A Big Red Flag for Future Returns

Private equity hasn't gotten a lot of respect lately. If it's not manufactured controversies over Mitt Romney's former employment, it's more general complaints levied at fat cats making big deals that benefit few beyond the fat cats themselves. Market grumblings are reaching a high point now with the planned Carlyle Group IPO, as many savvy commentators -- including the Fool's own John Maxfield -- point out that private equity firms tend to go public only when their biggest growth periods are behind them.

But these aren't just savvy operators with massive war chests. Private equity firms employ some of the best and brightest financial minds in the industry. They can analyze economic trends small and large in ways the average individual investor could only dream of. When a firm goes public, it may be more than a cash grab; it may be a signal that there's a rough ride ahead for market participants.

Private goes public
Most private equity firms are still private, but there are a handful that have gone public -- and all somewhat recently. The trend started with Goldman Sachs (NYSE: GS  ) , which identifies itself as an investment bank, although it has managed significant private equity operations over the years. After playing a major role in the dot-com bubble, Goldman went public in May of 1999, near the bubble's peak. Over the next three years, Goldman would see slightly positive (if volatile) returns, but the broader market suffered.

GS Total Return Price Chart

GS Total Return Price data by YCharts.

The timing couldn't have been better. With far fewer speculative dot-com companies to take public after the crash, Goldman had to shift gears. Revenues suffered, but paydays didn't. Jon Corzine, at Goldman's helm during the IPO, made more than $300 million -- later used to finance his political ambitions in New Jersey.

For a while there was little competition in the publicly traded private-equity arena. The market recovered from its doldrums and made for new heights. The Dow hit all-time highs in 2007, just as a pair of major private equity firms prepared to go public.

Second verse, same as the first
Fortress Investment Group (NYSE: FIG  ) had its public debut on Feb. 9 of the market's peak year, and private-equity titan Blackstone Group (NYSE: BX  ) followed in June. I shouldn't have to tell you what happened in the following years. If you'd like to know the specifics, here's what went down:

FIG Total Return Price Chart

FIG Total Return Price data by YCharts.

The new crew couldn't even muster a Goldmanesque outperformance in the three years following its debut, drastically underperforming even the anemic results of the index. The S&P 500 still hasn't recovered to its 2007 heights. It has made some impressive gains for those savvy investors who jumped in two years later, but if you're following the pattern shown here, that may not last. Another wave of private equity IPOs crashed ashore beginning in 2010.

Are things different now?
The Kohlberg Kravis Roberts (NYSE: KKR  ) IPO in mid-2010 stands out from this pack for arriving relatively early in a period of growth. Not only did the index boom after KKR went public, but KKR's stock was a notable outperformer:

KKR Total Return Price Chart

KKR Total Return Price data by YCharts.

But when Apollo Global Management (NYSE: APO  ) had its turn at bat, you could hear the whooshing sound clear out to New Jersey as the company's stock whiffed. While the index Apollo now lags is barely in the black for that post-IPO period, a few bad days ahead will make this yet another negative stretch:

APO Total Return Price Chart

APO Total Return Price data by YCharts.

All told, Goldman, KKR, Blackstone, and Apollo together make four of the top six private equity firms ranked by fundraising total in Private Equity International's PEI 500. When Carlyle Group goes public, it will be the fifth of six. The one remaining holdout is TPG Capital, based in Texas. Only KKR has done well for its investors while also enjoying a broader market improvement. That either represents KKR's superior ethics or betrays its poor timing; the firm was one of the major buyout players pre-crash and could have enjoyed some major market interest thanks to two 11-figure buyouts -- one in 2006 and one in 2007.

What lies ahead
Will Carlyle's IPO herald a new period of growth a la KKR? Or will the market's reactions come full circle as Carlyle heralds a new bear market and a return to the old private-equity-goes-public norm? That's a question serious investors should ask themselves as they survey the market and the broader macroeconomic trends that often move it. Remember, these are some of the savviest professional investors around. When they sell, it's usually for good reason.

Private equity may be cashing out, but other smart investors are still looking to cash in -- and you can ride their coattails to market-beating returns. Find out what greats like Warren Buffett are buying right now in The Motley Fool's free report on "The Stocks Only the Smartest Investors Are Buying." You'll even get the opportunity to discover a promising stock flying under Buffett's radar. To find out more, click here for your free copy of this important report.

Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter @TMFBiggles for more news and insights.

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  • Report this Comment On April 24, 2012, at 2:34 PM, TrojanFan wrote:

    Bravo to the author.

    Finally a sign of a healthy degree of skepticism from the Motley Fool. I don't see this nearly often enough from this website and I hope to see more of this sort of reporting in the future.

    I work in the private equity industry and from my own first hand experience I can say that the relationships that the author notes here are not a coincidence in the least.

    These IPOs absolutely should be taken as a harbinger of trouble to come and only a fool (small f) would ignore them.

    I would argue that Oaktree Capital also belongs in this list, though I will acknowledge that they are not a pure play private equity outfit and I generally hold them in much higher ethical regard then just about all of the firms mentioned above. I suggest including them not so much because they are a private equity firm, but to further illustrate the current trend that is well underway. In some ways they are like a private equity firm in disguise because they do a lot of distress for control investing which starts out as a high yield bond investment, but morphs into a private equity investment at some point down the road on the road to realizing their investment thesis.

    They just went public a couple of weeks ago under the symbol OAK.

    When you see a wave of these firms coming out and going public like we are experiencing now, that should be taken as a signal that we are approaching the next cycle peak.

    As the author correctly states, these are some of the savviest investors on the planet. They aim to sell high just like everyone else. The unfair part is that they control a lot of the levers that make the economy move, both up and down and they have access to lots and lots of insider information that only massive amounts of money and connections can grant one access to.

    In particular, the hyper leveraging debt machine that they use to make their business go has certainly been at least partially responsible for amplfying the intensity of the business cycles of late. The private equity industry sets the fuses on those debt bombs so they know better then anyone when they are likely to explode. It's not a coincidence that these firms trade with a beta multiple to the market. There is lots and lots of leverage in their business model, both direct and indirect; visible and invisible and that amplifies their results during expansionary phases and likewise amplifies the negativity of results in a downturn.

    This is one of a number of factors that is signaling the approach of the next recession which I wholly expect to actually be even more intense then the one we just went through if you can try and get your head around that and I don't think it's very far away, either. We will probably start feeling its effects in less then two years, but certainly within three.

    It's going to start in Europe (really already has), but it won't stay contained there and political upheaval and destablization is going to be a prominent feature in this next cycle. Lots and lots of globalization is going to start coming unwound, beginning with the breakdown of the Eurozone and radiating out from their to Europe's extensive web of trading partners. The ripple effects of that are going to be pretty profound once those dominoes begin to fall.

  • Report this Comment On April 24, 2012, at 5:39 PM, DJDynamicNC wrote:

    I think we can expect another bear market again, and sooner rather than later. Not sure we'll see another Great Recession, but if we do, I don't see how it avoids tipping over into a Great Depression - the political chaos alone seems likely to much everything up. You can expect a LOT more radicalism if governments continue to prize the property rights of wealthy bond holders over the lives of their own citizens. Agree or disagree with the rationale, people are going to be angry, there's no denying that.

  • Report this Comment On April 25, 2012, at 10:49 AM, bretco wrote:

    Trojanfan, great post, better than simply "food for thought", truly advice than will change my investment thesis. Thank you for sharing.

  • Report this Comment On April 25, 2012, at 3:56 PM, thevisigoth wrote:

    Yup. This, market is about to tank!

  • Report this Comment On April 26, 2012, at 8:12 PM, TrojanFan wrote:

    Here's an update for you.

    S&P just downgraded Spain from A to BBB+. That's a two notch downgrade and just two notches above investment grade.

    Here's the story:

    http://www.bloomberg.com/news/2012-04-26/spain-s-ratings-cut...

    This is very likely to trigger ECB and probably EFSF intervention with the help of the IMF so get ready for your next bailout.

    Market chatter today was that Bank of Japan is getting ready to intervene in their markets with 5 trillion yen. It's basically another money printing operation and my suspicion is that this new money is going to be used to offset Japan's contribution to the IMF that they pledged to make about a week ago, because the expected intervention is roughly equivalent in size to their pledged IMF contribution.

    Get ready for your next bailout everybody!!

    By the way, the US taxpayer is probably going to be participating in this one, too, via the IMF.

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