I just spent the last week at Oxford University’s Said School of Business on its popular week-long Private Equity Program for senior executives.
Say the word Oxford, and it conjures up images of a city of dreamy spires and ancient college courtyards. Yet if you squint your eyes on a rare sunny day in Oxford, the Said Business School campus looks more like Stanford University’s Business School in Silicon Valley than a medieval college situated on an 800-year-old university campus.
That’s because Oxford Said is a very new school in a very old university. Even the establishment of Said back in the 1990s was controversial, as the dons of Oxford questioned whether business was a worthy topic of study.
Fast forward 20 years, Oxford Said today is a thriving commercial venture led by former Harvard Business School professor Peter Tufano. Its halls are literally overflowing with students and executives from around the world bathing themselves in the reflected glory of the global Oxford brand. The executive education programs are held in a building appropriately named after Margaret Thatcher — even as Thatcher’s alma mater, Somerville College, originally a women’s school at Oxford College, refused to give her an honorary degree because the Oxford dons protested her cuts to higher education.
Thatcher Business Education Centre, Oxford Said School of Business
Although Oxford is a newcomer on the global business school scene, it’s hard to imagine a more geographically diverse group of students among a class of 30. On my right sat an auditor from a sovereign wealth fund in Oman; on my left was a pension fund manager from Ghana; and across the classroom were a snarky app developer and private investor from Portland, Oregon, who regaled the class daily with his varied choice of iconoclastic headgear.
Private Equity in Perspective
Oxford’s Private Equity Program is led by Professor Tim Jenkinson, a spritely, athletic and affable sixty-something former rower, who teaches students private equity as far afield as India, China and Silicon Valley.
Private equity, as Jenkinson defines it, includes venture capital, growth capital, leveraged buyouts and turnarounds.
However you define it, private equity — “capitalism on steroids” — does have an image problem. In the U.K. press, private equity is often synonymous with greed. U.S. investors still recall Oliver Stone’s 1987 film Wall Street, which told the story of a hostile takeover of Bluestar, which many regard — rightly or wrongly — as a quintessential private equity transaction.
Stripped to its essence, leveraged buyouts (“LBO”) — the most popular form of private equity transaction — are simply a way of financing an acquisition of a company with its own steady and predictable cash flows until the company can be restructured and sold at a large profit.
As ruthless as that sounds to the uninitiated, this is a perfectly rational strategy. Through the lens of private equity, many publicly traded companies are under-leveraged, and they leave a lot of money on the table — especially in an era of low interest rates.
And as it turns out, private equity investors are pretty good at showing their investors the money. That’s also why the Oxford endowment — whose deputy Chief Investment Officer, Jack Edmondson, spoke at the program — has allocated 20% of its funds to private equity, thereby closely mimicking the asset allocation strategy of the highly regarded Yale endowment.
Calculating Private Equity Returns
Private equity is all about the numbers. And in terms of headline returns, the asset class is impressive. Yet as it turns out, this has much to do with the dark arts of how investment returns in private equity are calculated.
Private equity calculates returns (and fees) on an Internal Rate of Return (IRR) basis, rather than “time-weighted return. The latter is the method you are more likely to see in your mutual fund or exchange-traded fund (ETF).
But there are good reasons for private equity to use IRR. After all, private equity involves constantly flipping deals and funds are never fully invested, as they are in, say, ETFs.
Still, some rates of return can be staggering — and deceptive.
That’s why the Yale University endowment caused such a stir when it recently revealed that its return on venture capital deals (a subset of private equity) had been an astonishing 92.7% over the past 20 years. Had Yale achieved that rate of return on its entire endowment of $4.86 billion starting in 1996, the endowment would be worth $2,422,537,000,000,000 — or 8x more than the $300 trillion of the entire value of financial assets across the globe today.
But if you use time-weighted returns, Yale’s venture capital portfolio’s 20-year return drops rather dramatically to 32.3%. And once you exclude the dotcom boom by looking only at the last 10 years, even the IRR drops to 18%. That’s still impressive. But at least it’s believable.
Trends in the World of Private Equity
Here are three major insights about private equity I took away from the week.
First, academic studies confirm that private equity investments do make more money for investors. While the managements of publicly traded companies are “fat and happy” and today spend the bulk of their time on compliance and investor communications, the board members of private companies not only have skin in the game, but also have the time and energy to focus on improving the business. Combine that with leverage, and the returns ramp up fast.
Second, private equity is still in its infancy. Average allocations among funds is 4%, while most are targeting twice that level. Sovereign wealth funds — say Norway with its $875 trillion — alone could have a major impact on the asset class. Private equity is also emerging as the favored approach in fast-growing emerging markets. Perhaps that explains why one-third of the Oxford class was made up of students from Africa, Latin America and Eastern Europe.
Third, private equity is becoming a victim of its own success. As with any popular asset class, too much money is chasing too few deals. That means returns to investors — “LPs” or limited partners in private equity jargon — are falling precipitously.
Finally, here’s what worried me most: Private equity is now the number one career choice for newly graduating Oxford MBAs. That trend ruffles my contrarian feathers.
Playing the Private Equity Game
So can you be a player in the private equity game?
The short answer is: “Not really.”
Investors — the LPs — in private equity are almost exclusively pension funds, endowments and some family offices.
But there are a few indirect ways you can gain exposure to the private equity game — though they are unlikely to yield the same type of returns.
PowerShares Global Listed Private Equity ETF (PSP) is an ETF that invests in many of the private equity management companies that back deals, including those funded by business development companies (“BDCs”), by master limited partnerships (“MLPs”) and by other vehicles.
In terms of investment strategies, “activist investing” is a close cousin of private equity. In that space, there are a handful of publicly traded vehicles including Carl Icahn’s investment partnership, Icahn Investment Partners (IEP), and Bill Ackman’s Pershing Square Holdings, Ltd. (PSHZF), which also trades OTC in the United States.
Finally, a new Global X Guru Activist Index ETF (ACTX), launched on April 29, tracks the investments of 50 of the largest and most successful activist investors. Six of Icahn Enterprises’ top 10 positions are included, such as Apple and eBay. More than half of Bill Ackman’s Pershing Square Capital Management’s holdings are represented and include Zoetis and Canadian Pacific Railway.
In case you missed it, I encourage you to read my e-letter column from last week about the best-performing income ETFs in 2016. I also invite you to comment in the space provided below.