‘Efficiency at all costs’
Perhaps the most aggressive proponents of efficiency in the corporate world are private equity funds. When they acquire a company, their model boosts near-term free cash flows by aggressively cutting costs and capital expenditures (‘operational efficiency’) and leverages return on investment by using the target company’s own balance sheet to help fund the deal (‘capital efficiency’). While this model has successfully transformed some businesses, applying it on a much broader scale and more aggressively carries significant risk. In 2018, about 65% of buyouts in the US were leveraged at 6 times earnings before interest, tax, depreciation and amortisation (EBITDA) or greater, and about 40% at 7 times or greater (according to data from LPC). The non-recourse nature of a private equity fund shields the manager from most losses if an investee company goes bankrupt. This is a huge incentive to gear underlying companies to the limit to boost potential returns and carried interest.
A mismatch of stakeholder time frames
The private equity time horizon is short, with the median buyout fund investment sold after four years. Most private equity buyouts co-opt senior executives as fellow shareholders and align their incentives and timeframe with the fund. Dressing up the numbers for sale means that costs or investments that will not generate a quick payback are unlikely to be sustained, even if essential for the long-term health of the business. Other important stakeholders of a business – customers, suppliers, employees and the local and broader community – tend to have much longer time frames and are put at risk when the controlling shareholder is intent on short-term monetisation.
While still small in South Africa, the growth in private equity funds internationally means that more than 8 000 US companies are now controlled by private equity firms. This is a very significant slice of the US economy (and for context compares to some 4 000 listed companies).
Why the rapid growth in private equity funds?
Globally, institutional benefit funds and sovereign wealth funds are allocating an increasing proportion of their assets to private markets. They are attracted by two things. Firstly, private equity funds have reported high average historic returns (albeit with a very wide dispersion) when compared to listed equity market indices. Their ability to utilise leverage means returns have been enhanced in the low interest rate environment. In addition, institutions tend to use price volatility as a proxy for risk, and private funds are normally marked only monthly or quarterly using assumptions that typically generate only muted changes in value. They therefore display much lower volatility than comparable listed investments.
Higher returns at lower risk, what’s not to like?
The most important factor in determining future returns in equity investment is the entry multiple. The median valuation multiple for global private equity deals in 2018 was 11.1 times EBITDA, up from a low of 6.4 times in 2009. Whether future returns will bear any resemblance to historic returns given these high entry valuations is questionable. More importantly, that an investment in a concentrated portfolio of highly-geared, illiquid small and mid-cap companies can be regarded as lower risk exposes the inherent weakness of the volatility-based methodology used by most asset consultants and institutions.
Of even greater concern is the unintended consequences of the private equity model growing to become a significant slice of the economy. A handful of companies gearing up, slashing costs and forgoing investment to juice their reported numbers is one thing, but corporate America now faces significant risk that the high proportion of private equity-owned companies can magnify normal economic fluctuations into serious credit events.
The difficult balance between efficiency and redundancy
The engineering concept of redundancy, or surplus capability, is a useful way of thinking about efficiency. A bridge should be built to withstand forces many times stronger than those exerted by the heaviest vehicles on the road. A ‘super-efficient’ bridge (i.e. just strong enough) may save money in the short term but would clearly be imprudent for all involved.
A business also needs to balance optimising costs and resources for prevailing conditions (‘efficiency’) with the resilience and flexibility provided by having surplus skills, assets and capability (‘redundancy’). Any significant change in the operating environment, whether cyclical (such as a recession) or secular (such as new disruptive competition), could be a very severe challenge for a business that has pursued efficiency at all costs.
The US retail sector provides a preview of what is to come
Despite the longest economic recovery in recent times, the growth in online sales and resultant new sources of competition have severely disrupted many store-based retailers in the US. It has become essential for store-based retailers not only to migrate to being omni-channel with an integrated online offering, but also to reinvest in their stores and merchandise to keep attracting footfall.
The evidence shows private equity-owned retailers have been unable to adjust to the new environment. The private equity playbook for a retailer (gear up, sell properties and lease them back, and slash costs) clearly raises vulnerability. Sure enough, of the 14 largest retail bankruptcies since 2012, 10 were private equity owned. A common theme is high debt service costs overwhelming attempts to restructure. For example, Toys “R” Us was purchased in a $6.6 billion buyout by Bain Capital, KKR and Vornado Realty Trust in 2005. While it had $11.5 billion of revenue in 2017, its heavy debt burden (over $5 billion) and inability to invest money to compete with retailers like Amazon prompted the owners to put it into bankruptcy. 800 US stores were closed and 33 000 employees laid off. (It should be noted that Toys “R” Us continues as a successful retail brand in other parts of the world.)
The US corporate sector has considerable risk
A broader stress to the US economy, delivered, for example, by the next recession, will impact private equity-owned companies across all sectors. It is likely that many more firms will be unable to weather even a relatively mild economic downturn, and the second-level impacts, especially on credit markets, will be considerable. We should also note that debt levels have risen across the whole corporate sector, with this debt primarily being used to repurchase shares or make acquisitions, rather than to expand productive capacity. Finally, it should be noted that the US corporate sector still needs to be tested after a 10-year period of consistent growth and easily available liquidity. This stands in sharp contrast to the South African corporate sector, most of which has displayed resilient cash flows through the very tough recent operating environment, acting as a warning to investors that the grass may not always be greener offshore.
Kevin Cousins is the Head of Research at PSG Asset Management.
This article originally appeared in the Business Day on 4 November.