Dear Friends of PPE:
Mike David, Andy Kuhar and I founded Partners Private Equity one year ago. As we approach our first anniversary, it is appropriate to reflect on the past year and look forward to the future.
There is a local Cleveland mid-day sports radio show that ends every day with a segment in which the hosts ask “Why are you smarter?” (i.e., for having listened to these two morons for your entire lunch hour).
So like the radio sports morons, we ask ourselves, “Why are we smarter?” (i.e., for having worked our tails off to get PPE established over the last year). Of course, scientific research shows that we are no smarter—indeed, as shown in the chart below, science suggests we are measurably less intelligent than this time last year.
However, with the passage of time we have learned more facts. Net-net, I believe we are no worse for wear.
So a slightly different form of the question—what have we learned in the past year?
The investment environment currently is extremely competitive and characterized by a general lack of fear. There is some ambiguity in the statistics, but we believe private equity valuations are at or near historic highs. We at PPE are value investors by nature and generally seek opportunity in old economy “story” deals where we can add value by recruiting new management, improving operations or implementing new strategies. Such deals generally sell at a discount. However, in the last year we opened files on 84 deals and submitted bids on 25. We were outbid on most of them—often by a lot. We don’t have perfect information but we believe that the winning bids were on average approximately 20-25% higher than ours.
This suggests that the “winning” private equity buyers are either (a) making much more heroic assumptions about future earnings growth/valuation multiples than PPE or (b) solving for lower equity returns. We estimate that at prevailing deal pricing, PE firms may get 12-14% average internal rates of return on their vintage year 2013 equity portfolios (if all goes well). By contrast, we try to price deals where, with reasonable projection assumptions, we can earn compound equity returns of 20-25%. We believe these are the appropriate returns for this asset class. However, our valuation standards have (for the time being) put us at a disadvantage.
Are we right to maintain our valuation discipline? Studies on crowd behavior suggest that people tend to believe the preponderance of opinion around them. The preponderance of opinion currently seems to be that asset values are going to go up significantly in dollar terms, at least in the near to intermediate term. There are a couple of ways this can happen but there are an equal number (if not more) ways that such values could go down. We try not wring our hands too much over that which is unknowable but we’re sticking to our guns on valuation discipline.
Sticking to our Guns
We try not to invest based on a macro view of the economic environment. However, we can make some observations about how the overall economic environment colors our investment outlook.
Most significantly, it appears that Mr. Bernanke has succeeded. The Fed’s quantitative easing policy has achieved its goal of keeping interest rates down and forcing investors back into risk assets (public and private equities, real estate, etc.). This has pushed stock indexes to record highs and re-inflated the real estate bubble to a significant extent. Private equity valuations have not been immune—multiples are at or near historic highs. However, the planned tapering and ultimate withdrawal of quantitative easing presents long term risks for all of these asset classes. It is likely, for example, that a reversion to long term average interest rates could cause equity values to fall 30% or more, all else being equal.
Overall, the pervasive influence of government in all aspects of our economy—money supply, interest rates, asset values and tax policy—tends to distort the efficient allocation of capital that has traditionally been a strength of the US economy. Markets now seem to be significantly more focused on government policy than on economic fundamentals.
Can economic fundamentals catch up to the Potemkin Village economy the Fed has created? Interestingly, the answer is yes. Implausible as it may seem, if Congress passes a comprehensive economic reform package—entitlement reform, tax reform, and budget reform—it could put in place a long term solution to the country’s fiscal problems and lay the foundation for decades of growth. It could happen and the economic implications would be profound. We are not holding our breath, but we note that the recent Congressional budget deal negotiated by Paul Ryan and Patty Murray is a baby step in the right direction.
However, all of these macro-economic considerations are out of our control and way above our pay grade. While we don’t craft our investment strategy based on these factors, we try to pay attention so that we don’t blindly get caught up in the madness of crowds and government policymakers.
The deal market often provides insight into sectors of opportunity and risk. When insiders in a given sector are aggressively selling, it can be a sign that the sector is approaching a peak and is exposed to downside cyclical risks, or that individual companies will not be able to sustain their performance. We have seen a large number of companies in the market that fit this description.
In many cases, these companies have declining growth rates and unsustainable margins. Coming out of the recession, many of these companies had pricing power as competitors folded and, with the recovery, have benefitted from significant increases in volume. As the economy continues to stabilize however, historically high margins will likely be arbitraged away in competitive bidding. Insiders who perceive these risks are, not surprisingly, motivated to sell.
We have also seen a number of good businesses with sustainable business models and good prospects. In the last year, many of these sold for high multiples of peak cash flow. Many of these businesses are cyclical and were financed with significant leverage. Buyers have to hope that they can get through several years of debt amortization before the next cyclical downturn. These deals may work out but we don’t believe high prices and excessive leverage represent a sound investment approach long term.
Despite these landmines in the deal environment, we are pursuing a number of interesting opportunities. As always, an important qualification is that we must acquire these businesses at compelling valuations. We currently are working on three deals where we have a very good chance of negotiating a letter of intent in the first quarter.
We are looking forward to 2014. We have recently moved into new offices in the Lakepoint office building in Beachwood after spending most of the year subletting from our friends at Kirtland Capital Partners in the same building. KCP’s partners were tremendously supportive (and surprisingly tolerant). We deeply appreciate their support at such a critical point in the development of our firm. We are especially grateful for the adult supervision and TLC provided by KCP’s talented office manager, Diane Johnson.
Our plan for the coming year is to continue to compete hard for deals—especially the more difficult “story” deals where we believe we have a competitive advantage. We plan to stick to our valuation discipline and focus on companies that are misunderstood and have significant value-creation opportunities.
Happy New Year!
John Mueller Michael David Andrew Kuhar