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00:00This is a story about beating expectations.
00:02For years, private equity has been an important tool in the investor's toolbox
00:06because of its ability to deliver better returns than public markets.
00:10Not to speak of what it's meant for entrepreneurs like Dan Namorow,
00:14who built his own electrical company,
00:16never expecting private equity to come knocking on his door.
00:22When I started my business, having an end goal was not even a thought in my mind.
00:28I had no idea about business, never for a second.
00:32If I was approached in year one by someone who said,
00:37Dan, you're going to sell this business in eight years for millions of dollars,
00:41I would have simply laughed at them.
00:43And then private equity arrived.
00:46First, I thought it was a joke. I thought it was a scam.
00:49I, within eight years, was going to almost 12x my EBITDA,
00:57and become a newly minted millionaire.
01:00But that payday came with a trade-off Dan says he did not fully understand.
01:05I do not want to disparage the company that acquired mine.
01:08But I can say that no matter what an owner thinks is going to happen,
01:16they need to take a step back and look at the reality of things.
01:22And what I mean by that is you are no longer in control of your business.
01:28It absolutely 100% hurt not only my soul, but the soul of the business.
01:35Dan's experience is one founder's account of one deal,
01:38not a verdict on private equity as a whole.
01:41And for Namuro, timing was everything.
01:44He sold at the top when cheap capital and rising evaluations fueled demand for companies like his
01:50and justified high prices.
01:52Private equity buyers could pay those high prices because they could generate returns
01:56simply off of the financing.
01:58But all that has changed.
02:01The role of private equity is to provide, hopefully,
02:07outsized returns relative to what could be gotten in the public markets.
02:10It's to provide incrementally higher returns and therefore raise the returns on the whole portfolio.
02:16According to a report by Bain, private equity deals, fundraising,
02:21and payouts to investors surged in 2021, fueled by COVID-related stimulus.
02:27But then dealmaking slowed in 2022,
02:30forcing private equity managers to return fewer profits to investors.
02:34Steve Ratner has spent much of his career in and around private equity.
02:38He is now chairman of Willett Advisors,
02:40which manages the personal and philanthropic assets
02:43of our founder and majority shareholder Michael Bloomberg.
02:46Ratner says changes in the market have made the case for private equity
02:50less straightforward for investors.
02:52There was a time when interest rates were near zero,
02:55where there was sort of a crying need for outsized returns.
02:59We now have positive interest rates.
03:02Has that reduced some of the attraction of private equity?
03:05Yes, in two ways.
03:06First, anytime interest rates go up, the attraction of equities goes down
03:12because if you can invest in a fixed income security
03:15and get an interest rate of X,
03:17and that's high enough relative to what you think you're going to get
03:20with the volatility and risk associated with equity securities,
03:25you're going to migrate toward fixed income.
03:27With respect to private equity specifically,
03:29there's an additional issue,
03:31which is that private equity is heavily financed with debt.
03:34And therefore, when rates go up,
03:36the ability to make the numbers work, so to speak,
03:38on a private equity investment gets harder
03:40because, in effect, your costs have gone up.
03:42And so you can't pay as much for the company
03:44and still make the kind of return you were hoping to make.
03:47Stephen Kaplan, a professor at the University of Chicago
03:49Booth School of Business,
03:51has studied private equity for decades.
03:53As you know so well, markets go up, markets go down,
03:56rates go up, rates go down.
03:57But as you look at it,
04:00to what extent was private equity doing artificially well
04:05because we had historically low interest rates?
04:08I mean, approaching zero interest rates.
04:10Did that distort the process?
04:12I don't buy that so much.
04:15Private equity really outperformed for a long period of time
04:20in all interest rate environments.
04:22And I think the late 20-teens rates were low
04:28and maybe that was a help.
04:31But the private equity firms also benefit
04:36from improving their companies.
04:39And the public markets also benefited
04:42from the lower interest rates.
04:44So it's sort of as an apples-to-apples comparison.
04:47That's why I like just looking at how the private equity does
04:53relative to the public markets
04:55and the S&P 500 in particular
04:57because the S&P 500 is going to be affected
05:00by many of the same things.
05:02According to Professor Kaplan,
05:04an analysis of U.S. buyout funds
05:06shows that private equity largely delivered
05:09on its promise of beating public markets for decades,
05:12from the 1990s all the way through 2018.
05:15But since 2019, that pattern has reversed
05:18in part because big tech's remarkable rise
05:21has pushed public market returns higher
05:23and in part because the higher prices generated
05:26during the boom days have made it harder
05:28for investors to get their money out.
05:30The ultimate goal, by and large,
05:33is to sell the company at some point.
05:35That has become more difficult in recent years,
05:38perhaps in part because of the increase in interest rates.
05:41Certainly, we talk to limited partners who say,
05:43wait, I'd like my money back now
05:45and the general partners say,
05:46oh, no, no, it's too soon.
05:47I'd like to hold on for a while.
05:49What's the problem with exit right now?
05:51The deals in 2020 and 21,
05:54they paid high prices.
05:55Then they got hit by interest rate increases.
05:59And those deals are not doing so well.
06:04And I think a number of the private equity firms
06:08don't want to sell
06:10because they think if they hold it longer,
06:12they'll be able to get a higher value.
06:15And as a result, they're not selling.
06:18And so realizations or what they call in the industry DPI,
06:23which is distributed capital per invested,
06:27is on the low side.
06:30And that's what LPs are complaining about, rightfully so.
06:34PitchBook reports that the backlog of companies
06:36held by private equity firms
06:37has now reached over 33,000,
06:40up from only 19,000 a decade ago.
06:43And with less support from cheap leverage
06:45and rising valuations,
06:47private equity firms are increasingly being judged
06:49on what they can actually do
06:50with the companies they buy.
06:52Andrew Weinberg, founder and CEO
06:54of the private equity firm Brightstar Capital Partners,
06:57says 2022 represented a fundamental shift.
07:01I think 2022 is an inflection point for our industry.
07:04If you look at the prior 20 years,
07:06if you bought something and grew at a few percent a year
07:09and took on some leverage and had multiple expansion,
07:12that was a great return.
07:14And I think the Bain Research Report
07:15did a great job of chronicling this
07:17and then said, okay, here's the new norm post 2022,
07:20which is the old 5% growth
07:23is really now a 12% bottom line growth
07:25to achieve the same return that one did before.
07:28I love it personally
07:30because I've been waiting for this market.
07:31I've been waiting for a market
07:33where the investor can differentiate
07:35between the manager that is purely focused
07:37on leverage and multiple expansion
07:39to the manager that is focused
07:41on operational value add
07:42and the application of AI.
07:45So in terms of being ready for this environment,
07:48we've built Brightstar
07:49to be ready for this environment.
07:51We have a deep team of not only investors,
07:53but operators who have experience
07:55in the space to do it.
07:57And I think what the investor
07:58is going to end up seeing
07:59is a much bigger differentiation
08:01or distribution of returns from managers
08:03based upon who has built their firm
08:06for this environment.
08:08As performance pressures
08:09for private equity funds grow,
08:11investors increasingly focus on issues
08:13like how they get their money out
08:15and what fees they're paying.
08:16Jason Tyler,
08:17president of wealth management
08:18at Northern Trust,
08:20helps wealthy families
08:21and family offices navigate
08:23the changing investment landscape.
08:25Now, the fund sponsors
08:27are coming up with,
08:28first of all,
08:29they're trying to get to new investors
08:31that didn't typically have
08:33either the interest
08:35or the ability to invest.
08:36And so they're trying
08:37to create more liquidity.
08:39And that will attract investors
08:41that don't feel comfortable
08:42having their money held up
08:44for eight to 10 years.
08:46That attracts a smaller investment size.
08:49And then on the conversely,
08:51a lot of the largest investors,
08:53a lot of the ones
08:54that we have as clients,
08:55their historical ability to invest,
08:57they'd say,
08:58well, we don't want to pay the fees
08:59that these funds have.
09:01So we'll be more patient
09:02and we'll look for ways
09:03to invest directly into companies.
09:05Well, now the private equity funds
09:07are saying,
09:07we'll find that opportunity as well.
09:10Maybe a client,
09:11maybe an investor
09:12can invest in our fund.
09:14But if they do that,
09:15we'll give them an opportunity
09:16to invest without the same fees
09:19directly into the company.
09:20Investors historically
09:21don't like to pay fees
09:22or at least like to pay
09:23the lowest fees they can.
09:25At the same time,
09:27are some family offices
09:28or ultra high net worth people
09:30discovering actually,
09:31it's not that easy
09:32and it's pretty expensive
09:33even to do it yourself?
09:35It's a great way to frame it
09:37because a lot of investors think,
09:39well, I love the investments I've had,
09:41but why would I want
09:42to have paid the fees here?
09:43So a lot of what the top
09:45private equity funds do
09:47is they're explaining
09:48to their investors
09:50all the hard work
09:51they're doing to source
09:52and then do research
09:54and their investment thesis
09:57and due diligence on companies
10:00as a value add
10:01so that direct investors
10:03acknowledge and have to appreciate
10:05that there is work
10:06that's being done by the funds
10:08that they're not able to do alone
10:10or even potentially
10:11with the family office staff
10:13that they've hired
10:14which oftentimes are great, great,
10:17very strong professionals
10:18but they just don't have
10:18the resources
10:19of a large private equity fund.
10:22There's little doubt
10:23that private equity
10:24is here to stay
10:25but as financing
10:27becomes more expensive
10:28and exits take longer,
10:30the market could be
10:31narrowing the field
10:32and rewarding firms
10:33that can prove
10:34they bring more than capital
10:35to the companies they buy.
10:37What you're going to see
10:38is some of these private equity firms
10:43perform,
10:44some of them don't perform,
10:46they're not going to get more money,
10:47in some cases they will
10:49and that's the capitalist system.
10:52But whatever the pressures
10:54on private equity firms,
10:56for people like Dan Namorow
10:57who are selling,
10:58the question isn't
10:59whether private equity
11:00is beating market expectations
11:02but whether the price
11:03they're receiving
11:04beats their own expectations.
11:06The sale of his electrical business
11:08gave him the means
11:09to start over
11:09which he's now doing
11:11from a beach
11:12in Costa Rica.
11:13A pretty comfortable way
11:15to beat expectations.
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