Monday, March 2, 2015

Private Equity and Buffett Envy

Remarks from the  2015 Super Returns Conference have implications concerning the future of PE. The industry is suffering from mediocre returns and LP dissatisfaction. PE firms are struggling with ways to react. Some are becoming asset managers, others investment banks and others smaller and more focused. This is important because record fund raising has pushed up the amount of dry powder (committed but un-invested) capital to over $1.2T. The investment fire power of that amount combined with a normal leverage multiple is huge. The money will be spent. The question is how wisely and what future returns can be expected as PPX are now 12X.

Blackstone hinted it is considering following Buffett’s Berkshire Hathaway by making long term investments in large public firms to take them private. An example is Buffett’s partnership with Brazil’s 3G to acquire H.J.Heiniz. Essentially, they seek permanent capital not subject to traditional investment and liquidation periods. Such investment in partnership with sovereign wealth funds would seek lower returns in the mid teens (usual PE targets are 20 %+) over a longer term horizon of 15+ years (compared to 10 years for PE). Is it realistic to expect PE success in copying Buffett? Is his success repeatable by others especially if many try to copy it at the same time?

Let’s first explore the source of Buffett’s alpha. My understanding of his Approach is as follows:

1)     Focus on investing in wonderful firms at a fair price. Wonderful is usually represented by consistent superior EBIT/Total Assets returns. Also, he focuses on low volatility assets (low beta).  Fair price means low EBIT/Equity Value. Academics call this a value or Bet Against Bet strategy.

2)     The above returns are modest and need to supplement thru cheap leverage. Here is Buffett’s secrete sauce-the cheap funding from Berkshire’s insurance float. Academics studies confirm the better route to higher returns is leveraged portfolio of low risk assets instead of high risk assets (like VC?). You are essentially monetizing risk reduction thru leverage.

Point #1 above is not always possible-especially in fully priced bull markets like now. Buffett has the discipline given his majority ownership to sit on his hands and do nothing in these markets and wait for his pitch before swinging. Not everyone has this advantage.

My concern with PE firms trying a naive copycat strategy is they will miss the nuances involved in implementing a contrarian leveraged high quality value strategy. Consider:

1)     Do PE firms have the discipline to sit out long periods of high bull markets with limited opportunities to invest at fair prices?

2)     Buffett does not charge fees or skim a co investment percentage of gains. Will PE change their business models to accommodate this difference?

3)     Can they resist the temptation to invest in high risk firms (e.g. First Data)?

4)     Can they supplement their returns with stable cheap leverage?

My take is the Buffett wanabes are unlikely to succeed. The basic problem remains of too much money chasing too few good opportunities in a bull market. In the meantime expect more “I am like Warren” fund raising strategies to be used. Nonetheless, investors collectively must hold the market. Thus, it is hard to be consistently difficult.


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