Sleepless Nights for Leveraged Buyout Firms and Private Equity Investors
Saudi Arabia Postscript

by the Curmudgeon

Buyout Boom to Go Bust?

“The world is changing, and many of us are too old to see it. 'Paranoia’ is the word at the top of the whiteboards in our office,” said Thomas von Koch, managing partner of Swedish buyout firm EQT at a conference last month. He noted that small online rivals were providing stiff competition for established businesses backed by private equity. For example, one of EQT's holdings - Scandic (a Nordic hotel chain) - has been threatened by Booking.com. EQT had started hiring entrepreneurs to help its companies deal with this kind of market disruption.

Indeed, the LBO/ leveraged buyout model (under which one or more private equity group(s) use debt to buy and remodel a company, then slash jobs and cut costs to raise cash to pay off the debt and then sell the company), is showing signs of being disrupted. LBOs have traditionally relied on falling borrowing rates and a cheap purchase price for the equity to enhance profits. With many European sovereign bonds at negative or marginally positive yields, intermediate and long term interest rates are starting to rise. As a result, debt will surely become more expensive to pay back for companies under private equity ownership.

“If you are investing in Europe today and you are growth-oriented, you’d better get comfortable with disruption . . . or you are unlikely to get the growth,” Joe Schull, Director of Europe LBO activity at Warburg Pincus, told the Financial Times. “We all [as private equity investors] look and sound more or less the same to managers. When you work with entrepreneurs, managers look at you differently across the table,” Schull added.

Prices paid by buyout firms for private companies are back to 2007 highs, while buyout volumes have begun the year at their weakest level since the first quarter of 2009. Meanwhile, expenses continue to creep higher for private equity investors.

Management typically charges investors 1 to 2 percent of assets and about 20 percent of portfolio gains. However, many charges are hidden from view, including transaction fees, legal costs, taxes, monitoring or oversight fees, and other expenses charged to the portfolio companies held in a fund.

Finally, few industries are more secretive than private equity. To outsiders, the lucrative business of borrowing money, buying companies and hoping to sell them later at a profit is a sure thing/slam dunk. It's not.

The rates of return and hidden costs are difficult to identify, even for investors in the funds or individual deals. A recent report by CEM Benchmarking, a Toronto-based consulting firm specializing in pension fund performance analysis, estimated that more than half of private equity costs charged to U.S. pension funds were not being disclosed. Those undisclosed charges are a meaningful drag on returns.

The CEM report also notes that even those cost disclosures provided by many private equity funds are understated. After investors objected to the excessive fees associated with private equity, most firms began to offset some costs, returning a portion of them to fund holders. But such rebates only give the illusion of a fee reduction, CEM said, because those fees are also being charged to the portfolio companies in the fund, reducing the ultimate value to investors.

“There is not a broad consensus within the industry on what is a cost,” said Mike Heale, a principal at CEM Benchmarking. “Clearly we think there should be disclosure and standardized reporting on everything that the investor doesn’t get to keep.”

Beware of Private Equity Investments:

An academic paper “Beware of Venturing into Private Equity,” by Ludovic Phalippou, a professor at the Said School of Business at Oxford, found that the average private equity buyout fund charged more than 8 percent in fees each year.

"The average (private equity) fund charges the equivalent of 8 percent fees per year despite a return below that of the Standard and Poor's 500."

Private equity firms had been able to obscure their costs partly because of fuzzy accounting rules. The Governmental Accounting Standards Board states that investment-related costs should be reported as expenses if they are “separable from investment income and the administrative expense of the pension plan.” This, along with the practice of not detailing specific costs for such things as transaction expenses and monitoring fees, essentially lets funds decide which fees are separable, leaving most investors unaware.

Listed Private Equity (LPEq) lists the DISADVANTAGES OF PRIVATE EQUITY here.

Disclosure: Curmudgeon has lost almost his entire investments in two private equity funds. One of them was a multi-strategy hedge fund that converted to a private equity fund without consent of limited partners. The other was a PIPE (private investment in public equity) hedge fund that suspended redemptions in September 2008 as there was no longer liquidity for any of the portfolio companies which effectively became private companies.

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Saudi Arabia Postscript:

We received several valid complaints that last Sunday's Curmudgeon post: Iran Deal Revisited by Saudi and Gulf States – Possible Oil Shock?

We didn't note that Saudi Arabia (in addition to Iran) sponsors terrorist groups, mainly through "charities" that funnel funds to many Islamic terrorist entities. We do that now:

"Saudi Arabia is said to be the world's largest source of funds and promoter of Salafist jihadism, which forms the ideological basis of terrorist groups such as al-Qaeda, Taliban, ISIS and others. Donors in Saudi Arabia constitute the most significant source of funding to Sunni terrorist groups worldwide, according to Hillary Clinton.

According to a secret cable, Lashkar-e-Tayyiba Pakistani terrorists raised funds in Saudi Arabia "Saudi Arabia remains a critical financial support base for al-Qaida, the Taliban, LeT and other terrorist groups."

In a December 2009 leaked US embassy cable, then Secretary of State Hillary Clinton said Saudi Arabia is a critical source of terrorist funding.

"...more needs to be done since Saudi Arabia remains a critical financial support base for al-Qa'ida, the Taliban, LeT, and other terrorist groups, including Hamas, which probably raise millions of dollars annually from Saudi sources, often during Hajj and Ramadan. In contrast to its increasingly aggressive efforts to disrupt al-Qa'ida's access to funding from Saudi sources, Riyadh has taken only limited action to disrupt fundraising for the UN 1267-listed Taliban and LeT-groups that are also aligned with al-Qa'ida and focused on undermining stability in Afghanistan and Pakistan."

Victor responds to reader comment on Saudi vs Iran risk for U.S. and the dollar:

Thank you for your comments. Yes, it's true that Saudi Arabia sponsors terrorist organizations. But that's also the case for Qatar, Abu Dhabi, Dubai, UAE, and Bahrain.

While I'm not defending any of them in any way, they do it for "Protection." You'll notice that "terror acts" don't occur in those countries, because they PAY terrorists and radical Islamists.

The difference between Saudi/other Arab states and Iran which I was trying to convey (and emphasize) was that none of the former are doing any of the following: attempting to develop a Nuclear Bomb, threatening "Death to America," or chanting "No Cure for Barbaric Israel, but ANNIHILATION." Iran is doing all three!

Moreover, the key to our relationship with Saudi is the "petrodollar" and the supply of oil as the U.S. needs it in exchange for primary protection. This is an economic, pragmatic relationship. The Saudi's are as you state, but (unlike Iran) they are not a direct risk to the U.S.

Years ago, before I knew the deal between Saudi Arabia and the U.S. to price oil in dollars, I suggested that Saudi would be far better off to price oil as a basket of currencies, plus gold and silver. But then they would be open to attack from many bigger enemies.

So although you are correct on Saudi being a state sponsor of terrorist groups, it is different from the point I was trying to make of the risks the U.S. and the dollar face from a nuclear armed Iran.

Sincerely,

Victor Sperandeo, CTA

The Curmudgeon
ajwdct@sbumail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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