The big idea and why it matters: It’s easy to speak in general terms to rile people up and get clicks, but a deep dive into the processes and holdings of the highest-quality Private Equity and Private Credit managers would yield far less frightening conclusions. The patient nature of private investing can help managers navigate challenges that inevitably arise – whether on the debt or equity side.
“In private equity, patience is a virtue, as well as a competitive advantage.” —Barry Sternlicht (CEO of Starwood Capital Group).
My wife, Katie, and I recently attended an intimate omakase dinner and (separately) a music festival with family and friends at the Jersey Shore. I know there were wide-ranging perspectives (i.e., political, religious, etc.) among the attendees in both situations, but the focus on great food and music allowed differences to be set aside for wonderful shared experiences. Amidst the finger-pointing that seems to dominate much of media (and social media) coverage these days, these events served as good reminders that we humans value many of the same things, and that we can collectively enjoy life more by seeking points of common ground, rather than the opposite.
With this in mind, whether you love, hate, or are indifferent to private equity (PE), today we will explore some objective PE characteristics upon which we can (hopefully) agree for practical takeaways. To Mr. Sternlicht’s point, in contrast to public-market investing, the patience of private capital and private investment structures is one such attribute. Here we go!
PErspective
My podcast app recently auto-played a popular podcast featuring non-financial professionals trying to wrap their minds around private equity. They opened the conversation by citing the unfairness and destructiveness of private equity. So, where do you think it went from there? Hint: not into a fair and balanced PE analysis. Thus, if when I say “private equity,” your immediate reaction is how PE is a tyrannical money-grab, where the uber-rich and their investors get even richer by saddling victim-companies with irresponsible levels of debt and destroying jobs before running them into the ground, you’re probably not alone. But bear with me while we try to set aside biases and gain a more balanced perspective.
Big Apple, bad apples
Let’s be very open that there are troubling stories of how private equity has destroyed value, just like there are shootings in The Big Apple every day, perpetrated by some bad apples among the greater bunch of good people. While those are often the incidents that make the news, it doesn’t mean they are the common experience. The day-to-day life of most New Yorkers is far better than the more dire narrative I hear from those who don’t live and work here (including my mother 😊). I’m sure the same goes for San Francisco, Chicago, and – yes – even private equity.
We regularly use private equity on behalf of clients, but it remains an asset class with many risks to consider. And like the Enrons of public markets, you can have both bad business decisions and bad actors in private markets, so risk management must be front-and-center in the investment process.
Pumpkin pie
In the spirit of the simplest explanation being most likely, if private equity doesn’t consistently add value to the multiple parties involved in their transactions – e.g., sellers, lenders, buyers, and investors – then how would it have remained such a prominent (and, yes, lucrative) business now going on 80 years in its modern form? At its core, private equity is nothing more than people engaging in transactions that should make sense for all involved – aka free-market transactions – which are at the very core of what it means to do business. And that is as American as… (you could say “apple pie,” but I prefer pumpkin).
[Note that what we’ll cover here cannot be as robust as what David Bahnsen has already done in podcast format at the Capital Record, here (diffusing an entire book on the horrors of PE), here (conversation with a former Apollo exec), or here (in live debate format). I’d encourage you to check those out as additional resources if this topic is of interest to you.]
Scarecrows
There is plenty of negative press about the private investment space. While this example is more specific to private credit (h/t to Nick Murray for the link), I’d say it’s of better quality than your run-of-the-mill headline, as it a) comes from investment professionals, and b) points out some real risks bubbling under the surface:
“Inflows into the asset class meant too much capital was committed far too quickly,” JPMorgan analysts, including Stephen Dulake, wrote in a report this month. “Underwriting corners were surely cut, and losses will be outsized come the downturn.”
As mentioned in Part 4, the ability of private lenders to work with borrowers through difficult times can be a positive driver of mutually beneficial outcomes that might otherwise have led to default (bankruptcy). But as the article points out, too much patience and payment-in-kind (PIK) structures – which accrue interest rather than requiring a borrower to make payments to stay current – could introduce additional risks. For our current discussion, there are two things I’d encourage you to consider:
- Private Equity sponsors are involved on the borrowing side of many of these transactions (PE sponsor transactions), as they often utilize private credit to buy and fund businesses. If the article’s concerns focus on private credit loans going bad, then it implies much worse outcomes for the equity side of the equation. Thus, whether private credit is acting as the canary in the coalmine remains to be seen.
- None of this can be discussed meaningfully in general terms. Let’s assume that some (bad apple) managers cut corners in their underwriting process and loan deployments. The best managers – focused on risk management and the long game – could remain fully insulated from those issues. We have to view investments on a company-by-company, manager-by-manager, loan-by-loan basis. In the event a loan does go into default, the best underwriting processes could still ensure full recovery for investors, and potentially even better outcomes for debt holders through seizure of company assets. Without getting deep into the details of a given loan book with the team that manages it, articles like this may amount to a scarecrow, with limited risks behind the façade.
Fall down. Get back up.
With all of these points, there is a lot of nuance. It’s easy to speak in general terms to rile people up and get clicks, but the truth is likely far more boring. A deep dive into the underwriting processes (and underlying businesses owned/lent to) of the highest-quality Private Equity and Private Credit managers would yield far less frightening conclusions. The patient nature of private investing can help managers work through challenges that inevitably arise – whether that’s on the debt or equity side. In life and investing, the ability to get back up and keep going is often the key to success.
Stay tuned as we wrap up this series with more coverage on private equity, along with some parting thoughts.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
