Private Equity Run Amok

We launched Verdad in 2014 based on a simple observation: private equity’s historical success in the 1980s and 1990s came from holding small, cheap, levered companies that were paying down debt. But as more money flooded into private equity in the 2000s, it became harder for PE firms to buy companies at deep discounts to public markets. Today, the average private equity company is bought at 12x EV/EBITDA, which is in line with the S&P 500. At Verdad, we buy public companies that trade at a 50% discount to those valuations, with an average valuation of 6x EV/EBITDA across our portfolios in the United States and Europe.

Buying leveraged companies at a discount is crucial because leverage is a double-edged sword that amplifies return outcomes (both good and bad). When leverage is used to buy cheap companies, there is a low ratio between debt and earnings. This provides headroom against economic shocks and reflects a prudent approach to minimizing bankruptcy risk (analogous to why bankers set mortgage levels in relation to a person’s income). In Verdad’s case, the low valuations of our companies at 6x EV/EBITDA translate to a manageable debt-to-income ratio of 3x Debt/EBITDA.

On the other hand, the high valuations in private equity translate to an average debt-to-income ratio of 6x Debt/EBITDA. The Federal Reserve considers corporate leverage above 6x Debt/EBITDA to be excessive, and about half of private equity companies now exceed that threshold. Much of private equity today looks like approving mortgages for middle-income families to buy second homes in the Hamptons.

Figure 1: Valuations – Verdad vs. Private Equity (September 2019)

Sources: Capital IQ and Pitchbook. Private equity data is as of June 30, 2019.

It’s important to note that the true debt burden for private equity companies is likely to be worse than what’s reflected in the figure above. That’s because many private equity deals are valued on Adjusted EBITDA (as opposed to the standard approach of using actual EBITDA over the past 12 months, like we do in our portfolios). Adjustments to EBITDA help private equity firms to sell their deals; just as some men exaggerate about their height in online dating apps.

These adjustments tend to overstate EBITDA by around 30%, as an S&P study found when comparing the actual EBITDA of private equity companies in 2016 and 2017 against the PE firms’ own projections in 2015. The 30% difference is not the result of random forecast errors (otherwise the mistakes would average to zero). Nor is the 30% shortfall in actual EBITDA due to a slowing economy (US GDP grew by 1.6% in 2016 and 2.3% in 2017). So we’re left to conclude that private equity firms tend to exaggerate Adjusted EBITDA in order to close their deals.

Figure 2: Actual EBITDA of Private Equity Companies vs. 2015 Projections

Source: S&P Global (September 2018).

Credit rating agencies seem to agree with this argument, as evidenced by the fact that credit ratings of Verdad’s portfolio companies are significantly higher than private equity. Below, we map the credit rating of every US and European company in Verdad’s portfolio that has public debt. Our analysis focuses on the US and Europe because those are the primary markets for private equity. 60% of our US and European companies have public debt. The remaining 40% of companies without public debt are smaller in size, but they have identical valuation and leverage characteristics. Specifically, they trade at an average valuation of 6x EV/EBITDA and have an average debt-to-income ratio of 3x Debt/EBITDA.

The distribution of credit ratings for the 60% of our companies with public debt is displayed below. Of these companies, 89% are rated BBB or BB. As we have written before, these ratings bands offer the highest returns within corporate credit because of a combination of high yields and low default rates.

The credit ratings of our portfolio are systematically higher than private equity, where 98% of bond issuance is rated B or below.  

Figure 3: Credit Ratings – Verdad vs. Private Equity (September 2019)

Sources: Moody’s and Capital IQ. Private equity data is as of May 1, 2019.

Importantly, the higher credit ratings of our portfolio should mean substantially lower default risk. Based on historical evidence since 1920 from Moody’s, our portfolio has significantly less exposure to default risk than private equity and other issuers of high-yield credit. Indeed, a separate academic study that tracked private equity buyouts between 1980 and 2016 found that 20% of those PE companies went bankrupt, which is in line with the 21% estimate shown below based on Moody’s data.

Figure 4: Default Risk – Verdad vs. Private Equity (September 2019)

Sources: Moody’s and Capital IQ. Private equity and Non-PE High Yield data is as of May 1, 2019.

We regularly prune our portfolio of companies whose credit statistics have deteriorated, which is much more difficult in illiquid private markets. Managing the risks we can control—like limiting exposure to default probability—is important because this enables us to remain invested over the long haul. As illustrated in the table below, our portfolio is well positioned to capture the premiums associated with small value stocks. And we expect these premiums to be amplified by a continuous process of deleveraging among our portfolio companies.

Figure 5: Verdad Portfolio Statistics (September 2019)

Sources: Capital IQ and Verdad research. Includes all US and European companies in Verdad’s portfolio.

We buy our companies at a 50% discount to private equity, and based on long-term historical evidence, we end up with a portfolio that has about 1/3rd the bankruptcy risk. We don’t understand why the hottest thing in institutional money management is allocating to leveraged micro-cap growth stocks subordinated to CCC and B debt when better alternatives exist.

Over the three years to March 31, 2019 (the most recent data available), the Cambridge Associates US Private Equity Index returned 15.9% per annum, while the Verdad Leveraged Company Fund returned 20.1%. We look forward to the years ahead in anticipation of further validation of our core thesis.