Before becoming a professional Fool, I worked as an analyst at a boutique private equity fund placement shop. While in that space, I became hooked on the daily musings of private-equity-focused journalist Dan Primack. Recognizing a unique opportunity for a journalistic crossover and to share an expert's opinion with Fool readers, I was able to coax Dan into an interview for Fool.com.
Joe Magyer: First of all, thanks for joining us, Dan. How about you give Fool readers a bit of color on your background, areas of interest, and what you're currently working on.
Dan Primack: I'm a Pisces who enjoys long walks on the beach and the occasional margarita. I'm also one of the longest-serving indentured servants at Thomson Financial, having covered the private equity markets for the past eight years. I first joined in 1999 to cover private debt, but only because I had followed a girl down to Manhattan and needed to shell out $1,300 a month for my walk-up with a shower stall in the kitchen.
Soon after, I moved onto the private equity beat -- which Thomson defines quite literally as being both venture capital and leveraged buyouts. That meant running some print pubs for a few years, before moving back home to Boston (followed [the] same girl, but it's OK because we got married) and launching a daily email pub called the PE Week Wire. It's now over 41,000 daily subscribers via word-of-mouth, and last November we launched a companion news/blog website called peHUB.com.
My days are spent surfing the Web, writing self-indulgent commentary, and chatting on the phone with people who would never admit to knowing me if put on a witness stand.
Magyer: Is the window of what some have called the "golden age of private equity" closing, or does the buyout market still have room to run?
Primack: Here's the thing: I'm not so sure we actually had a "golden age of private equity." Or, if we did, it was like the "gold medals of Marion Jones." It's shiny for a while, but eventually you're going to have to pay for ill-gotten gains.
To be clear, private equity firms generated out-of-this-world returns for their investors in 2005 and 2006, which is reflected in annual financial reports from university endowments, private foundations, and public pensions. But they also spent the final few months of the "golden age" paying ridiculously inflated prices for companies -- particularly the large take-private transactions.
Here's how the inflation timeline worked:
- Fool Corp. hires a bank to solicit buyout proposals, with a basement of X dollars.
- Two firms indicate preliminary interest at X.
- One of the company's bankers tells a reporter that the company is seeking bids. The stock price jumps to X+Y.
- One buyout firm offers X+Y while the other, sensing stiff competition, offers X+Y+Z.
- Fool Corp. accepts the X+Y+Z offer, but activist shareholders insist the company is worth more. They threaten to withhold their "aye" votes.
- Buyout firm offers X+Y+Z+sweetener like stub equity or a few extra bucks per share.
- We have a deal.
Big buyout firms are going to have a very hard time exiting these companies at a profit, let alone the large profit needed to beat the public equity indices (which is what private equity boasts it can do). Investors have already been told to expect lower returns, and some are already diversifying into smaller deals to mitigate risk.
All of that negativity aside, I actually do believe there is tons of runway for good deals to get done. It's like a test pilot landing strip out there. The hope is that buyout pros will learn from their mistakes, like some venture capitalists managed to do after the Internet bubble bust. We've even seen some new debt commitments coming out of the bank, which really is the engine that drives this train.
Magyer: After the challenges they've faced with KKR Financial Holdings
Primack: Not if common sense gets a say. Then again, this is Wall Street we're talking about ...
What's so vexing about the KKR IPO is how completely unnecessary it is. Does KKR need extra investment capital? No; it has a huge general fund and a multibillion-dollar co-investment fund listed in Amsterdam. Does KKR need to generate brand equity for its founders? Maybe, but it could do that by selling an ownership stake via a private placement, like what The Carlyle Group, Blackstone, Ares, etc., have done (I know Blackstone later went public, but that was nearly a decade later).
The stated rationale is to help KKR build out capacity, such as an M&A advisory or fund placement unit. In other words, it wants to imitate Blackstone (or at least emulate it). But if KKR feels it can't afford to expand without a $1.25 billion IPO, then it is in need of a perspective readjustment. Or maybe some new accountants.
Either way, it comes off as a childish "me-too" move, like when all those LBO [leveraged buyout] firms filed to raise publicly traded BDCs back in 2004, because Apollo had successfully priced one. Most of those got pulled, which is what I think will eventually happen with KKR. The only wild card here is the embarrassment factor, which should never be overlooked.
Magyer: Should retail investors be dabbling in any of the publicly traded private equity plays that are out there? If so, what should be their approach to getting exposure to the space?
Primack: Sure, so long as they don't delude themselves into thinking they're actually investing in private equity. That adjective actually means something, and listed "private equity" securities simply don't have the same ROI potential or investor protections that a real private equity fund has. And you won't get into one of those unless you're an accredited investor, at which point you still need to know somebody who knows somebody.
Some have done well, and some have done not so well. There's even an ETF for private equity-related securities. Do your research like you would any other financial stock. Don't get caught up in the hype.
Magyer: What is the current political spat about carried interest all about, and which publicly traded firms would stand to lose in the event that Congress cracks down?
Primack: Do you have a few hours? OK, here's the CliffsNotes version: Democrats want to raise taxes on private equity professionals. Republicans don't. The Democrats are right.
Here's how a typical private equity firm operates: It raises a fund (i.e., blind investment pool) from limited partners like university endowments and state pension plans. These are just commitments, with the fund able to call down capital as needed. The limited partners pay an annual management fee on the committed capital -- typically 2% -- which is used to pay salaries, lease office space, etc. -- and it generally ratchets down over time. All of that management fee income is taxed at ordinary income rates.
But there is a second way private equity pros make money, and it's called carried interest. For every dollar in profit that a fund makes off of its investment, only about 80% (sometimes less) actually gets distributed to the limited partners. The rest gets kept by the general partner, as a sort of incentive bonus. This gets taxed as capital gains, which currently stands at 15%. So if a buyout pro made $4 million last year with $3.5 million of it coming from carried interest, he only paid around $700,000 in taxes.
This is a great deal for private equity pros, but is fundamentally unfair to everyone else. It really does border on corporate welfare, and the only decent counter-argument is that a change in tax treatment would be the first step toward an overall abolition of capital gains benefits (which limited partners do, and would continue to, receive). But wrong is wrong.
This would impact publicly traded and privately held partnerships equally, and basically mean less take-home pay for firm execs. More significant is some bipartisan Senate legislation that would increase taxes on publicly traded partnerships to corporate levels. No immediate impact if it were to pass, since the legislation has a built-in grandfather period for already-public firms. It's referred to as the Blackstone Bill, but a more appropriate moniker is the anti-KKR bill ...
Magyer: You've previously expressed your view that the traditional VC model is "broken." Can you expand on that and the potential ramifications for the public markets?
Primack: Let me clarify: I think the traditional model is just fine. I'm like one of those Barbie collector purists who only finds value in the original, and believes everything that came later is a diluted perversion. Except I'm not a racist, misogynist, or doll collector.
The traditional VC model requires excellent deal-sourcing abilities, and the willingness to invest in something so embryonic that most others can't yet see the value. What happened post-bubble, however, is that many VCs became so risk-averse that they began investing in later-stage deals at higher valuations, thus lowering their return potential. And these deals required more dollars, which skewed overall industry returns downward. For example, all VC funds raised between 2007 and Q1 2007 have a median IRR of -2.6%. Even if you accept the J-curve theory that recent VC fund returns will be below water, it's a figure that portends extinction.
What is needed is a wider adoption of "traditional" venture capital -- particularly because many of our best companies were funded and nurtured by venture capitalists. Google
Magyer: Are you the Bill Simmons of private equity, or is Bill Simmons the Dan Primack of sports journalism?
Primack: We're both from Boston, but I went national first. Plus, I still get to live here, while he's stuck in L.A. On the other hand, he has more readers than me, makes more money than me, and gets to watch sporting events for a living. Edge: Simmons.
Magyer: Thanks for joining us, Dan. Much obliged!
Primack: It's an honor just to be nominated.