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The logic of private equity, there's more to it than you think

-Donal Curtin

Tuesday 22nd May 2007

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Suppose a financial backer came to you and said, "You're a smart chap. Here, have an unlimited amount of US dollars, and I'll only charge you 5% interest on them. Now go out and invest the money". What would you do?

You'd find, for a start, it would pay you to buy up a large proportion of the world's listed companies. Any company on a price-to-earnings ratio of less than 20 would be in your sights. That's because if you turn the p/e ratio upside down and get the e/p ratio, any company with a p/e ratio of under 20 must have an earnings yield (the e/p ratio) of more than 5%. So you're earning more than 5%, and paying only 5%: nirvana.

Unrealistic? Not really. The US government borrows ten-year money these days at 4.6% and as a well-regarded private equity investor you won't pay a lot more than that. And even if your bidding drives up the price of your target companies, you'll still come out ahead on a lot of deals. Find a company on a p/e of 15, offer a 20% premium, and you'll still be well in the money.

In some markets it's going to work better than that. It won't cost you 5% to raise your money in euros, and a lot less than that to raise your money in yen. You'll pay something more than the 1.6% the Japanese government pays for ten-year money, but it's still going to be cheap financing. Even if you are conservative on the exchange rate risk, and only buy Japanese companies with your yen, and European companies with your euros, it's going to work out even better than it does with US dollars.

It's also helpful that European companies, in particular, are cheap on a p/e basis. The States is getting a bit fished out, with the top 500 companies trading on a p/e of 17.7 (though with the average across all the companies only 17.7, you should still be finding some reasonable opportunities in the cheaper half). But the top 50 companies across Europe are trading on a p/e of only 13.5, and the top 30 German companies are cheaper still, on 12.6.

All of which explains why there's a worldwide boom in private equity takeovers of listed companies, and why it's spread to Australia and little old us.

So it's not necessarily what you thought: the popular image is the hard-faced investment bankers taking a company private, extracting squillions in fees, perpetrating some financial engineering whizzbang, and selling it back to us at twice the price they paid for it (not that we always will, after Feltex). That's going on, of course, but there's more of an underlying logic to it than you might have realised.

If you're not convinced by the financial markets reasoning, macroeconomics will get you to the same answer. This year, the world economy's GDP is likely to grow by around 5% in 'real (that is, after inflation) terms. Contrast that with the 'real' cost of debt, which is only around 2.5% for the major currencies you are likely to be borrowing. So it makes sense to tank up on cheap debt and put it into higher performing equity.

The most alarmist of the propaganda about private equity - that it's driving prices to silly levels and it's typical 'top of the bull market' overexuberance that will end in tears - can't therefore be right. You can think of it as a global arbitrage between the cost of money and the return on it, and it will make real pots of entirely genuine money for every-one involved as long as the arbitrage gap remains open. Ultimately, the earnings yield will come down, bond yields will go up, the window will close, and the game will be over, but we're not there yet.

That's not to say the whole process is riskless for the next wee while. People getting into the game late are finding the best opportunities have been largely picked over, and the profitability of each deal must at some fundamental level be going down over time. And it's possible we're nearer the closing of the window than the players currently realise.

That's because corporate profits are unusually high in some markets, when measured as a percentage of the total economy. I've dug out the American statistics, which on my Datastream database go all the way back to 1950. American corporate profits are, for all practical purposes, at a record high of 12.4% of GDP. They were briefly higher, at the start of the Korean War in 1950, but otherwise they're at a peacetime high.

I don't have the same long-term information on Aussie or Kiwi profits, but what straws in the wind there are, show the same picture. In the September quarter of last year, the latest data, Australian pre-tax corporate profits were 16.8% of Aussie GDP, only slightly lower than the record 17% set in the previous quarter. These data only go back to 1994, but there is a looser profits series called gross operating surplus' which measures all companies, not just the corporates, and which on my database goes back to 1959. And guess what? It's also at an all-time high.

So is there more to this private equity caper than meets the eye? Sure. But anyone joining in the game well into its second half ought to realise they're taking a large bet on companies continuing to gush earnings at an unprecedented rate.

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