Capital markets are on the move!

Not a racy headline for a red top but of some import to folk who are investing their own or other people’s money. A lot has happened on the debt side since 2009 and a lot too on the equity side and, in particular, the rise and rise and rise of private equity. Private equity capital is going from being an alternative asset class to mainstream. This is not a bad thing at all, but it is a thing and means that in thinking what the future holds for private equity, we should not just study what has happened thus far.

At the sharp end, we see companies being sold from one private equity sponsor to another to another. First, we had secondary buyouts, then tertiary. I recently saw a quinary buyout. And in the VC and tech space, we see companies taking much longer to get to IPO. There are more companies spending longer in private ownership than before. What we are witnessing, stepping back from the frontline, is a steadily increasing share of the productive economy being equity financed by private equity sponsors. The public equity market, the other source of equity financing, is relatively providing less of the economy’s equity capital.

But has the money changed? Well, no, not really. The vast majority of the capital being intermediated through equity markets, private or public, is the accumulated surpluses of sovereigns, pension funds, insurance floats and corporate balance sheets. The owners, managers and trustees of these pools are simply choosing, at the margin, to own more of their business assets through private equity sponsors than through active stock pickers or ETFs.

Why is this? For some companies, particularly those that are smaller or undergoing great change, being owned by private equity is a better ownership model than the public equity market. Private equity sponsors exercise their governance powers better, they decide more quickly and are able to supply additional capital more quickly. It does not eliminate the principal-agent problem, it just changes it. In public equity markets, it is between institutions and their stock pickers and the company management. In private equity markets, it is between the private equity sponsor and the limited partner.

The irony is that, whilst institutions are embracing risk and illiquidity in private markets, they are eschewing it in public ones. A company that misses its quarterly target is punished. Institutions, particularly those with defined liabilities, really want bonds but cannot resist the siren call of equities. Their solution? They pretend equities are bonds with regular steady earnings and dividends and get frustrated when equity risk rears its head.

In addition, they have, over the years, put pressure on regulators to make public equities safe for institutions, to make public equities more like bonds. This has had many effects but let me highlight two that are tail winds to the private equity flotilla. One is that it is now very hard for smaller companies to access public equity to grow. What private equity sponsors do so well is to provide equity capital in a disciplined fashion for roll-ups, roll-outs, platforms – all the tools that get small companies to be medium-sized ones. Public markets do not.

Private equity has its limits. Outside particular regions of the US and Europe in particular sectors, private equity sponsors are not providers of very risk tolerant capital. This is really the role (and duty) of wealthy families. I digress, but the most compelling argument for wealth inequality is the provision of true risk capital, the “it might go to zero” risk capital. You have to own great wealth to be able to stomach that “go to zero” risk.

Another curious unintended consequence of the regulation of public equity markets is that they are full of orphaned listed companies: orphaned in the sense that there is no active guardian or parent. The company is not big enough for institutions really to care. Sell-side brokerage research is much reduced. The historic solution of a controlling family keeping it honest is less fashionable. It is easy in these circumstances to blame management. Maybe. But ask yourself, with whom can they have a strategic debate? It is no good asking their owners what they want because there is no one to answer if, indeed, there is any answer.

So, private equity is our current best answer to the question of how you most efficiently recycle financial surpluses to certain sectors of the economy. So does it just go on rising and rising? Our guess is yes, with a blip and a but! The blip is that sponsors are paying very high prices for assets. In the olden days, sponsors would buy companies at a discount to their long-term public market valuation. They are now sometimes paying a premium. This will unwind when we have a downturn.

Thereafter, if public equity markets reset to a new lower base, the huge reservoir of uncalled commitments can be released onto the fertile lowlands of the productive economy. The but is that the rules of the games have changed. When private equity was financed by rich families with “it might go to zero” risk capital, losses were borne with annoyance and disappointment, I am sure, but with no appeal to regulators, or, at least not one that would meet with any sympathy.

Not true now: if the blip above is more of a shuddering bump, pensions payouts will shrink, widows and orphans will suffer, and, worst of all, become a charge on the public purse. If this happens, regulation will follow. You cannot simultaneously be a niche alternative asset class and be buying large companies employing large workforces and owning national brands.

This is not to say private equity is not a good ownership model. It is. But it is to say the future of private equity will not be a repeat of its past. Past performance will truly be no guide to future performance.

In the 1980s, property developer Robert Campeau embarked on a bidding war for the New York retail group that owned Bloomingdales and ended up winning the deal but at $600m more than it was worth. The Wall Street Journal noted that “we’re not dealing in price any more but egos”. Campeau filed for bankruptcy shortly afterwards.

When ego enters the process it can be difficult to change course and this is one cause of the phenomenon known in behavioural science as escalation of commitment – a pattern of human behaviour whereby individuals or groups receive increasingly negative feedback about a decision but continue on the path to destruction nonetheless.

Other psychological phenomena that lead to poor decision-making include the sunk-cost fallacy in which decision-makers oblige themselves to go ahead with a project because they have already spent money on it even if it no longer makes economic sense.

And then there’s the emotional cost of reversing a course of action, particularly if relationships have been forged along the way and a degree of social identity is wrapped up in the outcome.

Investors are just as vulnerable to these behavioural missteps as anyone else, and until we take the human entirely out of the process and replace ourselves with robots, all we can do is create systems that reduce the potential for these behaviours.

Family offices and investment offices are both places for decision-making so it is worthwhile ensuring that good decision-making can flourish therein. Some of the rules are simple:

• Be alert to financial incentives for completing on decisions and where possible, replace these with financial incentives for engaging collaboratively in discussion with colleagues.
• Find ways to reward the team for not investing. A decision not to invest is as valuable as a decision to invest.
• Break the decision down into parts and evaluate those parts separately. Allowing the decision to become cumulative makes it harder to back out, even if the signs at the end of the process are flashing red.
• Keep ego out of the room.

As Robert Campeau found, escalation of commitment is a classic error in investing. He managed not only to bankrupt himself but also to bankrupt 250 department stores in the process. Careful investors can learn from his mistakes.

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