Barron’s | A Lender Be to Private Equity

By January 31, 2012In The News

These are not the best of times for private equity. The campaign for the Republican presidential nomination by former Bain Capital head Mitt Romney has shone an uncomfortable light on a business that always has been, well, private.

Not the least on its favorable tax status from the so-called carried interest provision. That’s meant most private-equity executives pay only the 15% capital-gains tax rate on what would otherwise be ordinary income to ordinary folks, which would mean a cut upwards as high as 35%.

There’s been no small amount of consternation among critics of the practice, even extending to that notorious. lefty bomb-thrower, Rupert Murdoch (who, for all the Martian readers of this column, is the chief executive of News Corp., the parent company of the publisher of Barrons.com.) “Time both parties stopped selling out to Wall Street,” he recently Tweeted on the topic of carried interest. Meanwhile, Sen. Chuck Schumer, the New York Democrat who’s an otherwise resident in good standing in the People’s Republic of Park Slope (the trendy enclave that stands apart from most of the rest of Brooklyn), has staunchly defended the carried-interest “loophole,” as Murdoch calls it.

But tax brouhaha hasn’t seemed to hurt Romney in Florida, who looks likely to win the state’s GOP primary by a hefty margin, unlike the double-digit trouncing he took in South Carolina from former House Speaker Newt Gingrich. Florida, however, is different; it’s a tax haven for rich folks who are attracted by more than the sun and beaches. There’s no personal income tax and Florida got rid of its “intangibles” tax on stocks, bonds and other investments in 2007. And there’s no state estate tax, either. Maybe wealthy, tax-averse Florida Republicans are less troubled by Romney’s tax status?

As for private equity, the real problem is that it’s no longer the sure path to riches that its fans think. Indeed, in the quest by institutions such as pension funds and endowments for returns that are a distant memory in an investment world where the Federal Reserve has pinned interest rates at nearly zero, they have poured billions into so-called alternative investments. In the process, they have driven up prices to the point that returns are likely to be low.

The best returns from private equity, in fact, may not come from the equity but from investing in the debt used to finance their deals. Buying high-yield bonds that fund leveraged buyouts may provide higher returns than the LBOs themselves, especially when the relative risks are considered. And if an investor uses the cheap money from the Fed to lever an investment in the LBO debt, the risk-adjusted returns from the high-yield bonds appear better than the payoff from the equity.

That’s the view from Highland Capital Management, a Dallas money manager specializing in credit strategies with $23 billion under management. Returns from private equity depend on the timing, the price and the manager, according to the firm. But the time to earn outsized returns from large-capitalization PE funds may have passed, according to its January newsletter.

Assets bought at fire-sale prices generate big returns, and vice versa. When too much money is chasing too few good deals — as when the markets were awash with liquidity in 2005-07 — returns end up being poor. Highland points out the multiples of invested capital to cash flows now are even higher than the 2007 peak.

Investment returns are apt to be low as a result. PE has some $937 billion in “dry powder” to be invested, which drives up the price of deals and, in turn, drives down future returns. The firm also contends high U.S. debt levels will lead to higher taxes, including a value-added tax, to avoid the fate of Greece. That would mean slow growth and low returns.

The best returns will likely come from the debt securities issued to finance these deals, says Highland. Bank loans and high-yield bonds have cheapened in price (resulting in higher yields) because of technical reasons. “This is particularly true for large LBO-backed debt, which currently trades at a blended spread of 788 basis points [7.88 percentage points over comparable Treasury securities], approximately 160 basis points wider than the broader loan and high-yield markets,” according to the note…

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