Saturday, January 14, 2012

Private Equity: Hero or Villain?

The battle for the Republican presidential nomination seems to have claimed another "financial markets" casualty, at least in public opinion. In the last few weeks, we have seen Mitt Romney, who made his fortune at Bain Consulting, attacked for being a heartless, job-destroying private equity investor. I prefer not to enter political debates, but some of the critiques of private equity are so misdirected and over the top that I have to believe that these critics have no sense of what private equity is, the companies that they target and what they do at these companies. 


What is private equity?
If asked to provide a prototype of a private equity investor, many critics present you with Gordon Gekko , endowed with all of the characteristics that they want to attribute to a villain: a greedy, immoral man who delights in inflicting pain on the less fortunate. I could tell you that most private equity investors that I know don't even come close to that stereotype, but that is unlikely to convince anyone. In my view, here are the three ingredients for an investor to qualify to be a private equity investor:

  1. Equity: At the risk of stating the obvious, to be a private equity investor, you have to be an investor in equity, either in publicly traded companies (as stock) or in private business (as owners' equity). So any criticism of private equity that segues into mortgage backed securities, which are generally debt, or into overreach at investment banks prior to 2008 is mixing up its villains.
  2. Activist: A second feature of that separates private equity investors from most other equity investors is that they are activist, rather than passive investors. Thus, you and I, as passive investors, may buy stock in a company, believing it to be under valued or sub optimally managed, and then sit back and hope that the price moves up. An activist investor would buy stock in the same company and put in motion actions aimed at changing the way the company is managed (shutting down bad businesses, take on more debt, pay more dividends) or in fixing the reasons for under valuation (spin off, split offs, divestitures).
  3. Private: While activist equity investors have been around as long as markets have been around, there is a third aspect to private equity investing that sets it apart. Private equity investors preserve the option (though they don't always use it) of "taking private" some of their targeted publicly traded companies. In effect, they remove these companies from the public space, run them as private companies for a period of time (during which they make changes), and then either go public again or sell them to other public companies.

With this definition in place, you still see diversity within this group. Broadly speaking, private equity investors can be classified into three categories: lone wolves (like Carl Icahn, Nelson Peltz and Bill Ackman), institutional activists (mutual funds and pension funds that trace their lineage back to the Calpers fund in the 1980s and are activist on the side) and activist hedge funds (which is where I would put Romney's Bain fund, KKR and Blackstone).


What types of companies do private equity investors target?
If activist investors hope to generate their returns from changing the way companies are run, they should target poorly managed companies for their campaigns.
  • Institutional and individual activists do seem to follow the script, targeting companies that are less profitable and have delivered lower returns than their peer group. 
  •  Hedge fund actvists seem to focus their attention on a different group. A study of 888 campaigns mounted by activist hedge funds between 2001 and 2005 finds that the typical target companies are small to mid cap companies, have above average market liquidity, trade at low price to book value ratios, are profitable with solid cash flows and pay their CEOs more than other companies in their peer group. Another study of the motives of activist hedge funds uncovered that the primary motive is under valuation, as evidenced in the figure below.


In summary, the typical activist hedge fund behaves more like a passive value investor, looking for under valued companies, than like an activist investor, looking for poorly managed companies. Activists individuals are more likely to target poorly managed companies and push for change.

What do they do at (or to) these targeted companies?
The essence of activist investing is that incumbent maangement is challenged, but on what dimensions is the challenge mounted? And how successfully? A study of 1164 activist investing campaigns between 2000 and 2007 documents some interesting facts about activism:
  • Two-thirds of activist investors quit before making formal demands of the target. The failure rate in activist investing is very high.
  • Among those activist investors who persist, less than 20% request a board seat, about 10% threaten a proxy fight and only 7% carry through on that threat.
  • Activists who push through and make demands of managers are most successful (success rate in percent next to each action) when they demand the taking private of a target (41%), the sale of a target (32%), restructuring of inefficient operations (35%) or additional disclosure (36%). They are least successful when they ask for higher dividends/buybacks (17%), removal of the CEO (19%) or executive compensation changes (15%).  Overall, activists succeed about 29% of the time in their demands of management.
A review paper of hedge fund activist investing finds that the median holding for an activist hedge fund is 6.3% and even at the 75th percentile, the holding is about 15%. Put differently, most activist hedge funds try to change management practices with well below a majority holding in the company. The same paper also documents an average holding period of about 2 years for an activist investment, though the median is much lower (about 250 days).
Following through and looking at companies that have been targeted and sometimes controlled by activist investors, we can classify the changes that they make into four groups as potential value enhancement measures:

  1. Asset deployment and aperating performance: There is mixed evidence on this count, depending upon the type of activist investor group looked at and the time period. Divestitures of assets do pick up after activism, albeit not dramatically, for targeted firms. There is evidence that firms targeted by individual activists do see an improvement in return on capital and other profitability measures, relative to their peer groups, whereas firms targeted by hedge fund activists don’t see a similar jump in profitability measures.
  2. Capital Structure: On financial leverage, there is a moderate increase of about 10% in debt ratios at firms that are targeted by activist hedge funds but the increase is not dramatics or statistically significant. There are dramatic increases in financial leverage at a small subset of firms that are targets of activism, but the conventional wisdom that activist investors go overboard in their use of debt is not borne out in the overall sample. One study does note a troubling phenomenon, at least for bond holders in targeted firms, with bond prices dropping about 3-5% in the years after firms are targeted by activists, with a higher likelihood of bond rating downgrades.
  3. Dividend policy: The firms that are targeted by activists generally increase their dividends and return more cash to stockholders, with the cash returned as a percentage of earnings increasing by about 10% to 20%.
  4. Corporate governanceThe biggest effect is on corporate governance. The likelihood of CEO turnover jumps at firms that have been targeted by activists, increasing 5.5% over the year prior to the activism. In addition, CEO compensation decreases in the targeted firms in the years after the activism, with pay tied more closely to performance.
Do private equity investors make high returns?

The overall evidence on whether activist investors make money is mixed and varies depending upon which group of activist investors are studied and how returns are measured.
  • Activist mutual funds seem to have had the lowest payoff to their activism, with little change accruing to the corporate governance, performance or stock prices of targeted firms. Markets seem to recognize this, with studies that have examined proxy fights finding that there is little or no stock price reaction to proxy proposals by activist institutional investors.  Activist hedge funds, on the other hand, seem to earn substantial excess returns, ranging from 7-8% on an annualized basis at the low end to 20% or more at the high end. Individual activists seem to fall somewhere in the middle, earning higher returns than institutions but lower returns than hedge funds.
  • While the average excess returns earned by hedge funds and individual activists is positive, there is substantial volatility  in these returns and the magnitude of the excess return is sensitive to the benchmark used and the risk adjustment process. Put in less abstract terms, activist investors frequently suffer setbacks in their campaigns and the payoff is neither guaranteed nor predictable.
  • Targeting the right firms, acquiring stock in these companies, demanding board representation and conducting proxy contests are all expensive and the returns made across the targered firms have to exceed the costs of activism. While none of the studies that we have reference hitherto factored these costs, one study that did concluded that the cost of an activist campaign at an average firm was $10.71 million and that the net return to activist investing, if these costs are considered, shrink towards zero
  • The average returns across activist investors obscures a key component, which is that the distribution is skewed with the most positive returns being delivered by the activist investors in the top quartile; the median activist investor may very well just break even, especially after accounting for the cost of activism.
Here is an indisputable fact. If you are a stockholder in a publicly traded company, the entry of a private equity investor into your stockholder ranks is good news, since stock prices go up substantially:

Is private equity good or bad for the markets? How about for the economy? And for society?
For some of you, this entire post may be missing the point of the criticism, which is that private equity investors are job killers, not job creators. To me, that criticism is misplaced, because you cannot measure the success of a business by the jobs it creates or saves, but by the value it creates for its stockholders, by making money, and for its customers, by providing a needed product or service to customers. In the process, if it is successful, it will hire people and create jobs.
In fact, today's New York Times carries a story about one of the companies targeted by Bain in its Romney days, where 150 people lost their jobs, and it specifies that the company primary products was photo albums. Thus, while it is easy to blame Bain for the layoffs, the real reasons lay in a shifting market, where digital photography and computerized albums were replacing conventional photographs. The story's bigger point is that the people in the town have moved on, found other businesses to work for and are frankly surprised by the attention.
Since the critics are using fictional characters to beat up private equity investing, I will use one of my favorite fictional characters, from a great movie, "Other People's Money", to counter:


If private equity investors are primarily interested in slimming down companies and creating value for stockholders, do they create value for society? I believe that they do, and for two reasons. First, they are the battering rams that we use as passive investors to initiate and create change at public companies, and especially at companies that need to change. Second, even when private equity investors target companies, force them to divest assets, slim down and pay out the cash to stockholders, the cash does not disappear into thin air. The stockholders who receive the cash use it to pay for products and services (which creates jobs) and to invest in other companies with better growth prospects (which in turn hire more people).
In fact, my response to those who have a problem with private equity would be to ask the following question: Which aspect of private equity investing do you want to ban? Assuming that it is not equity investing collectively, it has to be either the activism or the "taking private" components. And what would that accomplish? Banning these practices would leave incumbent managers ensconced at publicly traded companies, unchallenged and unwilling to make changes, and the only jobs saved will be theirs.

Bottom line: If you don't like Mitt Romney, don't vote for him. Find a good reason, though! The fact that he worked at a private equity firm, and was good at his job, should not be that reason. In fact, since the US government looks more and more like a badly managed enterprise in need a major restructuring, a "good private equity investor" in charge may be just what the doctor ordered. 

38 comments:

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Immortal said...

Impressive and appreciate that you base your arguments with solid research and stats...i know its demanding but please post with less intervals..its a delight to read :)

Vinicius Caldas said...

Way to go, man!An amazing article, once more. Ought I say that the equity investor is a marginal investor as well? Thanks again.

Ian said...

Damodaran,
You miss the point. Is Romney good or bad for the economy and the country? To help us answer this question one place we can look is at his previous job history which includes a stint in PE. Ignoring for a second the overarching question on whether or not PE is good, lets look at the mentality of the PE investor. The PE investor is only interested in the enrichment of his/her equity investors. He/she is also only focused on the short term (most PE firm are only looking to invest in a company for 4-6 yrs at the most). Therefore, if I'm debating whether or not voting for Romney is a good idea, I think it very much makes sense and is valid to look to his involvement in PE. In fact, I think one can make a valid argument that the majority of Romney's perceived "flip-flops" are attributable to his PE mentality. He'll say whatever needs to be said in order to get the short-term gains he is looking for, much in the same way a PE investor may make harsh (but perhaps needed) cuts in a business in order to realize a return on an investment for his/her limited partners. We also have to ask who is Romney's "investors" in his bid for the Presidency. Republicans? The country? Himself?

While I think PE to have a useful role in the economy, I don't think the titans of the industry necessarily have a valid argument for their role in politics and government based purely on their success(es) in PE.

Unknown said...

It is very true that PE investor play the role to activists for the passive investor. But, below points also need attention:

- What if PE iinvestor has less than 5% stake in a company? Can they push for changes they would like to see?
- What if they just have Short Term perspective on underlying companies? Activism may not come into play in short term.
- PE investors keep one CEO for many companies? How many companies a CEO can run efficiently? Would not it affect their efficiency?
- PE and Hudge Funds themselves are not much regulated. We dont get to see their upto date financial and their actual position in underlying companies? We only see what they want us to see.
- Hedge funds' major reuturn are based on philosophy of high leverage (e.g. LBO financing). Can they really play activist role if they are not in majority?
- If they foresee anything wrong and bleak future. They would be the one to leave first, deserting minority investors who don't have much information on company and thus are not able tomake timely decision.
Though we have looked at brighter side, should not we look at darker side? Not as much as other critics but may to some extent?

Aswath Damodaran said...

Ian,
As I said, if you have issues with Romney, vote against him but don't make generalizations that are not based on the facts. First, you argue that private equity investors care only about equity investors and that is true. Who else should they care about? That is like arguing that lawyers care only about their clients (and not about the overall justice system) and doctors only about their patients (and not about the overall quality of national health care). Second, you make the statement that private equity investors are short term and you define short term as 4-6 years. The typical mutual fund manager has a time horizon of 3-6 months and the typical retail investor holds a stock for 1-2 years. What exactly is your definition of long term and what investors meet that criteria? Third, you make a point about flip flops reflecting the PE mentality. To be a good PE investor, you cannot flip flop, since you have negotiate from strength. So, if Romney is a flip flopper, don't attribute it to his PE background.

Aswath Damodaran said...

Unknown.
I did not look at the bright side. In fact, one reason I focused on the overall average and across all PE investments is to avoid basing my conclusions on the exceptions (on either side). Are there PE investors who borrow too much and make a hash of the companies they invest in? Sure. Are there PE investors who create amazing turnarounds in companies that have been given up for dead. Sure. But neither group represents the typical PE investor and that is why I think we need avoid using either as the example.

Loganthan said...

Campaign politics is not a quest for truth or fairness but is about winning. The more desperate one gets the more the urge to adopt slash and burn tactics with a quotable soundbite and a eye catching ad clip which will help in winning votes. I think that is what is happening here rather than a denounciation of PE per se.

Having said this I think to be the President of the USA and leader of the free world requires a lot more qualifictions other than ability to manage busineess PE style which appears to (even according to the candidate) be Governor Romney's sole qualification.

Even restricitng the requirements to the narrow field of job creation the President needs to be one who can take decisions for the entire populace and for the overall good and not confine themselves to a narrow section of the population (a la a the one percent).

Loganthan said...

Campaign politics is not a quest for truth or fairness but is about winning. The more desperate one gets the more the urge to adopt slash and burn tactics with a quotable soundbite and a eye catching ad clip which will help in winning votes. I think that is what is happening here rather than a denounciation of PE per se.

Having said this I think to be the President of the USA and leader of the free world requires a lot more qualifictions other than ability to manage busineess PE style which appears to (even according to the candidate) be Governor Romney's sole qualification.

Even restricitng the requirements to the narrow field of job creation the President needs to be one who can take decisions for the entire populace and for the overall good and not confine themselves to a narrow section of the population (a la a the one percent).

Anonymous said...

What do you say to that?:

“Watch out for alternatives. Now there are two kinds of alternatives. When you get to private equity, David Swensen himself says, look, private equity on the record does about the same as the S&P 500 on average. So you've got to do a lot better than that. Same volatility, there is a lot of high jinks played in the private equity game, and a lot of grabbing from the cookie jar by the managers, and I just don't think that's a good idea for the average investor to do.”

Bogle Interview Transcript -- October 2011

The interview is available on Morningstar:

http://news.morningstar.com/articlenet/article.aspx?id=439223

ashwini chube said...

Very Good article Sir.
I always enjoy reading your blog and your books.You explain things really well and make the most difficult concepts easy to digest.Looking forward to read more posts from your blog

Pavel said...

Very informative article, Sir. But your argument appears to be double-edged for me. Ok, it isn't fair to judge Romney's qualifications only by disastrous blunders some his colleagues made. But what does your average picture tell us? Does "good private equity investor" in charge” have a recipe for success?
The stats you cited (if I didn’t misread them) tell us that average PE investor
1) isn’t a good crisis manager. ‘cause he isn’t keen on turning around anything, he targets companies that fare reasonably well but are somehow disadvantaged by the stock market (so much for the heroic turnaround of obsolete businesses story)
2) isn’t a good speculator, ‘cause his gains turn out to be negligible taking into account his costs
3) often doesn’t seem to make any meaningful impact on the company for better or worse at all
So do you really want to see this kind of guy at the helm of your country? And for the question you started you article with “Private Equity: Hero or Villain?” The answer appears to be “neither”. It’s largely irrelevant.

Pavel said...

Very informative article, Sir. But your argument appears to be double-edged for me. Ok, it isn't fair to judge Romney's qualifications only by disastrous blunders some his colleagues made. But what does your average picture tell us? Does "good private equity investor" in charge” have a recipe for success?
The stats you cited (if I didn’t misread them) tell us that average PE investor
1) isn’t a good crisis manager. ‘cause he isn’t keen on turning around anything, he targets companies that fare reasonably well but are somehow disadvantaged by the stock market (so much for the heroic turnaround of obsolete businesses story)
2) isn’t a good speculator, ‘cause his gains turn out to be negligible taking into account his costs
3) often doesn’t seem to make any meaningful impact on the company for better or worse at all
So do you really want to see this kind of guy at the helm of your country? And for the question you started you article with “Private Equity: Hero or Villain?” The answer appears to be “neither”. It’s largely irrelevant.

Aswath Damodaran said...

Pavel,
I guess you crystallized my argument. The critiques I see off private equity paint a sinister picture of extraordinary villains with supernormal powers who destroy lives. My point is that private equity investors are no different from any other group of investors. The average PE investor is just as ineffective as the average portfolio manager or the average value investor. But that is always true about the average, isn't it?
Thus, using the fact that Romney was a PE investor at one point in life as a critique is neither here nor there. Perhaps, people should be discussing whether he was an effective PE investor (or just an average one) and whether those qualities are those that would help his as president.

The Bloginator said...

You're missing the whole point, Damodaran. You may understand PE, but you don't understand politics. The guy stood up there and made an entirely baseless claim: I created 100,000 jobs. He left himself open for attack. And even for me, a student of yours, it is difficult to understand how a company he invests in can go bankrupt, and somehow Bain makes millions of dollars, especially the deal wherein the government had to step in to bail out the pension fund to the tune of $35-40 million, and Bain made $12 million on an $8 million investment and another $8.5 in fees. These deals beg questions, and in America, we listen to our candidates' answers, just as Obama had to answer for his relationship with Reverend Wright. Thus far, Romney hasn't had the Clinton-esque ability to answer these Bain questions, and it's starting to show he's out of touch with the problems average Americans are facing. It is almost impossible to become president in this country when you are out of touch. I personally think that's a good thing, because a president, unlike a PE titan, does need to worry about jobs.

Pavel said...

Sir, I would be grateful to know more about your opinion concerning these stats as such. Taking this political stuff out of consideration how would you explain such relatively lukewarm results on the part of PE funds? Is it corporate governance problem with portfolio companies i.e. disciplining effect of concentrated ownership (or threat of taking company closely held) on managers is overestimated? Or is it miscalculation on the part of fund managers in the process of selecting targets i.e. something like phenomenon of overcrowded strategies in hedge fund arbitrage trades (there can’t be really that many companies where you can realize some hidden value so they basically dupe themselves into discovering ones – pure wishful thinking)?

Anonymous said...

Great points and data re PE and Romney's PE experience being perhaps a good thing.

However your
"The stockholders who receive the cash use it to pay for products and services (which creates jobs) and to invest in other companies with better growth prospects (which in turn hire more people)." - It would be good to post some evidence that this kind of trickle down economics works or is it mainly a talking point?...may be instead of the stockholders the employees who keep their jobs and hence spend most of their paychecks would be putting in the same amount of money into the economy. I think the US is also not a corporation and does not have the same goals as a corporation. While business/PE experience may be a plus in reigning in budget deficits, it does appear based on recent events in Europe (Ireland etc) that austerity in the short term atleast is not really working...

Doesn't mean that the Left have the answers either but some of the Republican talking points regarding trickle down economics etc that you seem to echo need closer scrutiny.

Aswath Damodaran said...

Anonymous,
I am not even arguing that the money gets spent on good things. I am just noting that cash that is paid out by companies has to go somewhere else. It has to be spent (on something) or saved (in which case it is invested elsewhere). Either way, it just finds a different place in the economy. Am I missing a third place it can go?
As for Pavel, my post was about the general claims made about private equity investors being job destroyers. I was not debating Romney's specific claims about job creation. That would require that I have access to all of the companies he was involved in and I do not. I agree with you that it is a legitimate point to debate.

Anonymous said...

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Loganthan said...

I think PE has a bad name because the overall perception is it is exploitative in nature. I don't think the vast majority are against free enterprise or grudge people who are hugely successful. What irks the vast majority and creates the overall negative perception is that a few smart institutions and people can succeed hugely by exploiting. That's why I am not so sure whether the number and statistics given in the article is really reflective of the 'perception' as in general PE may have average success but it is the hugely skewed (unfair?)success of a few that drives perception.

I recall reading a NYT article couple of years ago and give the date and link to it and would request those interested to read it as I think it accurately captures the indignation people feel about PE.

The article is titled Profits for Buyout Firms as Company Debt Soared and was published on October 4, 2009 and written by Julie Creswell. (The link is 'At Simmons, Bought, Drained and Sold, Then Sent to Bankruptcy' http://www.nytimes.com/2009/10/05/business/economy/05simmons.html?pagewanted=all)

Andrej said...

Sir,

I think you might have not defined the PE categories correctly.Here's my take

Hedge funds are passive as you mentioned, hold minority stakes, and hope to implement small changes (typically executive pay, dividend policy, small divestments and corporate governance) and exit the company in a year or two.

KKRs and Blackstones of this world are in fact the real PEs: they buy majority, take companies off the market, significantly influence the management of the company's operations and target exists in 3-5 years through IPOs, and more often trade sales

Bobby Caygeon said...

"These deals beg questions, and in America, we listen to our candidates' answers, just as Obama had to answer for his relationship with Reverend Wright."

@ Bloginator - that one was funny. Spit up my coffee all over my computer!

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Anonymous said...

Nice Article. However, don't you agree that this attack on PE was invited by Mr. Romney himself when he declares with no basis “I’m very happy in my former life; we helped create over 100,000 new jobs.”

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QUALITY STOCKS UNDER FIVE DOLLARS said...

I have nothing against a private firm buying a company to improve it. But not if they must over leverage the company. It makes no sense to claim that your saving a company if their is a huge amount of debt created for a company to repay. Interest expense on a company with bonds with a junk bond credit rating could be 9% 10% or even higher.

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