Private Equity Past, Present, and Future by rub18840

VIEWS: 17 PAGES: 86

									Private Equity: Past, Present, and Future


                      Steven Kaplan
     University of Chicago Booth School of Business



                       April 2009




                           1                          Steven N. Kaplan
                           Overview
The 2nd PE wave ended in 2007. Now in a PE bust.
Address a number of questions:
 – What is private equity?
 – Why is it controversial?
 – How does the 2nd buyout wave compare to the 1st?
     » Capital committed? Money invested?
 – What do PE transactions / LBOs really do?
     » Why do PE transactions do what they do?
     » Are they good or bad for the economy?
 – What do PE firms do? How are they organized?
 – How good have returns really been?
 – Was the 2nd wave different or like the previous one?
 – What will happen next?
     » Why is there such chaos?
     » What will happen to PE?
     » What will happen to returns?
     » How will the companies and economy fare in a downturn?
                                 2                              Steven N. Kaplan
                    What is private equity?
Typical private equity transaction:
 – Private equity partnership (PEP) agrees to buy company.
 – If company is public, PEP pays a premium of 15% to 50% over
   current stock price.
 – Finances:
     » 60% to 85% of purchase with debt.
     » 15% to 40% with equity from private equity fund.
 – PE firm usually has majority control.
     » Exceptions are PIPEs, growth equity, debt investments.
 – Generally long-term investments.
     » Hold for 3 to 8 years, then exit -- IPO, sale to large firm, or sale to
       other LBO firm.
 – Investment size varies widely from $5 million to $1 billion+.
                                      3                             Steven N. Kaplan
Private equity fund / partnership:
 – Managers of PE firm are general partners (GPs), investors are limited
    partners (LPs).
     » GPs = Apollo, Blackstone, Carlyle, etc.
     » LPs = pension funds, endowments, etc.
 – GPs raise first fund. Say ABC I.
     » LPs commit to a certain amount of investment. Say $2 B.
     » Fund has a fixed life -- usually 10 to 13 years.
     » GP invests funds over first 3 to 5 years.
     » GP compensation:
           Annual management fee (1.5% to 2.5%) from LPs.
           Deal fees and monitoring fees from companies.
            Carried Interest = % of profits (usually 20%).
 – After investing $ (in 3 to 5 years), GPs raise next fund -- ABC II. $5 B?

                                    4                            Steven N. Kaplan
What happens if ABC I investments are successful and increase in
value from $2 B to $6 B?
 – ABC I returns investments to LPs.
     » Through sale or as public shares after an IPO.
 – ABC GPs earn:
     » 20% of ( $6 B - $2 B ) = 20% of $4 B profit = $800 M.
     » With 2% management fee, would also have received $40 M per
        year ( 2% of $2 B) for up to 10 years of fund.
            Total of $300 to $400 million.
 – Annual rate of return (gross): 25% per year.
 – Annual return to LPs (net of fees): 19% per year.
 – Note: 6% per year difference.



                               5                         Steven N. Kaplan
                  Why is it controversial?
Systemic effects of so much leverage?
Effect on workers?
Conflicts of interest?
 – Do CEOs and PE investors pay too little?
 – Why don’t the CEOs do more as public company CEOs?
Limited information when companies are private?
“Incredible Wealth, Incredible Disparity”?
 – “Though exact figures are hard to come by, the hallmark of the
    private equity industry is the incredible wealth being created for the
    small number of individuals who drive the buyout business.”
     » Service Employees International Union (SEIU)
 – Perception that PE investors enjoy low tax rates.



                                   6                             Steven N. Kaplan
7   Steven N. Kaplan
   How does the 2nd wave compare to the 1st?

Capital committed to PE partnerships.


Money invested in deals.




                                 8       Steven N. Kaplan
9   Steven N. Kaplan
Source: Private Equity Analyst, Steven N. Kaplan


                           10                      Steven N. Kaplan
U.S. Going Private Transactions




   Source: Mergerstat, Steven N. Kaplan

                                          11   Steven N. Kaplan
   U.S. Going Private Transactions
as a %of Stock Market Capitalization




       Source: Mergerstat, Steven N. Kaplan



                                      12      Steven N. Kaplan
U.S. Fundraising and Transaction Value
      as a % of Stock Market Value




                   13                    Steven N. Kaplan
Number and value of worldwide transactions




                     14                Steven N. Kaplan
    What do PE transactions / LBOs really do?
Early investors -- KKR and others -- discovered benefits of LBOs.
Benefits are now applied in most LBOs.
 – Financial Engineering:
     » High equity to management ==> improved incentives.
           CEOs receive more upside (and more downside) than in
           public companies.
           In ‘80s public-to-privates:
             – Median CEO from 1.4% pre- to 6.4% post-buyout equity.
             – Median mgmt. ownership increased by a factor of 4 X.
           Still true recently. In deals from ‘96 to ‘04:
             – In 43 U.S. deals, Kaplan and Stromberg (2008) find
                 CEO gets 5.4%, team 16% of equity
             – In 59 large UK deals, Acharya and Kehoe (2008) find
                 CEO gets 3%, team 15% of equity.
     » High Debt ==> Discipline15and tax benefits.            Steven N. Kaplan
– Governance Engineering:
   » PE investors control boards of portfolio companies.
         Boards are smaller than comparable public companies.
   » PE investors work closely with CEO and management of
     portfolio companies.
         In UK study, 12 formal meetings / year and many more
         informal contacts.
   » PE investors closely monitor CEO and portfolio companies.
         In Acharya and Kehoe (2008):
            – 1/3 of CEOs replaced in first 100 days.
            – 2/3 of CEOs replaced at some point (over 4 years).


                                16                         Steven N. Kaplan
Do financial and governance engineering actually matter?
Virtually all empirical evidence is positive re portfolio companies.
 – For deals in the 1980s, Kaplan (1989), Kaplan (1991) and others
    find LBOs associated with:
      » Improved operating margins (absolutely and relative to industry).
             Up by 10% to 20%
      » Improved cash flows margins.
             Up by 40%.
      » Increased employment (but less than the industry).
      » Reduced capital expenditures.
      » Lower taxes.
      » Substantial increases in value.



                                  17                           Steven N. Kaplan
– For deals in the 1990s and early 2000s (relative to industry):
   » Operations:
         Improved operating margins in UK and France for deals
         overall.
         But public-to-privates may be different:
           – Small increase in operating margins in U.S. public-to-
              privates (Guo, Hotchkiss et al. (2008)). (But very high
              investor returns).
           – Modest increase in operating performance in UK public-
              to-privates (Acharya and Kehoe (2008) and Weir, Jones,
              Wright (2007)).




                                 18                         Steven N. Kaplan
» Employment (Davis, Haltiwanger, Lerner et al (2008))
      Overall, lower growth in employment than industry.
      Both more job creation and more job destruction.
      France, with smaller deals, is more positive.
» R&D (Lerner, Sorensen, Stromberg (2008)).
      No decline in patenting.
      More efficient patenting.
» Reverse LBOs outperform market post-IPO. Cao and Lerner
  (2007).
      Changes are not temporary.



                           19                       Steven N. Kaplan
“There is a general consensus across different methodologies,
measures, and time periods regarding a key stylized fact: LBOs and
especially MBOs enhance performance and have a salient effect on
work practices.” Cumming, Siegel, Wright (2007)


Caveat -- public-to-privates may be different.




                                   20                      Steven N. Kaplan
More recently -- in the last 5 to 10 years -- most top PE firms have
added “operational engineering” to financial and governance
engineering.
 – Most top firms organized around industries.
     » Use industry expertise to generate deal flow.
     » Use industry expertise to identify improvements.
     » Use industry expertise to help drive change.
 – Most top firms have internal groups or use top consulting firms to
   identify opportunities for cost-cutting, growth initiatives, strategic
   changes.
     » Pioneered by Bain Capital (and Mitt Romney).




                                    21                            Steven N. Kaplan
     How does operational engineering work?
Large up front investment in due diligence / strategy change using
industry expertise.
 – Some focus on consulting experience / background.
 – Some use operating executives / CEOs.

At time PE firms invest, they have a value creation plan in mind:
 – Identified cost cutting opportunities / productivity improvements.
 – Identified strategic changes / repositioning.
 – Identified organic growth opportunities.
 – Identified acquisition opportunities.
 – Generally oriented to increasing margins, increasing ROA,
    increasing operating cash flows.




                                   22                          Steven N. Kaplan
Management changes and upgrades implemented, if necessary.

Post-investment value creation teams.
 – Former consultants.
 – Former operating executives.
 – Functional teams.
 – Outside consultants.

Plan is tested / refined in first 100 days after investment.
 – Heavy GP involvement.

Systems introduced to monitor plan achievement.

Some use shared services.

The days of pure financial engineering are over.
                                    23                         Steven N. Kaplan
        How good have returns really been?

Improved operating performance does not necessarily mean that PE
funds generate out-performance net of fees.
 – It depends on what the PE funds paid to acquire the companies.
     » Premiums go to selling shareholders.
 – It depends on fees.




                                24                         Steven N. Kaplan
What have returns looked like (in U.S.)?




                    25                     Steven N. Kaplan
26   Steven N. Kaplan
27   Steven N. Kaplan
           Key unanswered questions:
What are private equity returns? Do they beat the public market?

Are there good GPs?
 – Do the same GPs do well each time?

How does performance affect
 – GP survival? future capital raising?

We attempt to answer those three questions.
– Based on paper with Antoinette Schoar of MIT.
– We use most detailed data set available:
    » Venture Economics individual fund returns.
– Appeared in Journal of Finance in August 2005.
– Subsequent work by others largely consistent.



                                28                        Steven N. Kaplan
                               Data
Data set from Venture Economics on returns to individual funds.
 – Get data from both LPs and GPs.
    » Does VE have a bias?


Reported returns each quarter of fund life.
 – From 1970s to 2000.


Cash inflows and outflows to fund.




                                   29                       Steven N. Kaplan
                   Sample Construction
Focus on funds with largely realized returns:
 – Use only funds that have been liquidated; or
 – Have minimal residual value.
 – Restricts sample to mainly funds that were raised before 1997.
 – End up with 169 buyout funds.

Similar results if use larger (but noisier) sample:
 – All funds raised before 1998 336 buyout funds.




                                 30                          Steven N. Kaplan
                 Measures of Returns
– We use three measures of returns.
    » All net of management fee and carried interest.
– IRRVE = Internal Rate of Return by VE.
– IRRCF = Our IRR calculation using cash flows.
– PME = Public Market Equivalent.
    » (Grow fund distributions at S&P 500 Total Return)t
        (Grow fund paid in capital at S&P 500 Total Return)t
    » Compares fund to investment in S&P (including dividends).
           Greater than 1 beats S&P.
    » Relatively invariant to investment sequencing.
– Results are qualitatively identical using all three measures.



                                31                         Steven N. Kaplan
                        More on PME

Compare two investments:
 – 1. Invest $10 million.
    » 3 years later it returns $20 million.
    » IRR = 26% ; Multiple of Invested Capital = 2X


– 2. Invest $10 million.
   » 3 years later it returns $10 million.
   » IRR = 0% ; Multiple = 1X


– Which investment is better?




                                  32                  Steven N. Kaplan
                      More on PME - 2
Investment 1:
 – Invest $10 million in March 1997.
 – Return $20 million in March 2000.
 – Instead, if you had invested the $10 million in the S&P 500, you
   would have had $20.7 million in March 2000.
 – PME (gross) = $20 / $20.7 = 0.97.
 – PME (net) = $18 / $20.7 = 0.87.

Investment 2:
 – Invest $10 million in March 2000.
 – Return $10 million in March 2003.
 – Instead, if you had invested the $10 million in the S&P 500, you
   would have had $5.9 million in March 2003.
 – PME = $10 / $5.9 = 1.70.
                                  33                          Steven N. Kaplan
                    Blackstone’s S-1
Blackstone from 1/2002 to 12/2006 = 26% / year.
Compares to S&P from 1/2002 to 12/2006 = 6% / year.
 – Blackstone looks fantastic.




                               34                     Steven N. Kaplan
                    Blackstone’s S-1
Blackstone from 1/2002 to 12/2006 = 26% / year.
Compares to S&P from 1/2002 to 12/2006 = 6% / year.
 – Blackstone looks fantastic.
However, does not mention S&P from 1/2003 to 12/2006 = 20% / year.
 – Blackstone looks good, but not fantastic.




                               35                        Steven N. Kaplan
        Kaplan and Schoar re Fund Returns
Weigh each fund equally => average PME = 0.97.


Weighs each fund by capital => average PME = 0.93.


Large differences in performance across distribution:
 – Average PME = 0.97 / median = 0.80.
 – Large difference between bottom and top quartiles.
    » 0.62 versus 1.12 for PME.
    » 5% to 22% for IRR.




                                36                      Steven N. Kaplan
What does this mean:


– PE did not seem to outperform S&P net of fees.


– PE does outperform gross of fees, but GPs get the outperformance
  (on average).




                               37                        Steven N. Kaplan
                Persistence in Performance:
                 Are there good GPs? Yes!

Large and significant amount of persistence in returns across funds of
the same GP.
 – Significant relation to two previous funds.
     » Fund before last fund less likely to have investments in common.
 – Positive relation between current fund and third previous fund.
     » Coefficient similar in magnitude.


Also collected all data made available by public pension funds because
of FOIA concerns.
 – Persistence results are at least as strong!



                                 38                         Steven N. Kaplan
                           Persistence:
                                               Next Fund Tercile

                                      Lower      Medium       Upper
            Panel A: PME
                       Lower              44          37           19
Previous FundTercile Medium               24          34           42
                       Upper              11          34           55

                                      Lower      Medium       Upper
            Panel B: IRR
                        Lower             49          31           20
Previous FundTercile Medium               30          38           32
                        Upper             21          31           48



                                 39                                Steven N. Kaplan
 Past Performance, Fundraising, Future Performance

Capital flows into specific GPs related to past performance.
 – Good funds raise more money.


Capital flows into industry related to recent performance.
 – Money comes in after good returns.


Subsequent performance is negatively related to the amount of money
flowing into the industry.
  – Poor returns follow money coming in.


I.e., a boom and bust cycle.
  – Come back to the implications of this later.
                                   40                          Steven N. Kaplan
     Summary of Patterns for Buyouts

Returns / multiples strong in first half of 1980s.
Fundraising chases those returns in mid- / late- 1980s.
 – Returns in 2nd half of 1980s mediocre at best.
Fundraising is lower in early 1990s.
 – Returns / multiples better early 1990s, but not great.
Fundraising higher from mid-1990s to 2000.
 – Returns mediocre.
Fundraising lower from 2001 - 2003.
 – Returns better.
Better returns attracted huge amount of capital 2005 - 2007.



                             41                          Steven N. Kaplan
        Is 2nd wave different or like the 1st?

Some more data for U.S. public to privates.




                                  42             Steven N. Kaplan
EBITDA Multiples Were Higher




 Source: Kaplan and Stromberg (2009)
                                       43   Steven N. Kaplan
But, Equity Levels Were Higher




 Source: Kaplan and Stromberg (2009)
                                       44   Steven N. Kaplan
Cash Flows Relative to Interest Rates Were Higher:
      If borrow 100% at HY rate to buy company (EV),
                 generates EBITDA - HY rate




           Source: Kaplan and Stromberg (2009)
                                                 45    Steven N. Kaplan
So, Interest Coverages Were Substantially Looser




         Source: Kaplan and Stromberg (2009)
                                               46   Steven N. Kaplan
Debt Repayment Terms Were Substantially Looser




          Source: Kaplan and Stromberg (2009)
                                                47   Steven N. Kaplan
      What does all this mean going forward?

Why is there such chaos?

What will happen next in PE?
– What will happen to returns?
– What will happen to PE firms?
    » Was the PE explosion temporary or permanent?




                              48                     Steven N. Kaplan
                    Why is there such chaos?

Look at typical financial institution balance sheet.
Roughly $23 trillion in assets at U.S. Fin’l Institutions.




      Loans 100                             Deposits               70
                                            Short-term Debt        10

                                            Long-term Debt         10

                                            Equity                 10




                                     49                       Steven N. Kaplan
                   Why is there such chaos?

Mortgage (and other?) losses are substantial at financial institutions.
Losses are meaningful relative to equity bases of levered institutions.
Restoration requires rebuilding capital base of these institutions.



     Loans 100        92?                 Deposits                  70
                                          Short-term Debt           10

                                          Long-term Debt            10

                                          Equity                    10       2?




                                   50                          Steven N. Kaplan
   Once there is concern, then bigger problems
When equity capital is low, financial institutions can:
– Sell loans.
– Raise equity.


They usually sell assets first.
 – When equity goes down, bank becomes overleveraged.
 – Selling loans (at book value) and paying down debt reduces
   leverage.




                                    51                     Steven N. Kaplan
Unfortunately:
 – Hard to sell loans at book value.
 – Selling loans and assets depresses prices of other loans and assets.
    » Which in turn reduces the equity capital of all banks.
 – Selling loans, i.e. “deleveraging,” reduces amount of bank lending.




                                   52                         Steven N. Kaplan
More unfortunately:
 – When lenders and other counterparties question solvency of a
   financial institution, they stop lending and transacting with it.
     » This is a particularly big problem if the bank / institution relies on
       short-term debt. (E.g., Lehman.)
     » So you can have a “bank run” even if the institution is solvent (or
       would be solvent) under normal conditions.


At the peak of the crisis:
 – Everyone suspicious of everyone else.
 – No short-term credit available.
     » Banks will not lend to each other short-term.
 – Lots of mini-runs.
     » Rumors of trouble lead to runs on deposits, short-term debt.
 – ==> Downward spiral.
                                     53                            Steven N. Kaplan
         Key Issue: What are loans really worth?
Could really be worth 100. (Trading at 90 because of bank run fear.)
 – I.e., fear, distressed selling.
 – If markets calm, may really be worth 100.
Could fundamentally be worth 90.
Could be worth less than 90, say 80?



Loans 100      90?     80?            Deposits          70
                                      Short-term Debt   10
                                      Long-term Debt    10 10? 0?
                                      Equity            10   0?     0?



                                 54                          Steven N. Kaplan
TARP - 1
 – Assumed that assets worth 95 to 100 in calm markets.
     » I.e., we had a liquidity problem, not a solvency problem.
 – Idea was to buy toxic assets.
     » Show investors they were worth 95 to 100.
     » Possibly overpay to put more equity in.
 – Market clearly did not believe this.
TARP - 2
 – Realized we have a solvency problem.
 – Injected equity.
 – The right thing to try.
 – It stopped the panic, but:
     » implemented poorly.
     » explained / marketed poorly.
                                  55                           Steven N. Kaplan
           Since TARP-2 (end of September)
TARP - 2 stopped the financial panic, but:
 – Real economy has worsened.
    » Consumer reduced consumption.
    » Companies responded with layoffs.
 – What is drop in asset value on $20 Trillion in loans?


Fed and Treasury have responded aggressively.
 – Cost of funds is low, so lending is profitable.
 – But loan values will continue to decline.
 – Net effect?




                                    56                     Steven N. Kaplan
Lots of buzz words:
 – Nationalize
 – Good bank/bad bank
 – Buy toxic assets
 – “Ring fence” assets
 – Insure losses
 – Equity infusions
All schemes amount to taking stand on how losses and gains due to
existing assets are allocated to government and existing creditors
 – No one great solution.
Economy is in recession and will stay there for a while.
 – Will be better off the sooner financial system is stabilized.
 – Stabilization will be expensive in terms of govt. help.


                                 57                         Steven N. Kaplan
             What will happen next in PE?

What will happen to returns?

What will happen to PE firms?

Was the PE explosion temporary or permanent?




                                58             Steven N. Kaplan
              History repeats itself:
“I look with discomfort on the dangerous tendency of LBO
partnerships, bolstered by their success, to take more of
their compensation in front-end fees rather than in back-end
profits earned through increased equity value.”




                            59                     Steven N. Kaplan
               Michael Jensen in 1989:

“I look with discomfort on the dangerous tendency of LBO
partnerships, bolstered by their success, to take more of
their compensation in front-end fees rather than in back-end
profits earned through increased equity value.”




                            60                     Steven N. Kaplan
                   History repeats itself:
“LBO's work because the people doing them command a huge advantage
over the stockholders from whom they are buying the company...


“LBO's work because the people who do LBO's know the true value of
assets of every kind in every different mode ... and the market does not...


“And to some sad extent, LBOs work because management has willfully
deceived the market about the true value of its assets.”




                                    61                           Steven N. Kaplan
                        Ben Stein in 1987:

“LBO's work because the people doing them command a huge advantage
over the stockholders from whom they are buying the company...


“LBO's work because the people who do LBO's know the true value of
assets of every kind in every different mode ... and the market does not...


“And to some sad extent, LBOs work because management has willfully
deceived the market about the true value of its assets.”




                                    62                           Steven N. Kaplan
History repeats itself:




           63             Steven N. Kaplan
The more things change, the more they stay the same
 Huge amount of attention to LBOs, just as in late 1980s.

 Complaints that LBOs not fair to public shareholders, just as in 1980s.

 Complaints of excessive greed, just as in 1980s.

 Debt markets provided unusually, if not irrationally generous terms.
  – Junk bonds in 1980s.
  – CLOs / CDOs in 2000s.




                                   64                          Steven N. Kaplan
Activity Clearly Driven by Debt Markets




 Source: Kaplan and Stromberg (2009)
                                       65   Steven N. Kaplan
Earnings yields must be high relative to interest
            rates to have PE boom.
                    S&P EBITDA / Enterprise Value less High Yield Rates
                       vs. PTP Volume as % Market from 1984 - 2006
   4.00%



   3.00%



   2.00%



   1.00%



   0.00%

           1985               1989               1993          1997   2001   2005
  -1.00%



  -2.00%



  -3.00%



  -4.00%
                                                        Year
           Source: Kaplan and Stromberg (2009)
                                                        66                          Steven N. Kaplan
Likely that public-to-private deals driven by debt market conditions
rather than operating improvements.




                                   67                          Steven N. Kaplan
            Go back to the historical record

Private equity market is cyclical.
 – IRRs (and PMEs) related to funds raised.

– IRR Vintage Year =

    » 35% - 25 x PE inflows in current and prior year as % of stock mkt.

– Not exactly an efficient markets conclusion.

Where are we in the cycle?




                                  68                          Steven N. Kaplan
Source: Private Equity Analyst, Steven N. Kaplan


                                                   69   Steven N. Kaplan
Record fundraising levels in 2006, 2007 and 2008.
 – 1.14%, 1.57%, and 1.21% of the stock market.




                                 70                 Steven N. Kaplan
Record fundraising levels in 2006, 2007 and 2008.
 – 1.14%, 1.57%, and 1.21% of the stock market.

If historical relationships are repeated, 2006, 2007, and 2008 vintages
will have negative IRRs.
      » 35% - 25 x 1.8% = -10%
      » 35% - 25 x 2.7% = -32%
      » 35% - 25 x 2.8% = -34%

Looks like that could happen!
 – Particularly for 2006 and 2007.



                                  71                           Steven N. Kaplan
Is there any good news?




           72             Steven N. Kaplan
                 Is there any good news?
Capital structures safer than in late 1980s.
 – Higher coverage ratios give greater cushion.
 – Lower debt repayment requirements give greater cushion.
 – To the extent there are defaults, restructurings likely to be efficient.
     » Defaults from late 1980s deals were not that costly.
     » Distressed debt restructuring money available today.
 – Caveat:
     » Downturn this time may be worse.
     » Does not mean that returns will ultimately be good.
            PE firms paid high prices with high equity in 2006 and 2007.




                                    73                           Steven N. Kaplan
                 Is there any good news?

The “persistent” buyout firms have raised the greatest share of capital.
 – Megafunds like Bain Capital, Blackstone, Carlyle, KKR, TPG
   dominate fundraising.
 – Smaller funds copying larger ones.
 – Apply financial, governance and operational engineering.
 – These firms have beefed up capabilities to add value.


Persistent buyout firms are global.
 – Fundraising comparisons with past are misleading because more of
   money is invested outside U.S. (and Europe).




                                   74                          Steven N. Kaplan
                Is there any good news?
PE firm capital matches PE firm assets.
 – Long-term capital making long-term investments in companies.
 – Contrast with hedge funds and investment banks.
PE firm returns need to beat S&P (not absolute return).
 – S&P down 40% +.
 – 2006 and 2007 vintages look good if down only 20% or 30%.
 – Contrast with hedge funds.




                                75                        Steven N. Kaplan
                 Is there any good news?
CEOs / execs of public companies more receptive to PE than in past.
 – More pay.
 – Less grief from regulation, litigation, media, activist shareholders.
 – PE investors are partners not raiders.
 – Likely to accelerate if attacks by shareholder activists and new
   administration on governance and CEO pay continue.




                                  76                           Steven N. Kaplan
                Is there any good news?

At some point, debt markets will come back.
 – Probably will look like 2004 and 2005, not 2006 and 2007.
 – Depends on economy / financial markets.
     » Need to stabilize financial system.
     » PE volume remained less than 0.50% of stock market for at least
       six years after end of 1st wave.
 – Larger deals, public-to-privates most affected by cyclicality.
 – Middle market less affected.




                                 77                         Steven N. Kaplan
                Is there any good news?

PE investments in 2009 and 2010 likely to turn out well.
 – Similar to early 90s and early 00s when returns were strong.
 – And PE firms will have capital.
     » Previous large PE fundraising years coincided with boom years.
 – Government might help(?).




                                 78                         Steven N. Kaplan
One more regression:
 – Capital Committed to PE (as % of stock market value) versus
   previous years’ returns to PE.
    » Negative relation.
    » I.e., capital commitments decline when PE returns are poor.
           Boom and bust.
So expect commitments to decline in 2009, 2010, 2011.
 – Stock market down 40%, implies commitments down 40%.
 – Negative relation to returns implies further decline.
However:
 – There has been a positive trend of 3% per year since 1984.
    » Suggests secular trend of increase in PE.
 – Decline in commitments sow seeds for increases in returns.


                                 79                         Steven N. Kaplan
                        Bottom Line:

PE industry will undoubtedly and necessarily contract.
PE industry will do well relative to:
 – hedge funds.
 – investment banks / commercial banks.




                                  80                     Steven N. Kaplan
                          Summary
How does 2nd LBO wave compare to the 1st?
 – Record amounts, absolute and relative to market.

What do PE transactions / LBOs really do?
– Empricial evidence is favorable.
    » LBOs lead to operating improvements, more cash flow.
    » LBOs have mixed effects on employees.
    » Pretty strong evidence that they are good for the economy.
    » Exception possibly public-to-privates.

Why do PE transactions do what they do?
– Combination of financial, governance, and, now, operational
  engineering.



                                 81                         Steven N. Kaplan
How good have returns really been?
 – Historically,
     » returns gross of fees above S&P 500, but
     » returns net of fees about equal to S&P 500.
 – While PE firms add value to portfolio companies, PE firms charge
   fees and pay premiums to buy companies.
 – But, good firms persist (if they do not get too big).

Is the 2nd wave different or like the 1st?
 – Alike in many ways, different in some.




                                  82                        Steven N. Kaplan
What will happen next? Is the PE explosion temporary or permanent?

– Negative:
   » Near-term, economy / financial system depends on bank solvency.
         Likely to get worse. Probably not at bottom yet.
   » Returns to 2005 to 2007 vintages will be negative.
   » LP commitments will necessarily decline.
   » PE industry will contract.




                                 83                         Steven N. Kaplan
– Positive:
   » Deals structures of 2005 to 2007 less fragile than in first wave.
   » PE funds have expanded capabilities that are real.
   » PE investors are more attractive to CEOs, top executives, and
     boards than in the past.
   » PE firm capital matches PE firm assets.
   » PE firm returns need to beat S&P (not absolute return).
          S&P down 40% +.
          Contrast with (not really) absolute return hedge funds.
   » PE investments in 2009 and 2010 likely to be very attractive.
          Similar environment to early 90s, early 00s.
          And PE firms will have capital.
          Boom and bust cycle will repeat.


                                 84                           Steven N. Kaplan
5 years from now, PE will be in better position relative to other asset
classes, other occupations.




                                   85                           Steven N. Kaplan
                    Steven N. Kaplan
Neubauer Family Professor of Entrepreneurship and Finance
                 skaplan@uchicago.edu




                            86                        Steven N. Kaplan

								
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