Private Equity: Should You Invest and How?

The challenges of investing in private equity were addressed at a recent event held at 300 N. Wacker and hosted by CFA Society Chicago’s Education Advisory Group. There are numerous issues that arise when making the decision to invest in the asset class. One of the biggest is regarding transparency. Investors typically do not have information on which companies they will be investing in but rather must put their faith in a fund that follows a certain strategy.

The basic characteristics of an investment in private equity are certainly more complex than an investment in the public market. The typical investor becomes a limited partner in an investment fund with a fixed term. A private equity firm will usually manage a series of distinct funds and will solicit new money as previous funds become fully invested. Funds can be capitalized by equity or debt; highly leveraged funds are LBO funds. Liquidity is limited compared to the public markets and investors that unexpectedly need cash may need to search for a buyer of their investment.

The event was organized into two panels on which six (6) investment professionals participated.  The panelists were divided between asset managers, intermediaries and asset owners.

Panelists for Fund Managers and Intermediaries:

Tobias True, CFA – True is a partner on the Investment Strategy and Risk Management team at Adams Street Partners. He is responsible for portfolio construction and risk management as it applies to portfolios including commingled and separately managed accounts.

Josh Westerholm – Westerholm is partner in the Investment Funds Group of Kirk & Ellis. He is an attorney involved in forming and structuring private funds and advises clients with respect to regulatory exams and inquiries.

Panelists for Asset Owners:     

Brad Beatty, CFA – Beatty is the chief investment officer at Sirius Partners LP. He is responsible for developing and implementing the firm’s investment strategy and oversees the firm’s investment in private equity.

Michael Belsley –Belsley is one of the country’s leading attorneys in the field of secondaries. His practice includes formation and governance of private equity funds (including primary interests in and secondary markets sales of private equity fund interests). He counsels buyers and sellers in their secondary market activities.

Harisha Koneru Haigh, CFA – Haigh manages the Private Investments and Real Asset portfolios for Northwestern University’s $11 billion endowment. Prior to joining Northwestern, she was a private equity manager at PPM America Capital Partners, LLC.

Moderator:

Bill Obenshain – Obenshain is chairman of the Advisory Board of the Center for Financial Services at DePaul University. Before joining DePaul, Obenshain spent 38 years in the financial services industry with Continental Bank and Bank of America.  He is a member of the Economic Club of Chicago and the Chairman’s Circle of the Chicago Council on Global Affairs.

Each panelist gave a brief presentation and then answered questions from the moderator and the audience. The first panel featured fund managers and intermediaries and covered the following points:

What type of due diligence is performed on fund managers?

  • Knowledge of historical performance is critical, as there is evidence that top quartile performance may be a good predictor of future performance.
  • What were the drivers of past performance, what type of risks were taken?
  • What were the sources of return?
  • New investors need to know what type of valuation methods the fund uses. Most funds use a multiple of EBITDA to value potential investments.

What qualitative methods are used to evaluate funds?

  • Does the fund have the infrastructure and back-office personnel to sustain itself across any cycle?
  • What is the quality of the investment professionals making decisions for the fund and how are they compensated?

What are the challenges of creating a portfolio?

  • A portfolio of funds can be diversified by geography, sector and fund size. Over time, different sectors fall in and out of favor. Investment dollars that are paid out over different time periods will aid in the diversification of return.
  • Each investor will have a certain number of funds that they are comfortable investing in.

What is the risk of private equity with respect to other asset classes?

  • Public equity influences private equity; however there is a much different risk profile. Limited liquidity, blind pool risk and higher fees demand that private equity returns be superior to public equity.
  • Investments are made at intervals throughout the life of the fund; the timing will affect the IRR realized by the fund.

In the early days of PE, 25% to 30% returns were common; returns have dropped to the high teens.  How does this change the risk assessment?

  • Over the past 20-25 years there has been 10% annual growth in new dollars committed, this has compressed returns.
  • There is a wide range of returns among funds and access to funds and managers who outperform can be constrained.
  • Private equity funds must show performance at 300-500 bps better than public markets, LBO funds must demonstrate the highest performance premium.

What is a forever fund?

  • A typical private equity fund may have a 10-year life, at which time capital is returned to the investor.
  • There is very high interest from certain types of investors for longer terms from private equity funds. This is a better fit for institutional endowments and family offices needing investments for future generations.

What has been the trend in regulation?

  • With the passage of Dodd-Frank in 2012, private equity is no longer the “Wild West”.
  • Mandated registration has led to more oversight and enforcement actions are climbing.
  • PE firms face more questions from regulators; there is a focus on marketing materials being truthful.
  • More compliance personnel have been added, this is a positive for investors.

In the audience Q&A, the issue of risk was again addressed by the panel. True argued that risk can be defined by 1. Volatility (will it be lower?), 2. Fund Outcome (will return realized in 10-years be adequate?) and 3. Liquidity/cash flow (institutions have cash flow constraints that must be balanced with fund liabilities).

There was some audience Q&A with respect to the loosening of debt covenants and fee structure.  Higher leveraged funds will be riskier and require a higher return. Historically, the fee structure has been 1%-2% of assets managed and a 20% share of profits at the back-end. The limited partnership agreement must be specific when enumerating fees (list it or lose it).

After a short break the second panel was convened. This panel was comprised of asset owners who were able to provide some additional perspective on the issues.

What kind of due diligence is done before investing?

  • Haigh stated that 22% of Northwestern’s portfolio is in private equity. These are in co-investment’s with manager with which they have the highest conviction.
  • Investors are under pressure to commit money to managers within a relatively tight-time frame as funds are closed to new investors quickly
  • Staff resources are dedicated to getting to know the managers, those with a history of success are favored.

Now that all sectors are fair game for PE, how has the risk profile changed?

  • The benefit has been the ability to diversify within this asset class. Different managers may specialize in different sectors.
  • The challenge becomes “Which managers have the expertise for which sector?”
  • PE firms with specialty funds in out of favor sectors still have to do deals; given the time-frame can they attract investment dollars?
  • This trend reflects the maturation of the sector.

Given that the current part of this cycle has led to high valuations, what defensive measures do you take?

  • Patience is needed, however when top quartile funds are raising cash, you need to invest if you have dollars to put to work.
  • Investing consistently is important; timing the market is a mistake.
  • Take advantage of secondary sales if possible.

In the audience Q&A there were several questions concerning currently inflated valuations among private companies and the paucity of investment opportunities because of over-valuation. Investors take comfort in PE firms who have followed companies for 3-4 years and use consistent valuation methods. The computation for EBITDA can vary among managers, the biggest error can be overpaying for an asset.

Distinguished Speaker Series: James Grant, Grant’s Interest Rate Observer

James Grant has a resume. Navy man. Journalist. Founder and editor of Grant’s Interest Rate Observer. Author of books that range from the Great Depression, financial histories, a presidential biography, a forthcoming biography about Walter Bagehot, and appearances on numerous financial programs. Grant was the featured guest speaker at CFA Society Chicago’s Distinguished Speaker Series on November 14, 2018. Over lunch at the JW Marriot, Grant gave his views on topics ranging from interest rates to asset valuations and finished with questions from the audience.

Grant started with a U.S. economic review of the past 10 years concentrating on the progress and consequences of the monetary / fiscal policies applied over this period. Grant noted in 2007/08, the largest banks were leveraged around 29/1. The same group of banks are now levered approximately 13/1. While the risk these banks pose to the financial system has been reduced by de-levering over the past ten years, the leverage ratio of the Federal Reserve Bank has moved in an opposite direction, now standing at all-time highs. Fed policies have created a risky and perhaps fragile economic situation. Although the Fed has the ultimate backing of the U.S. government, at some point the investing public could say “enough” as ultimately the term “risk-free asset” will come into question. Grant then compared debt loads to GDP, asking rhetorically what is the level of debt that inhibits a country from issuing new debt at any price? Japan’s ratio of public debt to GDP is around 228%, Italy’s is 130%, while the U.S. stands at 105%. None of these countries currently have a problem issuing or servicing their debt. However, Grant explained that the level of debt is not the key, but how a country is viewed in the eyes of the world markets. For example, in 1978 the U.S. was in the midst of a funding crisis and the debt/GDP ratio was at only 26%. While finances and balance sheets matter, it is the cycles of interest rates that dominate a countries ability to raise debt and the world economies appetite for it. An alarming fact is the level of U.S debt issuance (in terms of percentage of GDP) is at its highest point since 1945. Grant pointed out the incongruity of the U.S. bond market activity and the overall economy. The economy by any measure has exhibited steady and reasonable growth in the past 10 years. Yet the U.S. government continues to issue more debt and increase the overall deficit in the face of increasing GDP.

Next, Grant addressed the value of risk-based assets. The past ten years of near zero term rates has created a perversely low cost of capital. By holding interest rates to artificially low levels, asset prices have inflated abnormally. Companies have exhibited a vicious cycle of issuing debt and using the proceeds to buy back their stock thereby propping up valuations. Fed policy is the main reason why there are a number of mega-sized companies that have recently gone or are about to go public. The commonality among these companies is that they typically make no money, have remarkably high valuations, and have easy access to cheap capital. Think Uber – it has never been profitable, year-over-year growth is decelerating, and it continues to lose market share. Despite this documented financial condition Uber has been recently valued at an enterprise value over $70 billion.

To underscore his points, Grant cited the works of two other authors. The first was Ed McQuarrie, Professor Emeritus at the Leavey School of Business, Santa Clara University. McQuarrie is a part-time market historian who takes particular issue with the views popularized by Jeremy Siegel of a 6-7% average return in the stock market over time. McQuarrie’s position is that for decade long periods the stock market has had negative returns and there is not necessarily a reversion to the mean. Grant strongly advised the audience to read Dr. McQuarrie’s paper Stock Market Charts You Never Saw.

When Grant finished his prepared remarks he fielded questions from the audience.

Q – Given your outlook on interest rates and asset valuations, is the pricing of private equity realistic?

A – Grant answered with a quick “No”, and pointed to a recent disagreement between Palantir Technologies and Morgan Staley which has a stake in the company. Palantir has been valued in the $30B – $40B range and is looking to launch its IPO in 2019. Morgan Stanley has lowered the valuation of the company to a fraction of its private market $30-$40B valuation. What does it say to the current state of private equity valuations if the very banks that are to take a company public cannot agree with the company on valuation?

Q – In the current market environment where would you put capital?

A – As bond yields go up (a certainty in Grants eyes), gold will also go up. When the public losses confidence in a country’s fiscal management, there will be a flight from that currency.

Q – Given the state of the U.S. finances, what is the answer – raise taxes, lower spending?

A – The first step to fixing our financial crisis is something akin to a person dependent on drugs. Admit there is a problem. Setting aside the lawmaker (or the out of power political party) that calls for fiscal responsibility, the U.S. government as a whole must tackle the problem. It is more likely that there will be monetary disorder before the problem is addressed. If this is the most likely scenario, then investors should consider gold as hedge.

CFA Society Chicago 32nd Annual Dinner

The CFA Society Chicago Annual Dinner was an event devoted to honoring the 148 new CFA charterholders and the recipient of the Hortense Friedman, CFA, Award for Excellence.  The evening also featured Heather Brilliant, CFA, past chairman of CFA Society Chicago and Keynote Speaker Richard H. Thaler, 2017 Recipient of the Nobel Memorial Prize in Economic Sciences and the Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business.

The newest charterholders were congratulated for passing all three levels of the CFA exam, and having the required four years of relevant work experience required to qualify for the charter.  Honoring their commitment to completing the program, a crowd of 1,050 attendees gave them a standing ovation. It is estimated that preparation for the exams requires nearly 1,000 hours of study. The newest charterholders now hold a professional designation that is recognized worldwide as a symbol of excellence in their profession and a commitment to uphold the highest ethical standards.

Heather Brilliant, CFA is currently vice-chair of the CFA Institute Board of Governors and a managing director at First State Investments.  She addressed the “State of Disruption” in the financial services industry.  Brilliant identified two disruptors: the rise of passive investing and the increasing influence of technology.  She viewed both as positive developments that will in the long-term serve client interests.

The changes these disruptors cause will need to be harnessed by CFA’s.  Active managers will face more consolidation and robo-advice will be more prevalent.  However, it is difficult for machines to empathize with clients.  Brilliant stated that the CFA Institute will offer more continuing educations support and continue to advocate for fiduciary duty.

Brian Singer, CFA was honored as recipient of the Hortense Friedman, CFA, Award for Excellence.  The award honors a member of the Chicago-area investment community who has demonstrated initiative, leadership and a commitment to professional excellence. Singer is the head of William Blair’s Dynamic Allocation Strategies team, as well as its lead portfolio manager.  In expressing his thanks for the reward, Singer spoke of the great experiences he had earlier in his career in working with Gary Brinson and Gilbert Beebower.  They collaborated on a seminal article published in 1991 entitled: Determinants of Portfolio Performance II: An Update.

The keynote speech took the form of a question and answer session between Richard Thaler and Thomas Digenan, CFA, chairman of CFA Society Chicago. The questions from Dinegan covered a wide variety of topics and took advantage of Professor Thaler’s expertise in decision theory.  The Q & A unfolded as follows:

Guess a Number between 0 and 100
The number guessed must be the closest to two-thirds of the average guess of people attending this meeting. After some calculations, you arrive at a mean of 25.4, two-thirds of that mean is 16.93. Professor Thaler made an initial guess of 17 without having to go through the calculations. He was hopeful that charterholders would arrive at a number close to the correct answer.

Outlook for the Chicago Bears
Professor Thaler states the due to the NFL salary cap; successful team must have players that perform at a level greater than their salary. This favors teams with good draft picks and teams that find good players that other teams don’t want. The Bears were forced to pay defensive lineman Khalil Mack a market value salary for the next four years. This acquisition does not bode well for the Chicago Bears as Mr. Mack must be highly compensated.

Lottery Ticket Purchase?
Given the $1.6 billion payout, Professor Thaler would have purchased a ticket. He called it a “smart dream”. Interestingly, of 14 people asked to sell their machine number generated $2 ticket for $4, 11 would not do so. Once you have something, you don’t want to give it up.

Health Care Options for Employees and the Role of “Nudge”
Employees routinely make bad decisions with respect to which health care plan is best for them. These decisions include paying $2,800 for reducing your deductible by only $2,000. Professor Thaler characterized the desire to go to a smaller deductible as a “negative nudge”. He co-authored the global best-seller “Nudge” in 2008.

During open enrollment, there is no action required if you want to keep the same plan as the year before, however if you want to change you are forced start over (go to zero). This leads to what he termed “status quo bias”. Few employees understand their health care options, which can be a bigger decision than what type of 401K you have.

An Example of “Sludge”
People who sell things need to nudge. Bernie Madoff nudged, however he nudged people for evil. It must always be our intention to “nudge for good”.
When trying to access a review in a British journal, Professor Thaler ran into a paywall. The paywall asked for only one pound of payment to access the article; however he was required to give them his credit card. After an initial period you were automatically renewed at the market rate. To stop the subscription, you were required to give 2-weeks’ notice via telephone. This is a prime example of what Professor Thaler views as “Sludge” (making it difficult to get out)

What is Life Like after Winning a Nobel Prize?
Professor Thaler has noted that he has encountered more “Sludge”. He is the third recipient of the Nobel Prize on the floor he works on at the University of Chicago, so after about a week everything returned to normal.

Thoughts on “Surge Pricing”?
Professor Thaler warned that surge pricing can be a huge blunder. This is especially true when it becomes too prevalent. Most customers are resentful when a hardware store raises the price of snow shovels during a snowstorm. During a snow storm in New York, Uber commenced surge pricing. He noted that Home Depot does not raise the price of plywood after a hurricane. Home Depot, by not implementing surge pricing, is promoting a long-term relationship with their customers.

How do you guard against over-confidence?
It is important to eliminate hindsight bias. You must distinguish between bad decisions and bad outcomes. In a football analogy, Professor Thaler stated that attempting to score a touchdown on fourth down with one yard to go for a touchdown early in a football game is a smart decision. If you are not successful, you give the ball over with no points scored. However this is not a case of overconfidence by the head coach. This is an example of good decision with a bad outcome. It is difficult to do, however it is better to evaluate the decision, not the outcome.

In his concluding remarks, Professor Thaler criticized point forecasts by analysts and advocated confidence limits. A $2.34 point forecast can be contained in $2.15-$2.50 confidence limit. It is also critical to be able to look back at forecasts to track errors. Forecasting is an important part of what people do and the more feedback you have the more you will learn.

 

CFA Society Chicago would like to thank the following organizations for helping to make the 2018 Annual Dinner a success!

PREMIER SPONSORS
Northern Trust
UBS Asset Management
William Blair

PLATINUM SPONSORS
First Trust Portfolios, L.P.
Mesirow Financial
Nuveen

Thank you to all our Gold, Silver and Bronze sponsors as well!