Following is a letter sent to the Editor of the Financial Times:
Sir,
I write to try to help out Michael Gordon in his attempt to understand the success of private equity funds (¨Am I alone in struggling to make sense of private equity's appeal?¨ Financial Times, January 30, 2007).
Let us remember that these funds buy (overpay?) companies, often against companies in the same sector and, after a couple years or less of private equity magic, they sell them back, either to the very same companies originally outbid or, through an IPO, to the shareholders of these very same companies, to investors similar to Fidelity, all at much higher prices!
Private equity funds have attracted attention because, by following this strategy, they have generated returns significantly above market returns for many years. Agreed that they invest in the same business and so do not diversify and agreed that they use much more debt (why not?). Also, investors need to be careful with the new entrants, including those new hedge funds that now want to play in this market, who lack the track record and particularly the experience in down markets.
Nevertheless, the private equity way of doing it is clearly superior as compared to the leisurely way company managements have historically acted to give investors market returns, at best.
Onésimo Alvarez-Moro
See article:
Sir, I have been following your newspaper's commentary on the growth of the private equity sector closely, but the report by Peter Smith (January 26) that the industry is set to raise $500bn in 2007 has stirred me to write this letter.
It's fair to say that the private equity groups have done a great job in persuading investors that they should classify their funds as a distinct asset class. Institutions can thus assign a portion of their money to private equity in the belief that they are managing risk through diversification.
But let us be clear what investors are actually buying here. In many instances, they are simply investing in the same companies that they formerly held as listed groups. Performance over time will be driven by the same factors: earnings growth, cost management and so on. The difference is leverage. Strip out the leverage and the correlation with quoted equities is tight.
Yet it is on the basis of this leverage that private equity houses justify their fees. Leverage should not automatically command premium fees. It would be worthwhile recalling what happened to investors caught up in the junk bonds fiasco of the late 1980s and how painful that was for many.
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