In a recent Wall Street Journal article by Andy Kessler dated March 29, 2015 entitled “The Glory Days of Private Equity Are Over” (read here) Mr. Kessler, an accomplished author, investment banker, research analyst, venture capitalist and hedge fund manager, makes an impassioned case for why macro trends will bury the private equity business model. His assumptions, however, may be too simplistic and his prediction- “Stick a fork in it “- may be premature.
Caveman Business Model
First of all Mr. Kessler thinks the private equity model is pretty simple. You buy a company mostly with leverage and run it for its cash flows with enough left over to pay interest, fees and dividends. Then you take it public or sell it to someone else. If it were that simple I am sure that accomplished venture capitalists and hedge fund managers, like Mr. Kessler, would be doing it themselves?
Caveman Cash Flows
Mr. Kessler believes that you generate cash flow, not by expanding the company, but rather by slashing costs, closing divisions, cutting staff, curtailing marketing, eliminating research and development and “more”. Maybe the biggest Neanderthals among us are still clinging to that “caveman” business model, but I have found that most private equity owners look for operational improvements, pricing opportunities, systems improvements, customer and supplier rationalization, compensation alignment, principal amortization, growth capital expenditures, management accountability and inclusionary governance. This is real company building based on people management, rational capital allocation, prudent capitalization, tuck-in acquisitions and attainable business strategies. At least that is what we attempt to do with all of our portfolio companies in the lower middle market.
Four Trends and A Funeral
Mr. Kessler then points to four obvious trends that will kill private equity and one that is the “killer”.
Trend #1: “Interest rates are going up”: Not according to our capital introduction expert, John Corrigan, who has been working with our middle market financing sources since 2010. During John’s tenure with us senior debt in the lower middle market has fallen from 5.25% to 3.25% for quality credits and mezzanine debt has fallen from 18% to 13%. Recently, he has seen a slight increase in mezzanine interest rates but he finds the senior debt market to be as “competitive as ever”. Mr. Kessler believes in the Stark family model from the “Game of Thrones” that winter is coming and that, inevitably, interest rates will rise and kill the private equity model. By the way almost all the Starks got killed by the end of the first book and their arch nemesis, the Lannister family, no doubt the earliest capitalists, ruled the world with gold.
Trend #2: “Banks are slowing lending for leveraged deals”: Mr. Kessler cites the Wall Street Journal as his source for regulators discouraging leverage structures more than 6x EBITDA. In the middle market and the lower middle market where the highest volume of M&A deals are occurring, the price for the whole company rarely exceeds 7x and the equity capital is usually 35-40% of the transaction. This means the debt capital structure is usually less than 5x and the bank portion rarely exceeds 4x. Our experience is that the middle tier banks are more aggressive today than any time since 2007. In fact, unlike the “too big to fail” banks, just recently the regulators have been easing up on them for the first time in years.
Trend #3: “Tax reform is in the air”: Mr. Kessler points to Lee-Rubio tax reform which could call for the end of the interest deduction on certain debt as a sure sign that the foundation of the PE model will shake and fall. He calls the interest rate deduction the “air that filled the private equity balloon for years”. I can think of a few more notable Hidenburgs who are many times more leveraged who have remained airborne due to the interest deduction like the US Housing Industry, the US Banking Industry, Fannie Mae, Freddie Mac. And on the tax point, there are at least 5 tax attributes that are equally or more important to most private equity partners: (a) the deductibility of goodwill; (b) the limited liability structure that eliminates double taxation of corporate profits;(c) the taxation of profits interests as capital;(d) the taxation of capital gains at a significantly lower rate than dividends and ordinary income and (e) deferral of tax on unrealized appreciation. Mr. Kessler is also crazy to believe that a debtor central government with debtor states and municipalities and debtor pension funds supported by a debtor populace will voluntarily vote in favor of raising their cost of borrowing by eliminating the interest deduction.
Trend #4: “Private equity is holding back the economy”: Since Mr. Kessler believes in the caveman approach to private equity he cannot believe that the prudent use of debt capital in a buyout model can lead to productivity, job growth or innovation. He believes that is possible only with venture capital because VC’s do not utilize debt in their investment structures. He bashes the derivative industry. He blames PE for a ½%-1.0% lower gross domestic product. But where is the evidence? Our experience is completely opposite. We buy companies and grow revenues through a combination of strategic and tactical management and operational improvements. We raise prices where we can. We invest in systems to give us better information for running our businesses. We hire sales people to boost revenues. We consolidate buying power to lower our costs from suppliers. We tuck in product lines to leverage our existing expense structures. Our employees get matches to their 401k plans and annual raises. Our management teams get bonuses when we achieve our annual budgets. This is not voodoo economics. It is old fashioned business based on perspiration, purpose and people.
Our Imminent Demise Is Highly Exaggerated
Mr. Kessler ends his article by saying that the first four trends are nothing compared to the last trend which is the scarcity of good investment opportunities other than mattress companies and food companies which he must believe are the safety trade for PE cavemen. Now this is something I can acknowledge is a fact; no, not the mattress and food company thesis but rather the scarcity of good investment opportunities. We have to work harder than ever and employ more investment discipline than in 1999 to find good opportunities and continue to meet our promised IRR hurdles. But we have found a perfectly good way to do that- actually invest in and improve the businesses you buy and raise smaller pools of capital with sidecar families who are willing to co-invest in larger transactions. We are adapting to changing circumstances with a business model that continues to work for us and our investors. We know that the PE asset class is highly Darwinian and that, as good stewards of capital, we have to evolve or perish. Our early demise has been highly exaggerated.
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