Michael Lewis has a dark article today ("Coach Class of Capitalism") about how the growth of private equity is affecting the structure of the investment world. There are two kinds of investors today, he says - regular people, who get mutual funds that have average return prospects, and the very rich, who get private equity with outstanding return prospects. His commentary comes as private equity funds continue to set records for both fund size and deal size.
Social investors shouldn't be thrilled with the rise of private equity, simply because these investments move the corporate world toward less disclosure and less transparency. Social research depends heavily on required corporate disclosures, such as 10-K and 10-Q reports - these go away when companies go private. Shareholder activism depends on the shareholder resolution process in place at public companies - there is no comparable forum for engagement with private firms.
From the private equity investor's perspective, that's all good. One of the key benefits of doing an LBO is strategic flexibility. In theory, at least, management can escape the constraints of public ownership and simply do what needs to be done to maximize the value of the business. (In practice the short-term accountability often just transfers from stock investors to bond investors, as the company piles on leverage to finance the deal.)
Lewis sees all of this as just another way for the rich to circumvent rules, but I think it's a little more complex than that. This surge in private equity would not be possible without attractively-priced stocks. There can't be a big LBO industry unless a lot of stocks are too cheap.
So who is selling? Well, mutual funds managers and institutions, mostly. The typical private equity deal takes years to work out - the returns will be there, on average, but you have to live with illiquidity and 'dead money' for awhile. By contrast, the typical money manager is measured quarterly and operates on a horizon of perhaps a year (as discussed here many times).
In a world where 5-star funds attract most of the investment flows, few mutual fund managers feel they can afford the luxury of long-term investments. So they sell 'dead money' investments to private equity investors, who resuscitate them and, after a decent interval, sell them back.
This seems to be another manifestation of the disease described by Hawley and Williams in The Rise of Fiduciary Capitalism. Individual investors have hired intermediaries (mutual fund managers and pension funds) to manage their wealth, and the evaluation/compensation cycle for these intermediaries turns out to be far shorter than that of the investors themselves. All this would imply that speculators could arbitrage time horizons, buying long-term investments at good prices. And that seems to be exactly what's happening.
Certainly a long-term orientation is no guarantee of success. It is a kind of a curse among my hedge fund friends - for them an investment is a trade that didn't work out. At dinner the other night one denounced a stock idea I presented on the grounds that "it hasn't worked all year."
And bad investors learn quickly to point to the long term. If you're a bad investor you want to be sure to convince your client of the merits of a long-term outlook because the sooner she evaluates you, the sooner you'll be fired.
Still, if you look at who's been successful in markets over the decades, my impression is that the long-term types have gotten a disproportionate share of the spoils:
- David Swensen at Yale posted a terrific track record over the past decade, partly by collecting liquidity premiums on 'alternative' investments such as timber and private equity.
- Warren Buffett has become the world's 2nd-richest man while maintaining a core equity strategy that has extremely low turnover. In his 1987 Chairman's Letter, he wrote: "Of Wall Street maxims the most foolish may be "You can't go broke taking a profit... We are quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business." Buffett is widely-read and many people say this, but it is completely incompatible with the kind of trading most managers actually do.
- The Dodge & Cox Stock Fund has managed to build a 5-star track record with 11% annual turnover.
- Even index funds based on the S&P 500 have performed quite well, despite portfolio turnover of less than 10% per year. Historically, the majority of mutual fund managers have not been able to keep up with this index, despite all their trading.
So the fault is not in our stars, but ourselves. When yours or my mutual fund gets behind, we tend to go hunting for one that's working better. The fund managers know they need good numbers to raise money, so they do something - anything - to get back on track quickly. Since about half of them are screwing up at any given time, there's a crowd at the exit and a lot of competition for hot new ideas. The net result is too much trading, too much renting of stocks, and not enough ownership.
I'm not thrilled about the rise private equity, but I think it's a symptom of a much deeper illness. If we were doing a better job of being owners, there'd be no need for private equity to step in and do the job for us.
By the way, friends tell me Lewis's latest book, The Blind Side, is an excellent read.