Analysis Of Private Equity Business

KING LEON Apollo Management founder Leon Black.

Image: From Bloomberg News/Landov

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Michael Gross, a founding partner of the private equity firm Apollo Management LP who is now at a hedge fund, recently asked a group of business students at Northwestern University this question: In three years’ time, what might the private equity and airline industries have in common? His answer: From day one, neither will have ever made a return for its investors.

It’s hard to imagine another industry that has suffered quite the unmasking that private equity has. Hedge funds underwent a calamity, but their basic business of buying and selling stock still works in a leaner world. The business of providing investment advice and making trades—the meat and potatoes of investment banking—will exist even if no independent investment bank does.

But private equity firms are another matter. Once, they purported to be in the business of buying troubled companies and turning them around. They contended that they could manage the companies better away from the public glare of shareholders. That pretense was dropped during the boom earlier this decade. When private equity shops took over companies like the Texas utility TXU Corp. or the casino operator Harrah’s Entertainment Inc., which was bought by Apollo, it was clear that these were thriving enterprises, not troubled at all. The private equity firms were simply engaged in “financial engineering,” a then-admiring euphemism for a simple conceit: loading up fine companies with massive amounts of debt in the hopes of flipping them to new owners at some point down the road.

When money was loose and leverage was king, private equity firms thrived. No more. In the wreckage of the bust, they have been revealed as hapless corporate stewards and gullible investors. The competition for the highest-profile debacle is stiff. Cerberus Capital Management hasn’t been able to manage Chrysler LLC or GMAC LLC. The private equity firm TPG leaped into buying a stake in Washington Mutual far too early and saw its investment wiped out. Stephen Schwarzman took his company public only to see its stock collapse. Apollo has faced one disaster after another. It lost money on Linens ’n Things when the retailer went bankrupt, and Harrah’s is struggling. Apollo’s Realogy Corp., a real estate brokerage that controls Century 21 and Coldwell Banker, is in the ICU. And Apollo has been knee-deep in litigation with chemical maker Huntsman Corp. and Carl Icahn.

Add to that the reality that private equity firms generally don’t make their money by choosing good investments. They make it on an amazing Technicolor array of fees: management fees, deal completion fees, consulting fees, performance fees, special events fees, fees of every kind and stripe. Chalk it up to yet another racket of the
bubble years.

So it would be natural to assume that private equity is in trouble. Yet, in one of the richer ironies of the Great Recession, private equity firms are poised to flourish. They’ve raised money for new funds and locked it in before investors have had a chance to fully realize how disappointing the returns will be on the last ones. Capital is king now, and many private equity firms have enough money for 10 years.

The private equity industry is shaping up to be a great example of why it can be rewarding to do irrational things in a bubble.

Finding the SuckersFor years, the academic research has revealed private equity’s pretense: After fees, private equity firms as a whole don’t beat the market. University of Chicago scholar Steven Kaplan studied the industry’s returns and in a 2005 paper reported that over a period of about three decades, the average private equity firm’s annual return was no better than that of Standard & Poor’s 500-stock index. Since then, he has asserted that private equity returns often appear inflated because of some flaws in the way in which they are compared with the broader market. Kaplan points out, for example, that Blackstone Group LP’s annual 26 percent return from 2002 through 2006 looked heroic against the S&P 500’s 6 percent. But if you lop just a year off the comparison and use Blackstone’s performance from 2003 through 2006, the results look much less impressive because the S&P returned 20 percent annually during those years.

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