The environment for private equity companies can still be described as beneficial. But there are also risks. Investors should be aware of these risks and at the same time know where undemanding valuations and appealing dividend yields compensate for these risks.
The term private equity still enjoys a somewhat myth-enshrouded reputation. On the one hand, there is a certain lack of transparency, and on the other hand, managers must juggle a large amount of money. However, it is quite easy to explain what the industry is doing. Ultimately, private equity firms put money from investors into companies for a certain period of time. The declared goal is to ensure the highest possible yields.
In the long run, and on average, this target is achieved. Over periods of five, 10 and 20 years, the performance in all regions of the world was higher than the corresponding local stock markets. In the U.S., the private equity specialists at Bain Capital quantify the return for the past 10 years at 14 percent, and for the past 20 years at 13 percent. These performance figures make private equity interesting from an investor’s perspective, especially since private equity traditionally has a low correlation with other asset classes.
According to surveys, institutional investors plan to further increase their investments in private equity. This growing interest also is related to the current positive environment. Rising stock markets, together with a booming IPO-market, improve the chances of exiting investments at a high selling price. Also, at the current price level, market participants sit on high unrealized gains on investments made in the past. Furthermore, the low-yield environment ensures favorable financing terms.
Don´t forget the risks
The current framework, however, also contains certain risks which have to be considered. After more than five years in a bull market, the valuations of potential targets are often quite high and there is a risk the new investments are overpaid. This risk is increased even more by the fact that money is being poured into the sector. Apart from this, potential investors should be aware that the owners of private equity companies profit heavily from every boom in the sector. Typically they charge a management fee of around 1.5 percent to 2 percent and a profit participation fee of 15 percent to 20 percent.
In addition, they also receive dividends from the stock they own in the company. In 2013, the top 10 earners in the sector managers made $1.7 billion through that channel alone.
Simon Johnson, a professor at the Sloan School of Management at MIT, notes: “The fee structure in this overall arrangement is such that the people running the private-equity fund want to have as much debt as possible. This will increase the way upside returns are calculated, which in turn is the main driver of the compensation that the controlling ‘general’ partners can receive. More debt, of course, also means more risk, but this is not a sector focused primarily on risk-adjusted returns.”
Potential conflicts of interest are always something the regulators have an eye on, and stricter regulation in the future cannot be excluded.
Investors who have no problem with all of this can invest in the sector via listed private equity companies. This is an easy way to get around the problem that the segment is usually primarily accessible only for institutional investors. This has to do with the typically high level of investment required. In the search for alternative investment possibilities, the U.S sector members especially stand out. The reason is a comparably low valuation. Based on the estimated earnings for seven big U.S. private equity firms, the price-earnings-ratio stands at 10.0 for 2014. On top of that, some of these companies also offer an appealing dividend yield. Thus, at least to a great extent, the risks already seem to be anticipated in the prices.
Moderate price earnings and respectable dividend yields
Even the Blackstone Group as the top dog in the sector has relatively moderate valuation figures, especially if one compares them with the general U.S. stock market. The company has assets of around $272 billion, which takes into account the mark-to-market valuation of the portfolio, from $628.3 million to $813.9 million in the first quarter. Although the stock has reached new highs in 2014, the price earnings ratio stands only at a moderate 9.93 for 2014, and the dividend yield is estimated at 5.7 percent.
But there are private equity stocks whose valuation ratios look better – for instance, KKR & Co. The company reported a decline in net income from $647.7 million to $630.3 million, but that was better than expected. The price-earnings rate for the current year is 8.95 and the dividend yield is 7.47 percent. Fortress Investment Group also has similar valuation figures. Here the price-earnings rate is 8.55 and the dividend yield is 7.6 percent. The ratios here probably are so low because the hedge funds managed by the group did not gain recently.
Number four in the list is Apollo Global Management, with a price-earnings ratio of 9.3 and a dividend yield of 9.89 percent. This provider of global alternative asset manager services has an interesting business model. The segment of illiquid credit instruments it has specialized in offers growth opportunities because a tougher regulatory framework forces banks to scale down that business. Nevertheless, the results Apollo recently presented did not keep up with the expectations, and that increases the risk of that investment.
In conclusion, not all of the private equity stocks have surpassed their former record highs, as opposed to the U.S. stock market overall. That has to do with the risk of the business, and if the bull market should end, these companies will probably be hit hard again. But at present, the business environment is still favorable, thanks to a booming IPO-market. But most of all, the reasonable valuations favor the sector members. To reduce the risk, it is advisable to hedge any investment by setting a stop-loss limit.