Wednesday, May 16, 2007

Private Equity

Thought I'd follow up my recent investment in a listed private equity fund with some thoughts on private equity. It certainly is "flavor of the month" - the latest headlines generated by Daimler effectively paying Cerberus to take 80% of Chrysler off its hands. Private equity investment means various things but essentially means investments in companies that are not listed on a stock exchange.

According to the Federal Reserve, business equity constitutes on average 17% of households' net worth - more than the 6% or so accounted for by direct stock ownership. If we assume that 70% of the holdings of mutual funds and retirement accounts are also in stocks we get the same 17% of net worth accounted for by stocks as by business equity. This means that if you are ony invested in publicly listed stocks you are missing around half the businesses out there by value! Being diversified across stocks does not mean you are diversified across equity investments! The average household also has 32% of net worth invested in a primary residence but only 6.4% in other property.

Aside from starting your own business how can you invest in private equity? It's certainly hard to get a stake in someone else's private firm without the right connections or being an accredited investor. Managed private equity investments fall into two classes: venture capital and buyout funds. Generally these are only open to accredited and qualified investors. The nearest equivalent in the US to AEP is Leucadia National. They buy businesses, turn them around and sell them. The company is often compared to Berkshire Hathaway. The difference is that Berkshire does not resell the businesses it buys and it buys successful not distressed companies. A big element of Berkshire is acquiring private companies. Owners who want to sell their company phone Warren up and do deals if he is interested. I have one BRK/B share currently. Leucadia is on my watchlist but seems pricey at the moment. It is a stock I would buy in a stock market correction. Another option, and way to get some more investment ideas is Powershares listed private equity ETF. Its biggest holding is... Leucadia National. You can also wait for the Blackstone IPO. But it is likely to be pricey. Several of my holdings are in the business mainly of acquiring privately held companies - these include CIF.AX, CIW.AX, and FLIP.OB.

Private equity has a reputation for extraordinarly high returns. Buyout firms have high returns due to their use of leverage. Without leverage they likely wouldn't do much better than listed equity investments. In other words the returns come from a high risk exposure. Venture capital firms that get things right can achieve extraordinary returns. Google is just one of the famous cases. Investing in start-up companies is of course tremendously risky, so a high expected return might make sense - there are a lot of total losses as well as tremendous successes. You have to understand exactly what kind of listed entity you are investing in. Don't assume that "private equity" is some magic bullet that will generate high returns.

4 comments:

Anonymous said...

While I think private equity has an important place in the investing world. I can't but feel that it's late in the cycle now. Some of this is my bias against MBAs. Apparently private equity is the hot thing right now - every MBA want a job in private Equity. Reminds me of when all the MBAs wanted to work in telecom before the long ride down.

Yannick said...

very good point! imo, the telecom boom and bust were clearly driven by over-investment, or too much capital chasing the specific market. when there are too much money in PE, there are simply not enough good deals left, even for Berkshire Hathaway. the herd is always one step behind the real opportunities.

"Be fearful when others are greedy. Be greedy when others are fearful". i've been increasing my cash holdings since last year.

mOOm said...

Probably why AEP is sitting on a huge pile of cash and isn't finding many good deals apart from the failed Qantas bid. It's reassuring that they aren't rushing out and spending the money.

Anonymous said...

Los Angeles private equity and hedge fund borrowing are the main things propping up the stock market these days. That won't last forever, but for now it's hiding the real economic damage that is being done.The tax issue is valid, and something most people can understand, but the real tragedy of the current situation is much more complex.