Once upon a time, there was an arbitrage lurking in the US markets. Publicly traded companies have long been the subject of intense scrutiny. They are legally obligated to disclose financial data on a quarterly basis. Their executives answer questions on publicly available calls with shrewd Wall Street analysts. Millions of market participants buy and sell public company stocks on the open market between 9:30am and 4pm Eastern time Monday – Friday. While perhaps not perfect, public markets are ruthlessly efficient. The price at which a given company’s stock is trading is the aggregate market’s opinion of the value of that company. Everyone is operating with the same information. There is a high level of price discovery in the public markets. When you buy a stock, you are paying a fair price.
Privately held businesses are different. Determining the price of a private company is an onerous process. The owner of a private company may hire an investment banker to do a thorough autopsy of his business, clean it up to make it more appealing to prospective purchasers, and shop the business to a network of sophisticated buyers who have the capital and expertise required to purchase a business in its entirety. It is a time-intensive and costly process. Valuing, packaging, and selling private businesses is a big business today, but this was not the case in the not-so-distant past. A few decades ago, there was no established process for determining the value of a private business and executing a transaction. There was no army of investment bankers scouring the private markets for businesses to sell and the capital markets for buyers to sell them to. Lack of price discovery in private markets meant many companies were mispriced. Many of these businesses could be purchased cheaply – at a substantial discount to the present value of their future cash flows. Thus, an arbitrage
Some shrewd entrepreneurs noticed this arbitrage and raised money to buy these businesses at attractive prices. Then they worked to improve them – professionalize management, systematize business operations, update technology, rewrite contracts, and perhaps add a bit of leverage – before selling them for a price that better reflected the present value of their future cash flows. Add to this the tailwind of interest rates in a secular decline from the 1980s through 2021 lowering the cost of borrowing (leverage) and increasing valuations. Even the entrepreneurs who were not effective operators of the businesses they purchased often did well. Buying a business at a discount to fair market value, doing nothing while interest rates decline and valuations expand, then selling at fair market price could generate nice returns, particularly with a little leverage mixed in. These shrewd entrepreneurs became billionaires. Their business is called private equity.
As the entrepreneurs who first noticed the arbitrage got rich, other people noticed. That guy is on a yacht because he bought and sold businesses? Where do I learn to do that? The best and brightest students began pursuing finance in hopes of finding their way into a private equity shop. People took entry level jobs on Wall Street to leverage as a stepping stone into private equity. Private equity firms are now massive alternative asset managers with hundreds of billions of dollars under management. They compete with one another when bidding to purchase private companies. The owners of private businesses hire sophisticated investment bankers with experience in their niche of the market to solicit biddings wars between the private equity giants. Buying and selling private businesses is now its own industry. This leads to fair question:
Why would private businesses still be mispriced?
Arbitrages have three commonalities: (a) they lurk in corners of the market where no one is looking, (b) you can make a lot of money exploiting them, and (c) once everyone finds out, the arbitrage disappears. Private equity spent the last few decades exploiting an arbitrage with compelling (and very public) results. Today if you are considering buying a private company, you are not the only one. There is an established industry of deep-pocketed purchasers looking to put capital to work in the private markets. If you are not competing with someone, you should take a moment to discover why that is the case (I can already tell you the answer).* Price discovery found its way to the private markets. Private businesses are bought and sold at prices equivalent to the present value of their future cash flows. Good luck purchasing private companies at a discount today.
Will there still be private equity investments that generate outsized returns for their investors? Absolutely. Will that be the case for the investors in most private equity deals? Eh... probably not. If presented an opportunity to invest in a private fund, should you assume it found its way to your desk only after being passed on by larger, more sophisticated investors? Almost certainly.
Traditionally, there are two downsides to private markets: fees and liquidity. The fees in the space are high – limited partners (the investors) pay the general partners (the private equity firms) an annual fee as well as a percentage of the profits upon the sale of the business – traditionally 20%. The fees are easy to pay in a marketplace awash with mispriced private businesses. Buying low and selling high can generate outsized returns even after paying the general partner a percentage of the profits. It is much more difficult to pay a manager a percentage of profits in an efficient market. The other downside is liquidity. The public markets provide a high level of liquidity – you can sell your publicly-traded stock for the current fair market price during trading hours Monday – Friday. In the private markets, your capital is locked up until the general partner finds a buyer. The median duration is about ten years. Would you rather be able to access your money tomorrow or in 2035?
This is not meant to be a piece arguing against allocating to private equity. It is a prudent allocation for some investors. But it is not a prudent allocation for all investors (and some of the literature we’ve been reading lately argues the latter). We have access to private equity deals for our clients, but we’re very judicious in making recommendations. Be slow in considering, advised Bias of Priene. We believe attractive private equity deals are more difficult to find today than in the past because of the introduction of price discovery to private markets. Meanwhile the asset class maintains the twin headwinds of high fees and low liquidity. If one cannot shake the irresistible urge to allocate to the asset class, may we suggest an alternative…
Instead of owning a private business as a limited partner, paying a management fee and a percentage of profits to the general partner, just buy the general partner and share directly in the profits of the GP’s business. The largest, most successful private equity firms are publicly traded! Blackstone, Brookfield, Apollo, Ares, KKR, Carlyle, Blue Owl, etc. You can pay the fees and sacrifice access to your capital for a decade as an LP, or you can share in the profits from those fees and retain immediate access to your capital by simply owning the stock of the GPs.
Sean Cawley, CFP®
*Everyone else already passed on it (likely for good reasons).
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Content here is for illustrative and educational purposes only. It is not legal, tax, or individualized financial advice; nor is it a recommendation to buy, sell, or hold any specific security, or engage in any specific trading strategy. Results will vary. Past performance is no indication of future results or success. Market conditions change continuously.
This commentary reflects the personal opinions, viewpoints, and analyses of Resolute Wealth Management. It does not necessarily represent those of RFG Advisory, clients, or employees. This commentary should be regarded as a description of advisory services provided by Resolute Wealth Management or RFG Advisory, or performance returns of any client. The views reflected in the commentary are subject to change at any time without notice.
Any companies mentioned are for illustrative purposes only. It is not a recommendation to buy, sell, or hold any specific security.