Monday, May 25, 2015

Corporate CFOs Are From Venus and Private Equity GPs Are From Mars Part II

General Partners (GPs) in private equity (PE) firms behave differently than corporate chief financial officers (CFOs) concerning investment and capital structure decisions. CFOs tend to follow more textbook approaches; GPs, however, deviate from the textbook in several respects. This has gone largely unnoticed by academics until recently.
I have noted before how PE capital structure decisions differ from corporations. An interesting paper expands on the differences as follows:

1)     Corporations follow the textbook ratings based static trade-off approach when making capital decisions.
2)     PE firms do not follow the textbook. Rather, they use as much debt as they can get given existing market conditions. Thus, they use more debt in bull markets when debt is both easily available and inexpensive. This is consistent with my experiences when dealing with PE. As one GP stated it-“where I come from more debt and less equity is always better!”
3)     Higher debt levels allow PE to bid higher for investments. This in turn depresses returns on late cycle acquisitions leading to booms and busts.

PE also acts differently from corporations when making investment decisions.

1)     CFOs tend to follow the textbook or best practices valuation approaches. This means they use discounted cash flow based net present value models to evaluate investment opportunities. Furthermore, they use risk adjusted discount rates utilizing CAPM methodology.
2)     A survey of PE GPs reveals GPs do not follow textbook prescriptions regarding investments. First, they do not use net present value discounted cash flow methods. Instead they use MOIC (money over invested capital) multiples, which ignore the time value of money. Second they do not use risk adjusted hurdle rates or CAPM. Rather, they use flat 20-25% hurdle rates.
3)     This makes sense-why use complicated methods to evaluate projects when the driving force is debt based affordability based on market conditions? It is also consistent with my private equity experience. The investment committee never paid much attention to DCF or risk adjusted capital measures. All that mattered was the expected MOIC.

The obvious question is why does PE ignore the textbook and engage in primitive and value destroying methods compared to corporate CFOs? For me it comes down to incentives-people do what they are paid to do and not what they are told to do. The incentive arrangements in PE partnership agreements include:

1)     Limited investment period of 5 years. Either GPs use the LP’s commitments within that period or they expire and the fees and profits to GPs expire with them.
2)     The carried interest is an option. Option values increase as risk increases. Hence GP become risk seeking thru higher risk investments or increased leverage.
Thus, there are real agency conflicts from the misalignment of GP and LP interests. The next obvious question then becomes why do LPs put up with this? Consider there are similar agency conflicts between LP’s and their beneficiaries. The LP’s and their consultants are evaluated (i.e. compensated) based on nominal not risk adjusted returns. Furthermore, most LPs cannot lever their investments. Investing in PE allows them to gain implicit leverage which they are willing to pay for by accepting the agency costs.

In any event institutional factors can drive financial behavior as is apparent with GPs.


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