The Rise of Private Equity

Illustration by David Foldvari.

That street vendor hawking Japanese-style hot dogs in front of your office tower—you know, the one with the lineup snaking down the block every lunch hour. That place on Main Street that’s been selling carpet since forever. That multi-billion-dollar conglomerate that’s into everything from automotive retailing to radio broadcasting to apple juice. They all have something in common: they’re all privately owned. And they’re all making money hand over fist.

While the financial press remains largely focused on the companies that collectively make up the stock market, the bulk of the business that goes on in this world is conducted by companies that are privately owned—by the entrepreneurs who founded them, by families that inherit them, by partnership groups that manage them, and sometimes by all three. These “private equity” companies are under no obligation to publish their revenue or profit figures. Nor do they trade on an exchange. They just go about the business of making money, for the most part coolly and soberly, far from the madding crowd of traders, analysts, and pundits that make up the Wall Street hype machine.

How much money, you ask? Hard to say—one of the benefits of being privately owned is that you can keep the company books to yourself. But somebody must be getting rich. Why else would pension funds, university endowments, and the ultra-wealthy have more than $2-trillion (yes, with a t) in the private equity game as of March of last year? Why else would the number of professional fund managers pursuing private equity deals expand from a few dozen in the early 1980s to more than 4,500 today? Why else would the venture capital side of private equity move from the back page of the financial section to prime-time reality television from Britain to Japan to Nigeria?

What data that does exist seems to suggest that private equity is an excellent place for the portfolio to be. The Cambridge Associates LLC U.S. Private Equity Index tracks the performance of more than 5,000 “institutional-quality” private equity partnerships, comprising more than 65,000 individual company investments. As of September 30 of last year (the most recent data available), the index has returned an impressive 13.71 per cent annually. Compare that with the 8.01 per cent the broad-based S&P 500 index has posted over the same time frame.

Short of setting up your very own hot-dog stand, is there a way for you, Mr. or Ms. Average Canadian Investor, to get a seat at the private equity table? And if so, is it worth the risk? In a world of angels, sharks, and dragons all pursuing private equity deals, does it make sense for the little guy to do the same?

It’s Just Business

Tom Kennedy wants you to know that he’s in the business-transformation business. Sure, in the 30-plus years since he’s been at the private equity table, the founder and managing director of Kensington Capital Partners has made plenty of deals. He’s sold dozens, perhaps hundreds, of businesses, and made a good deal of profit for himself and his investors. But the whole corporate raider thing—that’s really not him.

“People come into our office and are amazed at how quiet it is,” he says with his characteristically deadpan delivery. “They’re expecting it to be like a trading floor—they’re expecting all kinds of deals going on. There are deals going on—it’s just that they take six to eight months to put together, and most of that time is spent with your nose down doing a lot of research on people, on companies, on competitors, on products. It’s pretty quiet stuff.”

In this respect, Kennedy’s job is closer to a management consultant or a number-crunching MBA than it is to a boiler-room deal maker. Sure, the stakes are high. But the drama isn’t. “The key attribute of successful private equity investors is their ability to identify and execute a business strategy that really improves the value of the company,” Kennedy says. “The vast majority of our time is spent assessing a business and trying to assess the quality of management, and trying to come up with a strategy to take the business and the management, and double or triple the revenue on it.”

Another misconception: that private equity is synonymous with the high-risk, high-return scenarios of Dragons’ Den. Although Kennedy has had past success with start-ups and IPOs (his participation in one of the early financing rounds for Pandora Internet Radio returned 10 to 12 times his initial investment), the vast majority of his purchases are—to put it plainly—considerably more boring.

“The business of selling a company for four or five times what you invest in it, and the IPO process and those kind of things—people like to read about them,” he says. “That tends to occupy more press than a three-day strategy session with a bunch of executives locked in a meeting room coming up with a game plan to penetrate the European market. It’s not very newsworthy, but it actually does create quite a bit of value.”

Obviously, such strategy takes time to execute. Which is why the phrase “quick flip” isn’t in Kennedy’s lexicon. “What we’re trying to do is to buy a company and do something different with it,” he explains. “We’re trying to change its attributes, change its revenue line and growth opportunities.”

Example: A Canadian subsidiary that’s never been allowed to compete with its American parent. Or a successful manufacturing business that’s 80-year-old owner hasn’t bothered to expand into China. Or maybe a European multinational that decides to shed its non-core North American operation. These are the types of scenarios Kennedy and his team look for, seeking to add value by exploiting an opportunity that current management has overlooked.

“While a private equity fund owns [a] company, it should be in a [state] of change,” he says. “It should be going through a growth period, and when it gets finished with that growth period, the private equity firm is probably wise to sell it to a bigger company that isn’t in the business of buying a company, changing it, and making it bigger—but they’d sure like to own that product once it’s got a dominant market share somewhere.”

Needless to say, such an approach can work well for investors. But it can work for managers as well. By taking a company private, Kennedy eliminates the burden of producing quarterly earnings reports, conducting analyst interviews, managing public perceptions, and complying with public regulations, leaving managers free to do what they do best: build the business.

“We [bring in] a lot of people who have been senior executives in public companies,” Kennedy says. “It’s a breath of fresh air to them. It’s so invigorating to them to have three shareholders instead of 3,000 shareholders. No analysts—the shareholders are their board members, and the board is only five people in total, including the CEO.”

Buying Private

Should the “average” investor be interested in private equity? To Kennedy, that’s an easy question to answer: if the plan is to make money, private equity needs to be a part of the plan. “The private equity market is four, five times bigger than the public equity market,” he points out. Investors who ignore private equity are in effect ignoring the vast majority of investment opportunities that exist. “I don’t understand why you’d ignore 80 per cent of the market. It’s that simple.”

Kennedy says the exact form of that investment can vary. Those with deep pockets can often invest in businesses directly—either through outright purchase or by becoming angel investors. Those looking for more diversification can team up with professional managers through pooled private equity funds. Such funds often limit access to accredited investors who must pass federally mandated criteria for either income or net worth. For those with more modest portfolios, a number of mutual funds and ETFs offer some degree of exposure to the space.

Regardless of the form, the mindset of the private equity investor should remain constant: “[It’s] similar to a Buffett-style buy-well-and-hold attitude,” Kennedy says. Sure, investors could approximate a private equity trading strategy by jumping in and out of private equity fund managers—say, Onex Corporation in Canada, or the Blackstone Group in the United States. But even here Kennedy suggests caution. “I don’t think there’d be much advantage in that, because [the company’s] assets are very long-term holds.”

While Kennedy is reluctant to declare now the “perfect” time to invest in private equity, he acknowledges that the investment climate is positive. “All of the characteristics around buying a private company are in pretty good shape,” he says. “We can negotiate terms with the vendor that are sensible terms. The banks are open for business and the cost of money is stable and low. Usually when you can buy on reasonable terms, if you can execute a game plan to build the business well, you should do pretty well.”

As for specific opportunities, Kennedy is understandably tight-lipped about potential targets. Still, he identifies several broader themes that his team is interested in. “One that we’ve been having some success with is the ‘rebuilding’ of North America,” he says. “There’s a tremendous need for infrastructure investment in most developed economies. Our roads, our pipelines, our power systems, bridges—they all need to be either replaced or repaired, or new ones need to be built as our population grows.”

Such investments place him at the front line of another theme: the renaissance of the North American manufacturing industry. “A lot of manufacturing has been offshored over the past 10 to 15 years—to Mexico, to Asia,” Kennedy notes. “And a fair amount of it is coming back. Partly because local demand in those markets is chewing up capacity, and partly because there are shipping and quality issues that need to be addressed.”

As Kennedy explains, for well-run, privately held companies that make specialized equipment in industries where precision and quality matter more than cost, this is truly the best of times. “There are tremendous opportunities there.”