How to Invest in Private Equity

Investing with Dr John

Imagine you have a private company with 100 shares and you’re making £100 after-tax profit a year. You’ve run a tight ship and have no debt in the company. That’s an earnings per share of £1 and if your shares were priced similarly to sensible public market valuations (say the FTSE 100) they might be valued at £10 each. This is because the price per share (£10) divided by the earnings per share (£1) is 10. The price/earnings ratio (p/e) is 10. The whole company is worth £1000.

Now, you’re having coffee in the city one day and some gal comes up and tells you you’re a fool. She says she can add fifty percent to your share price with a bit of financial engineering. “How so?”, you ask. Her proposal is that you borrow £500 at 5% interest (which she can arrange) and use the money to buy back half your shares for £500. What’s happened?

Well now the earnings are not £100 but £75 (because you have to pay £25 interest on the £500 loan). But there are only 50 shares in issue and so the earnings per share is £1.50. For your shares to trade on a p/e of 10 they would have to command a premium of £15 per share, a 50% rise in share price. You’re suckered in.

Photo by Keenan Barber on Unsplash

To paraphrase Reagan’s famous most expensive 9 words in history (“I’m from the government and I’m here to help”), they tell you “I’m a private equity specialist and I’m here to help”. 

But then it all goes wrong. Interest rates rise to 10% and now you’re paying half your profits out as interest. And there’s a recession and your profits halve. Had you not listened, you’d be making profits of £50 a year still. But now all that £50 goes in interest payments and you can’t sleep at night because you’re making no money at all. Soon you might have to call in the administrators….

But that nice lady showed you this chart of the sorts of returns this financial engineering seemingly does. 

What’s going on here?

The private equity industry is to stock markets a bit like the shadow banking system is to banks. Most shares we are aware of like Apple or Shell are traded on the stock markets be it NASDAQ, FTSE or AIM. But there is another set of markets out there trading in unlisted shares, private equity (PE), with no ready market available to investors like you and me. Most of the assets are owned by large private equity groups and often partly by the management of the companies themselves. 

The private equity market is worth between $5 and $10 trillion, according to McKinsey’s Private Markets Annual Review, with big players like Blackstone, CVC Capital, and KKR and Co managing billions in investments, typically charging high fees (sometimes as high as 2% plus performance fees, a bit like a hedge fund). And a lot is invested in high-growth companies, especially in the tech sector.

Private equity groups are always trying to add value. These companies are geared-up (like the example above), sliced and diced, asset-stripped and merged with competitors, restructured, subject to management buy-out and buy-in in a seemingly endless circus to improve shareholder returns. And often they are sold on to other private equity groups at privately-agreed (some say high) valuations.

So, if there is a shadow industry out there that gets management to borrow money, gear up, expose themselves to recessions and increasing interest rates, heavily into high-growth technology companies (seen the NASDAQ index’s fall this year?), charging its own investors high fees and selling on to other shadow groups at high valuations, why am I going to say investment in PE can be a good idea?

That’s for four reasons. Firstly, returns have been demonstrably good over so long and over such a wide geographical exposure there must be some genuine value-added going on.