sees opportunity for value enhancement (Pozen, HBR, 11/07): Keep idle cash to a minimum Take on more debt Design value-enhancing operating plans Tie executive compensation to shareholder value Re-focus board Puzzling thing is that all of the techniques that private equity uses to accomplish its value creation can be adopted by virtually any public company (except of course for the Going Private part) Yet it does not happen Jensen interprets this failure as evidence of the agency costs of the publicly held firm 9

10 What are the Advantages of Private Equity? Do financial and governance engineering actually matter? Virtually all empirical evidence is positive re portfolio companies For deals in the 1980s, Kaplan (1989) and Kaplan (1991) and others find buyouts associated with: Improved operating margins (absolutely and relative to industry) Improved cash flows Increased employment (but slightly less than the industry) Reduced capital expenditures Lower taxes Substantial increases in value For deals after the 1980s (relative to industry): Improved operating margins in UK and France No difference in employment, but lower wage growth in UK Reverse LBOs appear to outperform market post-ipo (Cao/Lerner 2006) Ongoing research on employment and productivity by Davis, Haltiwanger et al Source: Kaplan (2007) 10

11 What are the Advantages of Private Equity? So why is private equity so controversial? Effects on workers (although little academic research supporting this claim) Limited information when companies are private Why don t the CEOs do more as public company CEOs? Incredible wealth, incredible disparity Though exact figures are hard to come by, the hallmark of the private equity industry is the incredible wealth being created for the small number of individuals who drive the buyout business. The key principals at the largest private equity firms are billionaires. Service Employees International Union (SEIU) Some exact figures released in the wake of the recent Blackstone IPO Systemic effects of so much leverage Source: Kaplan (2007) 11

12 What are the Advantages of Private Equity? Such claims are not entirely new though The LBO Binge (Oct. 27, 1988) This cowboy capitalism requires devoting a large part of the economy to buying and selling companies. It s not terribly productive. It s Time to Stop LBO Nonsense (Feb. 24, 1989) The LBO/merger trend has been unhealthy and poses a serious menace for the future. LBO: Nightmare on Wall Street? (Aug. 20, 1989) A systematic destruction of traditional American business is underway. 12

13 Agenda What are the Advantages of Private versus Public Ownership? How Important is the Role of Private Equity in Financial Intermediation? Does Private Equity Really Outperform? Why Do Private Equity Firms Go Public? Why Now? And What are the Implications? What Next? 13

14 Role in Financial Intermediation Commitments to U.S. private equity partnerships have surged dramatically in recent years 1.40% 1.20% Fund commitments in percent of total stock market capitalization 1.00% 0.80% 0.60% 0.40% 0.20% 0.00%

15 Role in Financial Intermediation resulting in a more than doubling of U.S. private equity assets under management 800 $bn x

16 Role in Financial Intermediation The volume of U.S. buyouts has increased tenfold between 2001 and 2007, accounting for 30% of M&A activity Source: Thomson 16

17 Role in Financial Intermediation Credit market conditions have played an important role Source: Citi 17

18 Role in Financial Intermediation Large deals account for a rising share of the overall market 100% 80% 22.0% 14.3% 2.3% 1.5% 2.3% 2.2% 1.1% 0.8% 14.7% 27.9% 23.9% 24.7% 29.3% 35.8% 15.5% 10.4% 7.5% 34.7% 60% 37.4% 34.9% 23.9% 30.8% 32.1% 25.3% 31.0% 38.8% 40% 20% 0% 2000 (Obsevations: 123) 18.5% 28.6% 21.1% 20.9% 19.4% 16.5% 20.9% 43.3% 38.0% 10.2% 30.3% 13.8% 19.4% 21.1% 20.9% 14.0% 12.2% 5.7% 2001 (49) 2002 (43) 2003 (67) 2004 (133) 2005 (134) 2006 (178) 1H07 (129) 2Q07 (67) $1B or more $500M - $999M $250M - $499M $100M - $249M Less Than $100M Source: S&P LCD 18

19 Role in Financial Intermediation Let s take a longer-term view on public to private buyouts 2.50% Public-to-private volume in % of average total stock market value 2.00% 1.50% 1.00% 0.50% Relaxation of investment rules for US pension funds in 1979 leads to investment boom in the early 1980s The last share of publicly traded common stock owned by an individual will be sold in the year 2003, if current trends persist. Jay O. Light (current Dean of HBS) HBR, 1989 Collapse of the junk-bond market VC boom leading to IPO explosion Extremely liquid debt markets fuel 2. buyout boom 0.00%

20 Role in Financial Intermediation A long-term supply scenario Global assets managed by buyout firms amounted to around $850bn at end-2006, equivalent to around 1.2% of AUM of institutional investors and HNWIs Suppose that total AUM grow at their long-term CAGR of 7.8 percent. While AUM of institutional investors grow at their longterm CAGR of 9.6 percent, assume that financial assets owned by HNWIs increase at a CAGR of 6 percent. Suppose further that allocations to private equity gradually rise from 1.2 percent in 2006 to 2 percent in Under such assumptions, AUM in private equity (buyouts) will reach around $2.9tr by 2015, a delta of $2tr 20

21 Role in Financial Intermediation A long-term demand scenario Let s assume a 4-year fundraising cycle and 4-year average holding periods of portfolio companies Reaching an overall exposure of $2.9tr by 2015, annual investment volumes would need to rise to around $715bn (equity only), taking into account divestments Factoring in leverage, the annual buyout volume would need to reach around $2.1tr Sounds a lot but consider that global volume already totaled $872bn last year. There are around 6,300 US and European companies (public and private) with a market cap of > $500mn Suppose 400 private equity deals pa, with an average 4-year holding period, PE would hold around 1,600 firms, or 25% of all European and US companies with a market cap of $500mn some of which privately held before they are acquired by PE. Thus, even under rather optimistic growth assumptions the eclipse of the public corporation does not appear to be imminent. And by the way, don t forget the other end of the market where new listings increase the number of public firms 21

22 Agenda What are the Advantages of Private versus Public Ownership? How Important is the Role of Private Equity in Financial Intermediation? Does Private Equity Really Outperform? Why Do Private Equity Firms Go Public? Why Now? And what are the Implications? What Next? 22

23 Private Equity Performance What do we mean by outperformance? The portfolio company perspective Post-Buyout Value Value captured by next buyer Entry Price Acquisition Premium Pre-buyout value Fee to GP Proceeds to Limited Partners Exit Price Acquisition Exit Source: Gottschalg (2007) 23

24 Private Equity Performance What do we mean by outperformance? The GP perspective Post-Buyout Value Value captured by next buyer Entry Price Acquisition Premium Pre-buyout value Fee to GP Proceeds to Limited Partners Exit Price Acquisition Exit Source: Gottschalg (2007) 24

25 Private Equity Performance What do we mean by outperformance? The LP perspective Post-Buyout Value Value captured by next buyer Entry Price Acquisition Premium Pre-buyout value Fee to GP Proceeds to Limited Partners Exit Price Acquisition Exit Source: Gottschalg (2007) 25

26 Private Equity Performance What matters to us are cash flow based returns, net of fees Improved operating performance does not necessarily mean that private equity funds have generated outperformance It depends on what they paid to acquire the companies It depends on fees Academic research (e.g. Kaplan & Schoar, 2005) finds that private equity has outperformed S&P gross of fees. However, net of fees private equity did not seem to outperform, suggesting that GPs get the outperformance (on average). 26

27 Private Equity Performance If private equity does not outperform net of fees, why do investors commit increasing resources to the asset class? Part of the answer probably lies in the significant dispersion of returns 1.4 Returns 1/ Dispersion 2/ All funds VC funds Buyout funds 0.2 All funds VC funds Buyout funds Kaplan and Schoar (2005). Sample size includes 746 funds raised before Of these, 577 are VC funds. 1/ Returns measured by public market equivalents (PME). The PME compares an investment in a private equity fund to an investment in public equity. This approach is implemented by investing (or discounting) all cash outflows of the fund at the total return to the S&P 500 and comparing the resulting value to the value of the cash inflows (net of fees) to the fund invested (discounted) using the total return to the S&P / 25th and 75th percentiles and median, measured in terms of PME. The number of funds between the median and the 75th percentile is

28 Agenda What are the Advantages of Private versus Public Ownership? How Important is the Role of Private Equity in Financial Intermediation? Does Private Equity Really Outperform? Why Do Private Equity Firms Go Public? Why Now? And What are the Implications? What Next? 28

29 General partners serve as intermediaries between investors and companies requiring capital Going Public Supply Side (LPs) Intermediation (GPs) Demand Side (buyout targets) 29

30 Going Public What motivates GPs to go public? Until recently, IPOs have been regarded as inconsistent with the business model of private equity, requiring a significant amount of disclosure and the kind of visibility many GPs have been trying to avoid. There may be important reasons why private equity firms seek to raise permanent capital: to finance growth to gain strategic access to new geographies (Asia/Middle East) to provide an exit route for retiring GPs It appears that the more recent IPOs have been driven by the latter. On average 70% of the proceeds of the recent alternative investment manager IPOs (Fortress, Blackstone, Apollo) were used to cash out GPs (mostly the founding partners). Some of the most experienced and largest GPs face important generational transition issues: Peter Peterson (Blackstone), born 1926 David Bonderman (TPG), born 1942 Henry Kravis (KKR), born 1944 George Roberts (KKR), born 1945 Stephen Schwarzman (Blackstone), born

31 Going Public Going public or bringing in outside investors are not entirely new CalPERS bought a 10% stake in Thomas Weisel for $100m in 2000 AIG acquired a 7% stake of Blackstone for $150m in 1998 CalPERS bought a 5.5% stake in Carlyle for $175m in 2000 The S&P Listed Private Equity Index tracks 28 private equity firms, including Apollo, Blackstone, Fortress, KKR Private Equity as well as a number of large European publicly listed firms, such as 3i, GIMV, Partners Group and Wendel Investissement. Other listed private equity indexes are the LPX and LPE index family

32 Going Public What motivates outside investors to take a stake in a private equity firm (as opposed to committing to its funds)? Benefit from attractive growth prospects of the alternative asset management sector Opportunity to put money to work immediately and to deploy capital for a long period of time in private equity Further enhance key relationship benefits, such as preferred fund allocations, co-investment/secondary opportunities, etc Diversified income streams across a variety of alternative asset classes, investment strategies, vintages and geographies and smoother cash return patterns through annual dividend distributions (in some cases 75% of distributable income targeted) Partially fixed income stream from management fees and other, non-success based income, e.g. advisory/monitoring/transaction/arrangement fees Existing intimate knowledge of relationship GP, of the underlying assets and of longer term risk/return dynamics allow for a detailed bottom-up valuation of the GP 32

33 Going Public However, important conflicts of interests may arise if outside investors are also LPs in funds raised by the GP Traditional incentive structure benefiting LPs weakened by increased focus on management fees and indirect stock-based incentives instead of carried interest Potentially opposite interests with regard to hurdle rates, fee levels, fund sizes, timing of new fund raises/exits, etc Increased ( leveraged ) exposure to a particular GP and his underlying assets and potential further increase in exposure to a particular market segment (such as mega buyouts). 33

34 Going Public Corporate governance is generally weak for outside investors Fortress Blackstone Apollo Carlyle Group Investors/Ownership % Nomura/13.7% (1) Peoples Republic of China/9.4% ADIA & Calpers/10% Credit Suisse/2.5% Mubadala (Abu Dhabi Government)/7.5% Price Paid per Share $16.12 $29.61 $20.00 NA % Discount from IPO price 12.84% 4.50% 26-33% 10% ( Liquidity Discount ) Lock-up Period 120 Day IPO Lock-up 1 year for Numura and principals 120 Day IPO Lock-up 1 year for founders/senior MDs, thereafter max 1/3 p.a. for 3 years. NA NA Corporate Governance Principals have 77.7% of the voting power. As long as principals retain > 40% of total voting rights, they have veto rights on all major decisions. Existing owners have 86.4% of the voting power. PRC's shares have no voting rights. Founders/principals to retain a large voting majority No voting rights for Mubadala Comments Nomura has additional rights through a share-holder agreement, including a board seat, registration rights and drag-along/tag-along rights (1) Nomura had a 15% stake before dilution in IPO PRC agreed to a 4-year holding period and can only sell 1/3 p.a. thereafter for 3 years Most favorite nation status for 1 year if > 5% interest sold to other strategic investors AIG is an existing owner that has 4.5% ownership and has a gain of ~10x No public float as Apollo will be on the unregistered Goldman market ( GSTrUE ; max. 499 qualified investors) No prospectus publicly available Agreed valuation $20bn (-10% liquidity discount) Mubadala also committed $500m to latest fund Carlyle guaranteed a $20bn IPO valuation (make-whole provision) Calpers paid $175m in 2000 for 5.5% (6.3x MM based on $20bn) 34

35 Going Public To what extent will the publicly held private equity firm undermine the private equity business model? To a very significant extent according to M. Jensen The publicly held private equity firm is a non-sequitur both in language and in economics Permanent capital in the form of publicly held stock replacing some or all of the funding provided by the finite horizon will create more agency costs (think of closed end fund discounts) Private equity firms have their reputations on the line. If they want to raise another fund they must show good performance in earlier funds. Thus they have big incentives to do good deals and make them work. Much less so if firm has access to permanent capital Selling pieces of the managing company or going public will dilute incentives for future employees. Will either pay out more to rising stars or lose them (Kaplan, 2007) Macro: Increased cash inflows to the industry, resulting in higher deal prices and lower returns 35

36 Going Public To what extent will the publicly held private equity firm undermine the private equity business model? On the other hand Berkshire Hathaway is a highly successful publicly listed investor. Individual share price is extremely high to ensure that they have only sophisticated long-term oriented shareholders All important partnerships in investment banking are gone The onset of that transition can be identified with the 1978 and 1979 acquisitions of White, Weld, and Loeb Rhoades by Merrill Lynch and Shearson. By 1987, only Goldman Sachs and Lazard Freres among the major investment banks remained as private partnerships, and they eventually floated in 1999 and 2005, respectively. 36

37 Going Public What can we learn from the experience in investment banking? The early movers were particularly active in the securities markets where spreads were narrowing and economies of scale were increasing. As expertise in financial economics dispersed, the specialized partnerships that dominated the derivatives markets well into the 1980s were absorbed by commercial banks that could provide the capital required to operate at a commercial scale. The holdouts were those firms that generated a greater proportion of their income from advisory work. They continued to rely on tacit knowledge and faced a higher opportunity cost of going public. Not obvious to what extent the transition to a joint-stock model has undermined investment banks incentive to perform. Nor is it clear whether this transition has universally led to a fundamentally culture 37

38 Agenda What are the Advantages of Private versus Public Ownership? How Important is the Role of Private Equity in Financial Intermediation? Does Private Equity Really Outperform? Why Do Private Equity Firms Go Public? Why Now? And what are the Implications? What next? 38

39 What Next? Three broad trends Strong incentive to raise ever larger funds due to existing firm size distribution (and of course fees) Private equity firms becoming asset managers Going global» Vertical and horizontal expansion strategies provide strong incentive to gain access to permanent capital 39

40 What Next? Firm size distribution provides Upper mid-market 2,000 firms w/ market cap of $500mn-$1bn 1,500 firms w/ market cap of $1bn-2bn 800 firms with market cap of $2bn-$10bn Very large to mega buyout segment 450 firms w/ market cap of $10bn-$50bn Total value: $9.5tr Percentage distribution of U.S. and European listed companies with market cap of > $500mn, excluding top

41 What Next? important incentive to raise larger funds 100% Perfect equality Cumulative share of funds raised 90% 80% 70% 60% 50% 40% 30% 20% In 2006, the 10% largest US funds raised around 2/3 of all capital 10% 0% 0% 20% 40% 60% 80% 100% Cumulative share of funds 41

42 How the industry has evolved What Next? 2005 The New Merchant Banks: Flexible Capital, Permanent Capital and Public Alternative Asset Managers Late 1990s 2004 Asset Accumulation, Fund Expansion and Brand Extension Early 1990s Firm Formation Late 1970s Late 1980s Professionalized Leveraged Deal Shops Early 1970s Direct Investment Mostly Venture Source: Citi 42

43 What Next? Private equity firms becoming asset managers Private equity distressed opportunities Apollo Capital Markets: debt and equity investment opportunities in public and private markets Buyouts VC Long-short public equity high-yield corporate credit obligations Absolute return capital (fixed income, equity, commodity and currency markets Buyouts Real estate Marketable alternative asset management - Funds of Hedge funds - Mezzanine funds -Senior Debt Vehicles - Proprietary Hedge funds -Closed-End mutual funds financial advisory Buyouts VC Growth capital real estate leveraged finance 43

44 Going global What Next? Global investment opportunities 44 Financial intermediation Cross-border supply of capital

45 What Next? Largest Private Equity Funds to be Invested in Asia ($bn) 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1, KKR TPG CVC Carlyle Bain 45

46 Conclusions Private equity is a powerful model of general management and provides superior governance structures, with debt serving as an important control mechanism Private equity outperforms - but there is an issue in terms of distributing the profits There has been a huge inflow of capital, in part from unexperienced and undisciplined investors. As the PE funds deploy the capital, public-to private transactions look set to regain momentum. However, even under very optimistic assumptions about future commitments to PE funds and about debt capital markets, the publicly listed company is unlikely to disappear There is a bigger question as to whether the private partnership will survive. If investment banking gives us any guidance, the current going public trend looks set to accelerate. If Jensen is right and the publicly held private equity firm is a nonsequitur not only in language but also in economics, we might not worry about the eclipse of the public corporation 46