Twenty years ago, businesses mostly fell neatly into three types of ownership: publicly listed entities, private equity-owned portfolio companies, and entrepreneur/founder-owned businesses.
The first two categories are almost always ultimately owned by the same institutions, but, crucially, differ in the form of corporate governance that is applied. Obviously those two also differ in the leverage they use in their capital structures – and valuations need to be more transparent with listed vehicles.
The approach of private equity (in terms of money invested) is roughly 10% in venture capital and 90% in leveraged buyouts (LBOs) – historically my forte. The principal difference between these two is that the VC world makes less use of debt leverage, because of the risk inherent in typical VC investments.
Let’s focus on the “bread-and-butter” world of LBOs. An LBO portfolio clearly has lots of debt at portfolio level and, nowadays, frequently also has debt at the fund level, with commitments and net asset loans. Some investors are themselves leveraged, adding even more debt to the system.
Institutions dislike conglomerates, but don’t so much as flinch at wild diversity in LBO portfolios
The listed equivalents of private equity are a diverse group – called conglomerates. Generally, they also use debt – though mostly at the holding company level. But, for some reason, having diverse business streams in the listed world is regarded as a lack of focus. The category of conglomerate has almost become an insult.
I find it genuinely odd that institutions dislike groups of dissimilar businesses in the public world, but don’t so much as flinch at wild diversity in LBO portfolios – and provide an abundance of capital to support those investment strategies.
That’s not to say all conglomerates are struggling. Berkshire Hathaway is a spectacular, and singular, US success story. It has a market cap of more than $1trn, numerous businesses in diverse sectors, and provides great share price performance. As a business, last year Berkshire Hathaway paid 5% of all the corporate tax raised from businesses in the US.
Beyond doubt there will be analysts somewhere, tapping on computers, using AI more than likely, to see if the LBO industry could buy Berkshire and break it up – especially with chairman and CEO Warren Buffett trying to wind down his responsibilities as he heads towards his 100th birthday.
And there is convergence for sure. Berkshire Hathaway teamed up with private equity firm 3G Capital in 2013 for what remains the fifth-largest buyout of all time ($28bn) – Heinz. Shareholders in listed stocks have some powers that are not available to LBOs, such as voting for directors. Such tie-ups gives private equity more influence on boards.
And, as time has passed, PE firms have become subject to more edicts from institutional investors on matters such as ESG (Environmental, Social, and Governance) standards.
LBOs used to revolve around buying portfolio companies and selling them in around five years – now we have permanent capital vehicles, continuation funds and performance fees based (in part) on valuations. Unsurprisingly, hold periods have steadily increased towards seven years, and seem likely to be pushed out further. LBO portfolios have increasingly similar characteristics to a quoted conglomerate with a buy and hold strategy. More convergence.
PE traditionally paid senior executives a lot better than public companies – inevitably, the listed world then had to catch up with similar pay. Variable pay has grown substantially. Convergence again.
And there is another convergence afoot. This is where the actors get mixed up.
Asset managers buy PE firms. PE firms buy asset managers. PE firms expand into other assets, property, cryptocurrency and a long list of others. PE firms buy insurance companies and route their assets to the PE firm’s funds. Insurance companies buy PE firms. Consultancy firms buy PE firms and PE firms buy consultancy firms. PE firms use listed vehicles. This list is in no way comprehensive.
The point is that the categories are getting very blurred, with obvious potential conflicts and risks – as well as opportunities. Whilst all of those options are open, creative corporate financiers will continue to prosper.
