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The grey hair of Henry Kravis

Private equity as an industry is now reaching “middle age”. By that, I mean it is somewhere around 40 years old, having been born in the early 1970’s. There was a frustrating article in the Economist recently which suggested, it’s becoming dull and boring – no longer truly worthy of its status as an “alternative” asset class. I beg to differ. 

The Economist’s justification for its position was that four of the biggest Private Equity houses – KKR, Carlyle, Blackstone and Apollo – have changed their business models. They made their initial fortunes through leveraged buyouts (“LBO’s”) – using debt to buy under performing companies which were restructured and resold for huge profits. Now, the LBO is only a small part of their business – barely a quarter of the money managed by Blackstone is used in this way. Profit now comes from investing in infrastructure, or lending to businesses which might previously have borrowed from banks. The change has, in part, been forced by the eye-watering sums entrusted to them by investors: Blackstone is in charge of more than a quarter of a trillion dollars. That money no longer comes just from savvy individuals who know the right people. These days, investors or “limited partners” in the big four PE firms are more likely to be risk averse pension funds of blue-chip companies. They will be delighted with an IRR return that merely makes it into double figures.

This is all such a long way from the KKR described in the book, and subsequent film, “Barbarians at the Gate”. Written as a highly readable novel, it tells the story of how private equity came of age, with KKR founder Henry Kravis masterminding what was, in 1988, the biggest hostile takeover of all time – the $25 billion buyout of US food and tobacco giant, RJR Nabisco. What the film makes clear is just how small the KKR operation was. The deal was put together by a small group of very clever people, who managed to outwit the titans of US industry. They were able to do so because businesses like RJR Nabisco, and the people who ran them, had become complacent. Shareholders were struggling to hold the management of listed companies to account, and the result was that “agency problems” – where managers wasted shareholders money – was rife. RJR Nabisco CEO, F. Ross Johnson maintained a fleet of 10 corporate aircraft, which was unofficially known as the RJR air force. Its duties included providing transport to F. Ross Johnson’s pet dog. It was not hard therefore for Henry Kravis and his team to identify where savings could be made. Kravis was responsible for a classic line in the film – a sinister warning that “debt tightens a company”. Back in the late eighties, this was a revolutionary thought. This state of affairs could never last for long.

It is, therefore, no wonder that private equity has had to change. No company, however big, is immune from a private equity LBO. The best defence is to be efficient. That way, a private equity funded takeover will struggle to find free money swilling around that should have been returned to shareholders. Such companies do still exist; however they are no longer a big component of the Dow Jones industrial average. Pension funds, which are naturally conservative in their investment outlook, wanted exposure to Private Equity for reasons of diversification. That’s exactly what Blackstone et al have given them. The annual IRR’s achievement in years gone by of 30%, 40% or 50% would probably have been interpreted as excessive risk-taking by most boards of pension fund trustees. These trustees were often people who did not understand private equity, and as such, they were right to steer clear, until the “safe” mega funds of recent years were born.

These mega funds were created for people like pension fund trustees. This kind of investor frequently objected to the traditional “2 and 20” fee structure (where fund managers are rewarded with 20% of any profits in addition to a 2% of the committed capital as an annual management fee. Perversely the new “1 and 20” arrangements, which replaced them at some mega funds, has actually made fund managers even richer, given that fund sizes had climbed from hundreds of millions to tens of billions. The management companies behind the mega funds are fatter, employing thousands, rather than dozens of people. They are even listed on the New York Stock Exchange, giving inexperienced private equity investors a warm, comfortable feeling for no particularly good reason.

However, the old spirit is still alive and well in the mid market, and at the venture capital level. IRRs above 50% are still out there, if you know where to look. But these funds are not big enough to have pension funds, and their huge sums of capital they need to deploy, as their limited partners. This is a risky marketplace: for every fund that achieves extraordinary returns, there are many that do not. Even if investors have the skills to identify the funds that will succeed, they are still not guaranteed a place as a limited partner. Demand hugely exceeds supply. That is why the mega-funds have created different products for the mass market.

Those who dare suggest private equity has become boring should also note the pay of the nine founders of the big four firms. Last year, they took home £2.5 billion dollars between them. Middle age definitely has its compensations.

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