Your retirement savings plan could soon allow you to invest in a way hitherto reserved for an elite: private equity (PE). It’s an opportunity to consider – private equity firms can generate outsized returns – but first you need to familiarize yourself with the private equity business model.
The PE’s business model is complex but can be understood by comparing its more familiar cousin, the public holding company (HC) – think Warren Buffett’s Berkshire Hathaway BRK.A,
In both models, the company is in the business of buying several companies for investment purposes. But their approaches differ and pose compromises. (That’s why some companies mix the two models, but I’ll point out the contrasts.)
The first difference between the HC and PE model is what they look for in a business. Berkshire and other HCs are looking for companies that are already well run and can buy on the cheap. They aim to make money by paying a low price. In contrast, private equity firms look for companies with operational problems that can be fixed, poor managers with inflated cost structures. They aim to make money by fixing things.
A second big difference between HCs and PEs is financing, specifically the amount of borrowed money used to purchase a business. The private equity business model uses a lot of leverage, believing that by borrowing at low cost and deploying capital at high yield, equity investors benefit. While acknowledging these advantages, the HC model warns of the disadvantages: in times of crisis, too much debt is difficult to repay, which can wipe out shareholders.
Time horizons also differ. Since HCs make their money at the time of purchase (buying low), they tend to hold on to their investments for the long term – Berkshire says it never sells. In contrast, since private equity firms make their money over time through operational improvements, they are eager to cash out as soon as that mission is accomplished. A turnaround can take several years or longer – which may seem long-term to some – but private equity firms are determined to exit their businesses, not keep them.
Another difference is motivation – what’s in it for HC and PE companies. HCs are corporations with boards of directors, shareholders and subsidiaries, and no particular group is advantaged over the others. While the HC may receive profits or dividends from affiliates, it rarely generates significant commission income. Private equity firms, on the other hand, charge management fees and performance fees (you may have heard of the infamous “2 and 20”, referring to taking 2% management fees and of 20% of profits) plus a variety of service fees such as for advice, loan or board of directors.
But perhaps the biggest difference between HCs and PEs is the public-private distinction. HCs such as Berkshire must register with securities regulators, follow stock exchange rules, and respond to public shareholders and activists. Mutual funds that invest in these HCs are also regulated and subject to detailed information on fees, conflicts of interest and other similar matters.
Not so PE. The essence of the business model is off-market: private equity funds are loosely regulated and their beneficiaries are private companies, neither listed on the stock exchange nor transparent to outsiders. This frees operations from pesky overseers and public gadflies, saving private equity firms and their investees significant cost and hassle. Combined with business turnaround skills and leverage, the outsized returns compared to their chained HC cousins are no surprise.
It’s no wonder some investors are clamoring for the ability to invest in private equity — or regulators are reacting cautiously. Two years ago, with Republicans in charge, Department of Labor pension fund regulators signaled support for plans offering employees private equity funds, reflecting confidence in the private equity market as well as individual choice. Now, however, with Democrats in charge, the advice is more lukewarm, reflecting skepticism about people’s understanding of the somewhat opaque world of PE.
In the midst of this back and forth, take the opportunity to invest in private equity seriously, as we do in my family. For many years I was a physical education critic and shareholder and champion of Berkshire Hathaway, but my wife has worked in physical education and attests both to its considerable worth and substantial virtue.
I will turn 60 this summer and I look back with relief and pride on two decisions that I strongly recommend to you: I have maximized annual contributions to my retirement plan and with a portfolio allocation to stocks rather than bonds. If I were to redo this future planning, I would add an allocation to private equity.
Lawrence A. Cunningham is a professor at George Washington University, founder of the Quality Shareholders Group and editor, since 1997, of “The Essays of Warren Buffett: Lessons for Corporate America”. Cunningham owns shares of Berkshire Hathaway. For updates on Cunningham’s research on quality shareholders, sign up here.
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