Friday, September 08, 2006

A Delicious Irony- Lots of Dollars, Little Sense

In checking out this month's bonus edition of Value Investing Insight, a very worthwhile publication that I have recommended before, I noticed a terrific article that I had missed by Steven Pearlstein at the Washington Post.

He points out the delicious irony of large pension funds and endowments chasing down private equity players who of course command huge fees.

As he indicates, the lemming like movement into private equity believes: " it no longer makes sense for them to look for undervalued public companies, or promising new companies looking to go public. Instead, they prefer to put their money into private equity funds, which charge outrageous fees to look for undervalued public companies, or promising new companies looking to go public, and buy them up at a price 20 percent higher than the current stock-market price."

In order to finance these companies," private equity managers have their newly acquired company issue lots of junk bonds, at high interest rates. These bonds are then bought by hedge funds, which also charge outrageous fees and also raise most of their money from pension funds, university endowments and wealthy individuals."

Ultimately, " And to top things off, the new owners invariably offer fat new pay packages to the managers of the company they've just acquired -- in most cases, the same managers who were running the company when it was public. The idea is to give them even greater incentive to maximize the value of the company, so it can be taken public again."

Now let's think about this dog chasing its own tail behavior. Invariably, institutional investors love to have performance that resembles the benchmark index when considering their "normal" common stock portfolios. Highly concentrated positions are to be avoided at all costs in their mandates. The altar of diversification celebrates the sacrament of me-tooism that most pension funds feature. Charging active fees to provide near-index diversification ensures that performance will rarely provide cause for aggregate, as John Bogle points out, it becomes a prescription to underperform the market...we ARE the market when considering all managers in aggregate.

The self-imposed rules of diversification are suspended when you get to the private equity arena. Massive single bets on a single business with a leveraged balance sheet. Give the existing management a promote in terms of additional stock ownership, blather something about his skin in the game, and watch what happens.

Give it a couple of years, IPO it out to the sacrificial lambs...retail and other institutional types and sell off the risk. Ben Stein, commented on the enormous conflict of interest that exists in management buyouts in last Sunday's New York Times. (free subscription required) As he argues, basic fiduciary law requires that managers are required to put the owners' interest (that's we the shareholders) ahead of their own...if they aren't running the business to its maximum profitability, they are breaching their responsibility.Yet, internally, when a buyout is considered, substantially improved economics develop magically.Fairness opinions are contrived according to the whims and desires of the buyer, and minority shareholders get shafted at too low a price.

Yet, all of this behavior is encouraged by plan sponsors who hire buyout firms. Concentrated positions remain verboten to most money managers and mediocrity is encouraged by the plan sponsor rules. Weak results result in driving more and more allocation dollars into private equity funds. As Pearlstein indicates," A weak stock market drives money into private equity funds, draining even more money from the stock market and lowering returns even further. In time, one would expect this process to correct itself as private equity funds are unable to sell their companies into public markets and returns decline. In fact, the latest numbers indicate that this process is already well underway, with only a handful of the best private equity funds now generating above-market returns."

Concentrated positions rather than diversified positions will invariably provide better returns when you know what it is you own. You do assume additional risk, after all diversification is a protection against ignorance, but properly chosen, the reward more than compensates.

There is no magic in private equity buyout firms. Bidding up a stock at a takeout premium and leveraging up a bad business that you intend to take public at some later point depends on a succession of fools...doesn't this seem like a repeat of paying for eyeballs in 1999 and 2000?

Superior results can come from public equities but only if managers are allowed to manage to a disciplined style. Allow and encourage concentration in portfolios. Have an investment horizon that extends beyond settlement date! Trust a methodology that adheres to a discipline.

The worst thing that will happen to you is some private equity fund may take you out at a premium to start the whole Ponzi scheme he or she envisions. The best thing, you will continue to own a business that you understand and that will grow into considerable wealth.

Many years ago, I had complimented my mentor, a senior partner about a takeover a stock in our fund had experienced. "Oh sh#t " he exclaimed, "it means I have to come up with another idea."


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