Monday, March 29, 2010

Public Private Equity: A Dog Chasing His Tail?

Brett Arends' piece from the WSJ, (here from Yahoo!) gives some excellent, concise arguments why you should think twice before investing in public equities of private equity management firms. To summarize, private equity managers run opaque businesses, shrewdly raising capital from whatever source provides them the greatest benefit, meaning the poor saps who invest in their public offerings probably get lousy deals. 

While I agree with virtually everything he says, I suspect we reach different investment conclusions.

Investors commit to private equity because they believe the returns offer something substantially different than public equity markets.  (I argue here that the implied fees and underlying investment characteristics make this notion highly suspect for most funds.  The manager gets roughly 80 cents of value for every dollar committed.)

Additionally, PE investors perceive reduced the risk to their portfolios because private positions don't mark to market.  The positions don't trade, so they don't have to worry about losing least in the short run.

So, where's the problem with private equity firms going public? The IPO provides a publicly traded, mark-to-market vehicle to access previously unique risks...with better financing and more leverage!

A PE fund is a storage facility.  It takes significant capital (and potential access to capital) to make private investments.  The fund stores these novel, capital-intensive risks.  (If you're confused, you need to read my post on moving versus storage.)  The management company uses the fund to store risks, and the management contract to create options.  How?  Performance (and various other) fees create contingent revenues for the management company with upside only!  The management company requires very little capital to create and store these options (once they have the fund.)

So, what about unique access to risk?  Gone!  Once the management company trades freely, then options on the unique risks of the fund trade freely.  Nobody wanted the downside anyway.  However, that doesn't mean you don't risk overpaying for the options when you buy the stock in the management company! 

And what about reduced volatility because of positions that don't mark to market?  Gone, if you're honest about it!  (Well, if you are truly honest about it, this never existed, but...)  The prospects of the management company reflect the market's expectations about the value of the underlying investments.  Look at Fortress Investment Group, (NYSE: FIG.)  When the credit crisis hit, the public market immediately hammered the stock.  Why?  Equity owners in FIG marked down the expected value of FIG's PE funds' performance fees.  This happened faster than FIG marked down positions in their funds.  Shouldn't this have been reflected by investors?

So, what do I conclude that differs from Arends?  I suspect Arends says don't invest in public private equity managers.  I'd say if you want to take the risk, buy the management company, not the fund.

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