Examining Private Equity as an Asset Class
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Imagine an asset class with low volatility, low correlation to the public markets and higher historical returns than public equities.
The role of private equity firms provides “alternative investments” that involve the acquisition of a company, either publicly-listed or privately-held, through a combination of debt and equity.
Once a company is acquired, the private equity operators, for a sizable fee, enact strategic initiatives such as spinning of poorly performing divisions, downsizing head count and/or selling assets, with the intent of unlocking value. This can be very accretive for investors but this asset class is not without risk.
Private Equity is Illiquid
Without an active market like a stock exchange, the only values that are readily available with private equity investments are the purchase and sale prices. The daily volatility seen in publicly-traded securities is absent in private equity. Fluctuations in value exist but are not transparent to the investor. One never knows, therefore, what may be the true value of their investment.
The biggest risk of such an illiquid investment arises when the invested funds are required sooner than the expected investment time horizon. Since it isn’t a stock with an active market, investors must wait until a liquidity event occurs when the private equity investment is sold, refinanced, or publicly listed.
Since private equity investments can have a lifespan of 3–12 years, investors must prepare to be parted from their capital for a significant period of time. Tying up capital for up to a decade may make sense when the investment is made, but many things can change over that time frame.
Private Equity is less volatile than stocks but not bonds Correlation, or how asset classes perform relative to each other, is a critical driver of diversification. Owning assets that move in different directions is the core to preserving capital. Historically, in any one year, stock returns have ranged from -40% to + 45% while bond returns have ranged from -12% to +20%.
Private equity, which avoids the daily price reconciliation, as above, is often touted as a positive because it appears to help decrease correlation across asset classes.
However, while an investment may be privately held, the value can still change. You may not sell your home for many years but if your neighbors do, you will at least have a rough approximation of what value you may fetch in the market.
Shown in the table below, private equity is less volatile than stocks but not bonds.
Private equity does not have historical returns higher than public equities
Private equity supporters claim that alternative investments provide superior returns to public equities. There is an element of truth to this – short-term markets tend to be reactive to quarterly results and too impatient for strategic change.
What’s lost in the marketing, however, is that the returns are made using leverage – and lots of it. When buying a company, private equity investors routinely carry two to three times more debt than equity.
With a typical acquisition, between 60% to 80% of the purchase price is funded by debt and only 20% to 40% by equity. Because of the heavy leverage, expected returns should be significantly higher than publicly-listed stocks where the debt load is more in line to a one-to-one basis.
Looking at the data below, private equity (green bars) did outperform the public market equivalents (blue bars) until about 2005. Part of this decline was due to the sheer size of dollars allocated to private equity through the 2000s as assets under management (AUM) grew by USD $3 trillion. As more financing deals increased chasing fewer deals, purchase prices jumped and caused overall returns to drop.
Today, more assets continue to flow into private equity investments. While some strategies may outperform, the higher competition for deals, high equity market valuations and the threat of rising interest rates make us question the future returns of alternative investments.
At Liberty, we are not against private equity. The combination of operating excellence and leverage can generate significant returns.
Our strategy, however, is to gain exposure through publicly-traded entities that exhibit private equity investment characteristics (Danaher, Thermo Fisher, Roper Technologies, etc.) without paying the hefty fees involved with alternative investments. One of the most prolific Liberty portfolio private equity-like operators is Danaher Corporation.
Danaher Corporation
Danaher designs, manufactures, and markets products and services in Life Sciences, Diagnostics and Environmental and Applied Solutions. The company began as a real estate investment trust that made its first acquisition of an industrial company in 1984. Over the next two years, 12 more acquisitions were made in the manufacturing and instrumentation space.
Danaher recognized there were two ways to grow a business – organically (R&D and sales) and inorganically (acquisitions). While most companies tend to be good at one type of growth, Danaher excels at both.
This has allowed an accretive feedback loop to develop with existing entities organically generating free cash flow that is used to fund acquisitions. In turn, these acquisitions increase free cash flow and facilitate even more acquisitions and even greater free cash flow.
On the acquisition front, through the Danaher Business System (“DBS”), a philosophy of continuous improvement and dispersed accountably, modelled after the Japanese Kaizen, the company has created a repeatable playbook for selection, integration and growth of acquisition targets.
Acquisitions are divided into two purposes:
→ Establish the platform – Danaher enters a new segment and gains an advantage by implementing their DBS philosophy
→ Bolt-on acquisitions – a complementary business to an existing segment is added to drive economies of scale
DBS helps Danaher recognize when a division or segment should be spun off. For example, Fortive, a company specializing in Industrial Technology was spun off and publicly listed in 2016 and Envista, specializing in Dental Equipment and Consumables, was spun off and listed in 2019.
To see DBS in action on the acquisition side, Danaher, in early 2019, acquired General Electric’s biopharma division for $21.4 billion to improve its Life Sciences division.
Given that Danaher’s market capitalization was only $105 billion at the time of the purchase, this was a “bet-the-farm” acquisition that could have caused investors to flee. By then, however, Danaher had already successfully acquired over 100 companies and explained to the market that GE Biopharma was a crown jewel that would be more dangerous in the hands of a competitor.
Since the acquisition, operating cash flow has grown about 54% from $4.0 billion to $6.2 billion, while leverage has decreased $2.7 billion. Looking at the share price since the acquisition, it is clear the market appreciates Danaher’s DBS philosophy and execution.
Compared to traditional private equity investments, Danaher provides the benefits without the drawbacks. There is no illiquidity risk as 2.5 million shares trade each day. Should we ever need to sell the position, funds could be raised in short order.
As mentioned, while private equity investments give the illusion of low volatility and high returns, Danaher has done better. Since 2000, Danaher’s share price has risen 2,632%, or a compound annual return (CAGR) of 16.8%. This compares to the S&P 500 Index’s 323% return, or a CAGR of 7.0%.
We believe that investing in the right public companies that share private equity’s characteristics with neither the leverage nor the fees are a better use of client money.
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By Brett Girard CPA, CA, CFA,
Liberty International Investment management
Sources
https://www.libertyiim.com/wp-content/uploads/2021/04/Liberty_eNews_2021Q1.pdf
https://www.libertyiim.com/
