How to Beat Private Equity in the Public Markets
Limited partners are drawn to the attractive historical returns profile of private equity, which has been the best performing major asset class. Investors who believe these excess returns will persist must necessarily believe that there is something structurally superior about private equity relative to public markets. We have heard four major explanations for why this would be the case:
Discounted valuations in private markets relative to public markets
Superior management and governance in private equity controlled firms
The use of debt financing
The size of private equity deals, which are typically equivalent to micro or small cap public equities.
We can then make the case that if you do each of the following, you should earn returns comparable to the gross returns of private equity:
Buy at a discount to the broader market
Have management and governance comparable to private equity.
Use debt financing in roughly the same proportion as private equity.
Invest in companies that are in the small-micro cap size range.
If you’re still in agreement, I have a wager for you. I have built a small sample portfolio that looks like a private equity portfolio: a set of small, highly leveraged companies. Each of the companies in this portfolio is a private equity deal that has been taken public. Private equity firms remain large shareholders and have significant board presence. Each of these five firms has the financial characteristics of the best performing private equity deals: these companies are small, cheap, and highly leveraged. Whereas private equity paid on average over 9x EBITDA for this collection of businesses, we can buy these stocks today in the public markets for only 7x EBITDA.
I bet that an equal weighted portfolio of these five stocks will outperform the Cambridge Associates private equity benchmark for 2016 vintage private equity funds. I am willing to take this bet because these firms are significantly cheaper on average than private equity deals, which transacted at 11x EBITDA on average in 2015, and investors in this portfolio will not bear the 6% average fee load of private equity. I have included a summary of the financials of this portfolio as well as a short description of each stock. The biggest drawback of this sample is that it's too few companies and not diversified enough - I run my own portfolio with substantially more names - but this is a helpful sample of the broader set.
Orion Engineered Carbons (OEC)
Rhone Capital bought Orion in 2011 for 6.9x EBITDA, Today, you can buy Orion for 7.2x EBITDA. The business has deleveraged from 5.8x EBITDA to 2.9x EBITDA since the acquisition, while EBITDA has grown from 130M to 204M. For the same multiple, we get a bigger business that has a track record of deleveraging. Rhone remains the largest shareholder with a significant board presence.
La Quinta (LQ)
In the heady days of pre-crisis real estate deals, Blackstone Real Estate Partners bought La Quinta for 14.2x EBITDA, using 12x EBITDA of debt (you read that correctly). The total purchase price was almost $3.4B. Today, you can buy La Quinta for less than $3.2B, even though the company now generates 55% more EBITDA and has deleveraged from 12x to 4x EBITDA. Blackstone remains the largest shareholder with a significant board presence.
Metaldyne Performance Group (MPG)
American Securities combined HHI, Grede, and Metaldyne through a series of transactions between 2012 and 2014. The combined purchase price was about 5x EBITDA. Today, you can buy the combined company for 5.6x EBITDA. The business is still 62% leveraged and the synergies from the deal remain on the horizon. American Securities remains the largest shareholder with a significant board presence.
Tallink (TAL1T)
CVC International made a PIPE into Tallink, an Estonian ferry company, in 2012, at an entry price of 9.9x EBITDA. The total enterprise value was then almost 1.6B euros. Today, Tallink’s enterprise value is down to 1.1B euros, a 6x EBITDA multiple. EBITDA has grown 15% while the company has deleveraged from 5.2x EBITDA to 2.6x EBITDA. CVC International remains a large shareholder and board presence.
West Corporation (WSTC)
TH Lee and Quadrangle bought West Corporation for over 9x EBITDA in 2006 at the peak of the private equity bubble. The company now trades at less than 8x EBITDA, despite having grown EBITDA 66%. The company maintains a 5x leverage ratio. TH Lee remains the largest shareholder and a board presence.