what it is
Private equity project developers buy companies, very often ones that are not publicly traded. They intend to hold them for, say, five years. During that half-decade, the private equity principals polish the companies up. They improve management practices, expand the acquired firm’s market reach, sometimes by combining it with other, similar private companies to achieve critical mass. They may also aggressively shrink the workforce, something a publicly traded corporation, fearing damage to its brand name, may be hesitant to do. The end game is either to sell the remodeled company to a large corporation–who may have already indicated an interest in, and signaled the desired shaping of, the end product being shaped–or take it public.
As I see it, the late David Swensen of Yale is the person who put private equity on the map when he took over management of that university’s endowment in 1985. I was particularly interested in how he operated because I’d spent six years at Yale after the army and was also finding my own way on Wall Street at that time.
I think Swensen’s most basic observation was the simple one that a university endowment had a very long investment horizon–decades, in fact–and therefore didn’t need the daily liquidity that’s a key feature of publicly traded stocks and bonds. So why pay for that liquidity? Instead, buy shares in privately held companies, which could be had at considerably lower valuations. In addition, Yale’s injection of capital would in itself enhance the intrinsic value of the target company. Another win. In addition, in the pension world of the 1980s Swensen had the field more or less to himself.
On the view that there’s no “free lunch,” there are two offsetting factors to the apparent gains. The first is near-term liquidity, which wasn’t an issue for Yale. The second is how to value the portfolio positions in the absence of a market quote.
Forty years ago, this was not a burning issue, since Yale was the only game in town for private sellers. The key was/is careful analysis of audited financials. And Yale had no endowment rivals offering target companies a better price. I do recall one instance where Yale owned part of a company in Africa, whose business was so obscure that the endowment decided the best (only?) parties able to assess the company’s value was its top management. Not a good look, but presumably a tiny position (I have no clue how this worked out, though.) In any event, the overall results have been extremely good for a long period of time.
today’s world
The landscape has changed significantly. Virtually every large traditional pension or endowment organization seems to have a significant portion of its assets devoted to private equity. I find that in itself to be worrying, since the number of organizations looking to sell in the event of some adverse development is now enormous.
In addition, I read the emergence of etfs with a portion of the assets in private equity to be worrying in itself. A basic axiom of marketing is that there’s no reason to offer chocolate ice cream until the market for vanilla is saturated. Similarly, the emergence of strawberry (my favorite, but #3 behind #1 vanilla and #2 chocolate) implies that the market for chocolate is also saturated.
I also read this as saying that demand for private equity from traditional sources has dried up. If so, pension funds and endowments won’t act as a buffer to mitigate the potential decline in private equity prices in times of market stress.
If my analysis is anywhere near the mark, these new etfs are riskier than they might appear at first glance. Again, if so, great to buy at the bottom of a sharp market decline, not so much near a market top.