Going Private readers will, no doubt, be familiar with product and firm life cycles, characterized primarily by the "Introduction, growth, maturity and decline," patterns of expansion and contraction. It will come as no surprise, then, that these life cycles apply equally to financial services firms, financial services products and capital structure driven acquisitions (LBOs). The forces in the case of private equity are slightly different (credit availability and the existence of viable target firms and by extension of these two, available returns to LBO actors) but the cycle is equally valid. I tend to think that there is a first derivative order to the cycle for private equity as well (as debt financing never really goes totally out of style as a product) and we should, therefore, not be surprised by the regular ebb and flow of private equity.
Perhaps we should be slightly surprised by the immense growth in the field in the last 24 months, but then again, perhaps not given the perfect storm of SarOx, low interest rates and multiple targets. (At this point a quick pointer to the yummy Abnormal Returns' "Five C's" article and its follow-up seems in order).
Of course, it was fashionable to predict the imminent death of private equity as we know it far before I even began to pen Going Private, and the calls have continued unabated since. (As a side note, this month is Going Private's one year anniversary). After one of these back in August I postulated aloud that:
Mega-funds are the conglomerates of 2007. Big, unwieldy, potentially unable to attend to their many daughters properly. But most of them will live on. Weathering a storm, perhaps, getting a belt tightening, but enduring.
The Economist, it seems, has quickly come over to my way of thinking as they penned this back in December:
Are private-equity firms the new conglomerates? The two look more and more alike. The dozen or so top private-equity firms have taken positions in an extraordinarily diverse range of operating companies, much as big conglomerates have done. Each week brings another batch of multi-billion-dollar deals.
But, even as these cycles work their cyclical magic on the economy, we have other forces joining in the fray. Are poor performance issues marked by governance, inefficient capital structure and sub-optimal strategic initiatives best addressed by the harsh shocks of a surprise LBO? Or are activist investors enough of a check on public companies to drive efficiency and solve agency cost problems?
The answer, of course, is that both play different if somewhat overlapping roles in keeping the management and/or performance of public firms in check.
With the release of Brav, Jiang, Partnoy and Thomas' paper, "Hedge Fund Activism, Corporate Governance and Firm Performance," we see both that activist hedge funds command abnormal returns of some substance (I predict a growth in start-up activist firms given the publication), and that they look far more like value investors (particularly in terms of their holding periods and target profiles) than they have been given credit for. Their holding periods tend to be 2-3 years, in fact, before dipping back under the 5% metric. This is, however, a far cry from the 3-10 year holding period that typifies private equity investments.
A 5% interest in a $5 billion firm is, of course, $250 million and the need to keep long-term holdings mean that borrowing is not practical for activist funds. This means that in terms of size, all but the largest activist funds and the Carl Icahn's of the world are constrained to firms generally under $10 billion, though firms willing to press publicly and threaten proxy contests can accomplish their goals with lower stakes. (Relational Investors only holds about 1.2% of outstanding common in Home Depot, the homebuilder store with nearly $85 billion in market capitalization, but has still managed to badger the beleaguered retailer into caving to all Relational's major demands. Interestingly, this is over $1 billion in capital or over 15% of Relational's assets under management- a pretty serious concentration of assets in one bet).
These sorts of bets are well above all but the most determined, largest and cooperating private equity players. The more interesting interplays exist in the > $7.5 billion market capitalization area, where the two genres have more interaction. Reading the literature it becomes apparent that some of the highest gains in activist strategies are those where divisions or, indeed, the entire firm is sold. Private equity buyers wait eagerly in the wings. (Even now Home Depot struggles to shed itself of its commercial building business at the behest of Relational). One more force to prevent the "maturity and decline" segment of the private equity life cycle.