Private equity’s public reckoning

Katie Martin (0:09)

Private equity is a bit bunged up. The fairy tale, if you like, with these buyout firms is that they buy unloved, lowly companies, fix them up into shiny, amazing companies with their special brand of management genius, and then list them on public stock markets. Ka-ching! Money rains from the sky, everyone is happy. Now, like I say, that's the heroic origin story, terms and conditions apply. But anyway, the last bit of that process has issues. Launching companies onto public markets is proving much trickier than people had hoped. Instead, private equity firms are passing companies around to each other, or even selling them to themselves. Hmm? Listeners, you're not alone in thinking this makes very little sense. So today on the show, we're asking, why is private equity constipated? And will this all blow up in everyone else's faces?

This is Unhedged, the markets and finance podcast in the Financial Times and Pushkin. I'm Katie Martin, a markets columnist at the FT in a rather autumnal London. And I'm joined down the line from New York City by my comrade Rob Armstrong from the Unhedged newsletter.

Rob Armstrong (1:24)

I wish it was autumnal here. It still feels like summer right now in New York.

Katie Martin (1:28)

Always complaining. But also by our private equity man in New York, Antoine Gara. Antoine, welcome. We're delighted to have you here.

Antoine Gara (1:37)

Hi, thanks for having me.

Katie Martin (1:38)

So look, normal people don't know what private equity is, and they certainly don't know what a continuation fund is. So Antoine, please enlighten the class and also give us a sense of how big and important is this stuff.

Antoine Gara (1:53)

Sure, private equity is a fairly simple business when you think about it. Firms raise money from pensions or professional retirement funds, sovereign wealth funds, and you say, I'm going to go buy 10 to 15 companies in a fund. I'll spend the first four years buying the companies, and the fund will be 10 to 12 years. And by year five, you'll start to really see the money come pouring back in as we buy companies, fix them up, apply a little bit of debt to them, and make good money. Two to three times your return is the general expectation. And so that's a fairly simple business because it's bound by time. The cash goes out to the private equity fund, and then it comes back. And if everyone's happy, they'll do it all over again.

Rob Armstrong (2:41)

OK, I just want to stop and ask a question here. I have my answers to this question, and you have yours. So if over 10 years, you're kind of 2Xing or 3Xing your money, if I'm getting this right, that's like 20% a year. Plus, right? That's a meaty return. Right. Even a remarkable return. Just give us, in a short answer, what's the magic that allows these guys to do 20% or more a year?

Antoine Gara (3:08)

OK, there's a few things. First, there's just the use of leverage. So you're going to buy a company and use, say, half debt financing. So that means if you can even grow the value of the company slightly over time and find a willing buyer at the end of it, the leverage will earn you some return.

Rob Armstrong (3:27)

Will double your return if you're using 50% leverage.

Antoine Gara (3:30)

And then you're also trying to grow the business. You're trying to repay the leverage by finding cost cuts that then take the debt down. And so then you've created equity value. And you can also do all kinds of things like M&A. And also, you're obviously trying to pick sectors or industries or companies where you feel the market has misunderstood the growth or it's a public company that's just gotten way too beaten down and it's trading for less than the sum of its assets.

Rob Armstrong (3:59)

That's a nice story, Antoine. I think you have a future in public relations.

Antoine Gara (4:02)

Okay, wait, wait. But there's some fine print here. So I'll add a little asterisk. Those two to three times returns come with a little bit of gaming because there are things called subscription line facilities where I will go do the deal, but I won't actually draw the money from my investors until around like when the deal closes or six to nine months after.

Rob Armstrong (4:23)

When you bought the company.

Antoine Gara (4:24)

Yeah, yeah. And so there I'm gaining equity exposure with leverage, but I've not actually drawn the capital. And so then if someone comes and buys the company a year or two later, I'm making very, very high returns, 100 percent annualized return or something like that. And so there is a little bit of gamesmanship in that 20 to 30 percent figure. An easier way to look at it is like, how much cash did I put out? How much cash came back? And I would say a good fund, the litmus is you want to double your money, cash coming out, cash coming back. A lot of investors who have been around the industry for a while, they call it like cigar box accounting. You're in a smoky back room and you open the cigar box, you take the cash out, you give it to the investor and they give it back to you and put it back in and you make another decision ten years later.