How You Can Crush the Market with Private Equity

[dollar bills]

Tom Wolfe popularized the phrase “Masters of the Universe” in his 1987 classic, “The Bonfire of the Vanities.” Back then, “Masters of the Universe” were Wall Street bond traders, for whom making only $500,000 by the age of 30 “had a taint of mediocre.” In the 1990s, “the Yale men, and the Harvard men, and the Stanford men” moved to hedge funds. And if Wolfe were writing his book today, the “Masters of the Universe” all would be working at private-equity firms.

After getting pummeled more than most in the market meltdown of 2008, private-equity investing is back in vogue. Thanks to a combination of low interest rates, cash-rich corporate balance sheets and growing investor appetite for risk, private-equity funds have been shooting the lights out.

Of course, as a retail investor, you can’t invest directly in a private-equity fund at the click of a mouse. You can, however, invest in the firms that run them.

Starting a few years ago, several of these formerly secretive limited partnerships, including Blackstone Group (NYSE:BX), Kohlberg Kravis & Co. (NYSE:KKR) and The Carlyle Group (NASDAQ:CG), opened themselves up to the scrutiny of becoming publicly traded entities. According to Private Equity International’s annual ranking based on the amount of private-equity direct-investment capital raised by each firm in the preceding five years, only a single firm — privately held TPG — is bigger than the publicly traded “Big Three.” (By way of comparison, Mitt Romney’s infamous Bain Capital ranks #9 on this list.)

Private-equity firms go public for obvious reasons: The partners want to cash out, only non-controlling stakes are sold and it’s a cheap source of capital.

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And as an investor, there are some caveats, to be sure.

When you invest in these publicly traded entities, you are not actually investing “alongside” the partners. Any money raised is given to the partners to invest as they see fit. Nor are these firms even exclusively managing private equity anymore. Today, many have even bigger “public equity” investment-management businesses as well.

Finally, skeptics point out that private-equity firms sell themselves to “dumb money” at the market top. Private-equity firms’s stock prices are reputed to peak on their first day of trading, never to see those levels again.

Except that’s not quite true. Sure the private-equity partners are taking their pound of flesh. But they also leave enough crumbs on the table for mom-and-pop investors to share in the wealth. Over the past few years — admittedly a bull market — the returns in the publicly traded stock of many of these private-equity firms have absolutely trounced the S&P 500.

Blackstone Group LP (BX)

No private-equity firm got its market timing better than Blackstone. It went public in June of 2007, as Merrill Lynch CEO Chuck Prince was “still dancing” just before the Bear Stearns bankruptcy stopped the music. Blackstone also has the distinction of being the most embarrassing investment for China’s newly minted sovereign wealth fund, China Investment Corporation (CIC). The then-new fund bought a non-voting stake of less than 10% in May 2007 — although at a 4.5% discount to the firm’s $31 initial public offering (IPO) price, only to see the share price tumble to a low of $3.00 in February of 2009.

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Although Blackstone today still trades below its IPO price, its track record over the past five years tops all of its publicly traded rivals. For example, Hilton Worldwide’s upcoming initial public offering is expected to raise up to $2.37 billion in the biggest-ever hotel IPO, more than doubling Blackstone’s initial investment.
According to Morningstar, Blackstone has generated total annual return of 38.67% over five years; 33.34% over three years, and it’s up 89.93% year to date.

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Blackstone vs. the S&P 500

Kohlberg Kravis Roberts & Co. L.P. (KKR)

Thanks in part to the 1990 bestseller, “Barbarians at the Gate,” Kohlberg Kravis Roberts & Co. (KKR) probably has the highest name recognition among private-equity firms that prefer to shun the limelight.

After years of complex legal structuring that surely helped keep KKR’s lawyers firmly ensconced in their Park Avenue apartments, KKR finally listed its shares through KKR & Co., an affiliate that holds 30% of the firm’s ownership equity, in October of 2009. KKR’s shares began trading on the New York Stock Exchange on July 15, 2010.

Although investors have had to endure white-knuckle drawdowns in the stock, according to Morningstar, the firm has generated a total annual return of 28.13% over three years, and it is up 67.04% year to date.

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KKR vs. the S&P 500

The Carlyle Group LP (CG)

The Carlyle Group LP is the most recent addition to the holy trio of publicly traded private-equity firms, having gone public only in May of 2012. With a market cap of only $1.6 billion and one-tenth the size of Blackstone, it is also by far the smallest.

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In the past, the Carlyle Group has invested in and exited from high-profile investments like Kinder Morgan (KMI), Dunkin’ Brands (DNKN) and Hertz Global Holdings (HTZ).

In the midst of the best year for private-equity firms in recent memory, the Carlyle Group has been the weakest performer among the big three. Although it has outperformed the S&P 500 since it went public with a gain of 51.99%, the firm has lagged the broader S&P 500 this year with a gain of 22.74%.

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Carlyle Group vs. the S&P 500

In case you missed it, I encourage you to read my e-letter article from last week about the smart-beta investing opportunity. I also invite you to comment about my column in the space provided below.

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Joining me this week on PowerTalk is Peter Schiff, investment broker and financial commentator, as well as the CEO and chief global strategist of Euro Pacific Capital Inc. He is not shy about his views, and that always makes for a great conversation.

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