The Private Equity Firms' Private Equity Firm
Plus: Networks, The AWS of Finance, US Bank Results
|Marc Rubinstein||Jan 15||22|
Welcome to another issue of Net Interest. Every Friday I distil 25 years’ experience of looking at financial institutions into an email that explores key themes trending in the industry. If you’re reading this, but haven’t yet subscribed, join over 11,000 others by signing up now.
The Private Equity Firms’ Private Equity Firm
A few weeks ago, in Zuckerman’s Curse and the Economics of Fund Management, we talked about hedge funds. We concluded that owning a hedge fund, or at least a basket of them, could be more lucrative than investing in one. However, aside from Sculptor Capital Management (formerly Och Ziff) there aren’t that many publicly available.
What are publicly available are private equity firms. Large firms like Blackstone, KKR, Carlyle and Apollo all trade on the public markets. Joining their ranks in the not-too-distant future is Blue Owl, which is in the process of coming to the market via a SPAC merger.
Blue Owl is different from your regular SPAC because it is being formed via the merger of three companies rather than the usual two. One is the SPAC sponsor, the vehicle through which the others go public—Altimar Acquisition Corporation. Another is Owl Rock, a direct lending platform which lends to companies, including those that do private equity. And the third is Dyal, a private equity firm that invests in other private equity firms. In many ways this new company is the private equity firms’ private equity firm.
So if hedge fund equity was worth thinking about as an investment, what about this thing? And more broadly, how do the economics of private equity stack up against the economics of hedge funds?
What is Private Equity?
In the Middle Ages, Venice was possibly the richest place in the world. There were many reasons for its success. Its geography, in the middle of the Mediterranean, helped. But so did its use of a novel financing contract, the commenda—the precursor to today’s private equity deal. The commenda was used to finance merchant shipping. Passive investors would put up most of the capital and share in the profits of the voyage. In a downside scenario, they couldn’t lose more than they’d put in—their liability was limited.
Fast forward to today and private equity finances large swathes of the modern economy. Private equity funds own roughly 7,200 companies in the US alone, employing 5.4 million people. Today’s funds combine the rudimentary structure of the commenda with features that were developed over the 1960s and 1970s. One of those features is debt.
In 1965 Jerome Kohlberg was a banker at Bear Stearns. He’d been introduced to the owner of Stern Metals, who, at 71 years of age, was looking for a way to cash out without selling to a corporate buyer. Kohlberg designed a structure to buy the business for $9.5 million using $1.5 million of equity and $8 million of debt. The equity would be put up by Bear Stearns and some others including the Stern family. Within eight months, the company offered stock – originally priced at $2.50 – to the public at $11.75 a share. Four years later, it was sold at a price eight times the original cost.
Around to see the deal close was a summer intern, George Roberts. A few years later Kohlberg would join up with Roberts, and Roberts’ cousin Henry Kravis, to start a new firm, KKR. Rather than use Bear Stearns’ money to back deals, they would raise a fund from outside investors. Their first fund raised $32.6 million which, through a series of transactions like the Stern one, ended up returning $539.6 million to investors, before fees. It was the first of many successful funds. As they write in their public filings, “From our inception in 1976 through December 31, 2019, our investment funds with at least 24 months of investment activity generated a cumulative gross IRR [internal rate of return] of 25.6%.” It’s an impressive record, although, as we shall see below, the performance of the 1976 fund and the first few funds after that may flatter the picture.
Private vs Public
There are plenty of differences between private market investing and public, but three stand out.
First is access to information. Stephen Schwarzman, the founder of the largest private investing firm in the world, started out in public markets, as a securities analyst. One day, he approached a company executive, whose stock he was looking at, with a list of questions. The executive stonewalled him. Schwarzman was probing into areas outside the public domain and the executive was concerned about revealing inside information.
“I said, well if he didn’t answer, how in the world can you figure out what to do?… I’m not that smart; I need to have all relevant data and he’s the person who has it, so why won’t he give it to me?… What I’ve sort of done for a career is try and solve that problem of my initial meeting… I want people to tell me what’s really going on, so I can figure out whether what they’re saying makes sense or doesn’t make sense. You can do that in the private equity business.”
A second key difference between private and public investing is that, unlike in public markets, the prices of private companies don’t bob around day-to-day. Holdings in private companies are valued, typically once per quarter, on the advice of accountants and other professionals. None of the wild swings that are the price to play in public markets. Some see this as a positive. The Chief Investment Officer of the Public Employee Retirement System of Idaho called it the “phony happiness” of private equity.
The third factor, which partially derives from these two, is that transaction costs are much, much higher in private markets. Search friction is greater as fund managers and target companies need to find each other. This creates much leakage in value. One paper estimates that transaction costs come to around 3.3% of the valuation of target companies. In the case of Hilton Hotels – according to Bloomberg, “the best leveraged buyout ever” – transaction costs amounted to $470 million.
The combination of high transaction costs and a cloak of protection from the volatility of markets creates a model in which timing is everything. Unlike in public markets, you can’t just change your mind, or build into or out of a position. (In the financial crisis, when the Harvard University endowment changed its mind, it faced a 50% discount trying to exit its private equity holdings.)
Schwarzman likens the model to farming:
“…We’re like farmers. When we buy companies and real estate, it’s like planting crops. You put seeds in the ground, you water, and the seeds start growing, but you can’t see the crop yet. Then they grow very high, and it will be a great crop, and you will be very, very happy.”
It’s an interesting analogy that resonates across other areas within financial services, where there is a long duration with low frequency feedback. In credit for example, the performance of loans doesn’t become apparent until they have some seasoning behind them. Credit analysts look at loan pool vintages to track their performance over time. Similarly, in insurance, underwriting years don’t align with accident years. Even outside financial services, in the world of subscriptions, clustering customers into cohorts or vintages is a useful way to understand their economics.
If there are four kinds of business, then farming needs to be one of them!
The difference between private equity and these other lines of business is that the manager has a large amount of discretion over when to harvest. Take Alliance Boots, which was owned by KKR before being merged into Walgreens. KKR bought it in 2007 but under the weight of the financial crisis, it floundered; in 2011 it was valued at 1.0x cost on KKR’s books. But KKR didn’t have to sell—its fund investors were locked up and there was plenty of time to run on the clock. Most investors, when they come into a private equity fund, agree to commit capital for a period of ten years or more. KKR finally got out in 2014 with a return of 4.0x. Even if the clock had run down, private equity firms have an option to extend.
Howard Marks, co-founder of Oaktree, knows all about vintages:
“We have a good average return over those 32 years. It was moderate other than in about six years; and in six years we had financial crises – 90, 91, 01, 02, 08, 09 – and the funds formed in those six years had very, very high rates of return and pulled up the average considerably.”
Fund Investors vs Fund Owners
Long durations and non-market valuations render performance comparisons across private equity funds very difficult, allowing many firms to claim they’re doing better than perhaps they are. According to one consulting firm, over three-quarters of private equity firms claim to be top quartile, which is quite an extreme reflection of the Lake Wobegon effect.
The confusion arises because firms have several metrics to choose from. Two of them are multiple on invested capital and internal rate of return. The problem with the multiple on invested capital is that it doesn’t take account of how long it takes to get to harvest; the problem with the internal rate of return is that it assumes reinvestment of proceeds at the same rate. That latter assumption is a bit of a stretch, particularly when early returns are high—as they were at KKR. This explains why KKR’s 25.6% cumulative rate of return since inception has barely budged over the past ten years. In fact, it’s been fixed on that number since 2015, down just a tad from 26.1% all the way back in 2007.
Perhaps because of the opacity in terms of their performance, private equity funds are able to charge very high fees. They charge management fees at a rate of around 2% on capital commitments; they also take a 20% “carry” of any profits, and in some cases extract other fees from their portfolio companies. In the case of the Hilton Hotels deal, carry of $2.6 billion and management fees of at least $685 million were secured, albeit on a pretty good capital gain for fund investors. More generally, out of every $100 invested with a private equity buyout fund, an average of $18 is paid to managers.
In addition, unlike at hedge funds, most of the fees come as recurring management fees rather than as incentive fees. Of that $18, around 70% is derived from management fees and 30% is from incentive fees. This doesn’t align interests very well with fund investors, but from the perspective of the manager, it provides a very attractive revenue stream. All the more so given how long fund investors are locked in for.
When Dyal was formed by Neuberger Berman in 2010, it emerged from the gates with a strategy to invest in hedge fund companies. The firm picked up stakes of around 20% in hedge funds like Blue Harbour and Jana. In total, Dyal invested in 19 hedge fund companies. However, even though the firm was able to attain diversification, performance didn’t follow.
One of the issues is that hedge fund investor capital is not sticky. In fact, not only can it walk out the door, but managers can usher it out if they choose to downsize or shut up shop altogether. This was a feature we discussed in Zuckerman’s Curse and the Economics of Fund Management. A few years after Jana sold a stake to Dyal, it shut two of its flagship funds; assets dropped considerably and one of the key portfolio managers lost interest. Dyal sued; it didn’t want them to just “take that money and run.” Its Fund I, which was pretty much all hedge funds is valued at 0.94x the capital put in, and Fund II, which was mostly hedge funds, is valued at 0.87x.
As an investment, private equity is better, which is why Dyal pivoted to it by the time they raised Fund III in 2015 (valued at 1.55x capital). There are three main reasons.
First, investor capital has a contractual lock-up. Managers can sleep easy in the knowledge that investor capital isn’t going anywhere for at least ten years at a time. Second, linked to the complexity of the business, it is necessarily more institutional. More resource is required to get a leveraged buyout done than to buy stock on a public exchange. Consequently, more of the value accrues to the business rather than the individual. KKR pays out 40% of its income as compensation; Sculptor – a hedge fund – pays out around 50%. The third reason brings us back to Schwarzman’s remarks about access. A strong private equity franchise has access to dealflow which solidifies over time. This creates a competitive advantage which is measurable and, like in the previous point, extends beyond the people involved. KKR discloses that 57% of its private equity sourcing in Asia is “proprietary”.
Dyal wasn’t the only one to make the distinction—it explains why there are many more publicly traded private equity firms than there are hedge funds. Now it, too, is coming to the market.
Fund management companies are very protective of their culture, which tends not to scale—which is why the industry remains highly fragmented. So it is no surprise that the three parties involved in the formation of Blue Owl know each other well. Dyal already owns a stake in Owl Rock in one of its funds, and lends to it out of another. It also owns a stake in the company behind Altimar Acquisition Corporation. It is perhaps fitting that the PE firms’ PE firm should end up owning a piece of itself, but it does give rise to conflicts of interest given that ownership is on behalf of third-party investors (although Blackrock owns shares in itself on similar terms).
Blue Owl has assets under management of around $51 billion, coming roughly equally from Owl Rock’s direct lending platform and Dyal’s private equity business. Financially, the firm contrasts from peers in two distinct ways. First, a big chunk of its capital is permanent. This means that it is not subject to redemption at all—not in ninety days (like most hedge funds), not in ten years (like many private equity funds), not ever.
Permanent capital has become the holy grail for fund management companies over recent years. Hedge funds like Bill Ackman’s Pershing Square have permanent capital vehicles—in his case Pershing Square Holdings, a London listed pool of capital that invests exclusively in his fund. Access to this pool of permanent capital helped Ackman survive his bout of poor performance a few years back. Others like David Einhorn’s Greenlight have exclusive agreements with insurance companies (in his case, Greenlight Re) to provide permanent capital. Private equity firms have structured similar solutions with insurance companies and also use their own shareholders’ equity to provide permanent capital to their funds. The large listed private equity firms have around 20% of their assets under management locked up on a permanent basis. In Blue Owl’s case, the number is 92%.
The other distinctive feature is that Blue Owl relies much more on management fees. The direct lending side of the business is set up only really to accept management fees. The Dyal side of the business hasn’t achieved sufficient realisations to generate incentive fees. So revenues stem almost exclusively from recurrent management fees at a rate of around 1.4% on assets under management. With compensation running at around 25% of revenues, operating margins are quite high.
The key question facing Blue Owl is whether it is able to launch new funds. The downside with permanent capital is that, being a fixed pool of capital, it is not open to inflows and so growth has to stem from performance and from new fund launches. And on the Dyal side, that depends on there being a market of other managers willing to sell. Yet the higher the valuation of Blue Owl, the higher their valuation. This is a most meta of transactions.
More Net Interest
The same dynamics hold in the exchange space and there, too, new entrants are not to be dismissed. This week, “Hide Not Slide” profiles bond trading platform Trumid in their newsletter, Front Month. I highlighted the company in my piece on MarketAxess in November, but the Front Month write-up provides a lot more detail. The company has been around for only five years, but already its volumes are 1/4th the size of Tradeweb’s corporate bond business and 1/7th that of top player MarketAxess. The trigger was not privacy in this case (although that is an important issue in trading) but other functions of utility.
As Ben Thompson of Stratechery writes, “Network effects may seem unassailable, but they are unassailable in the way an oak tree stands strong against a storm: nothing can knock it over until the day it cracks, and then the unwinding can happen far more quickly than might happen with a more traditional two-sided platform.”
The AWS of Finance
In September we discussed Blackrock’s technology business in a piece, The AWS of Finance. The company reported earnings for full year 2020 this week, and for the first time surpassed $1 billion in technology revenue. It’s still only 7% of total revenue, but it’s growing fast, consistent with the company’s self-description as a company that “provides a broad range of investment and technology services to institutional and retail clients worldwide.”
No sign of a spin-off soon (“we are committed and remain focused on continuously evolving Aladdin for the next 20 years to come”) but plenty of emphasis on the earnings call of continued growth. In particular, Blackrock sees an opportunity to use Aladdin to help clients manage sustainability—a key battleground in the investment industry that we touched upon in our piece on S&P Global.
It’s also started to disclose annual contract value, which is “how leading technology companies measure their top line growth” and the target is low- to mid-teens growth over the long-term. No harm in releasing the SaaS within.
US Bank Results
We looked at US bank results after the first half 2020 reporting period, in What US Bank Results Tell Us About the State of the Economy. We concluded that banks were front-loading lots of risk. Back then JP Morgan was forecasting a base case of 10.9% unemployment at the end of 2020 and 7.7% unemployment at the end of 2021. Jamie Dimon said, “if the base case happens, we may be over-reserved. I hope the base case happens.” In fact, unemployment ended the year at 6.7% and is projected to hit 5.0% at the end of 2021.
Lots of US banks reported earnings for the full year 2020 today and sure enough, they are unwinding excess provisions. The four banks that reported today – JP Morgan, Citi, Wells Fargo and PNC – released an aggregate $5.6 billion in excess credit provisions between them.
In JP Morgan’s case it still might be too much: “with the near-term outlook still quite uncertain, we remain heavily weighted to our downside scenarios and at nearly $31 billion, we are reserved at approximately $9 billion above the current base case.” Whether that comes back this year, time will tell, but in the meantime, JP Morgan may face constraints on what it can do with it.