Lessons to learn from P.E.

Gym class heroes

a simple cash flow waterfall

Usually with derision, but often with amazement, I frequently describe public markets investors as a desperate group. Desperate for new ideas, desperate for thesis confirmation, desperate for their “stocks to work”, desperate for a remote catalyst to bail them out, a “hate the market, love my stocks” style of investment. To their collective credit, when pricing public securities, this group generally gets to fair value correctly!

It’s hard to know how much of market activity and price-setting is still controlled by this group; with the advent of algorithmic price-setting and the earnings-day price gaps seen in incredibly liquid stocks, it seems like fewer and fewer non-pod shop (a/k/a “multi-manager platforms”) participants exist. Not that any of it matters to the arbitrageur- the goal is still to identify mispriced securities with little attention paid to exactly who is selling them to you and their rationale. And securities rarely stay mispriced long enough for the market to rely strictly on the evaluation of shrewd fundamental analysis. The symptoms have many explanations, so it’s hard to ascribe any one disease to it.

Private Equity Has It Better- Maybe

Private equity’s limited history shows just how well the optimization of business practices can boost returns. The typical DuPont analysis would show that private equity can generally do more with less: take costs out, use fewer assets (tighter terms of trade, working capital releases), use those assets to generate revenues better etc. These assumptions generally rest on the following generalizations about private businesses:

1.) Private SMBs are run as personal piggybanks for founders/CEOs who run unnecessary costs through the business; public company CEOs do this too, but it’s exposed in the proxy for all to see.

2.) Headcount redundancies account for another portion of unnecessary cost in private businesses and can be cut to widen margins.

3.) Managerial/salesmanship skill hasn’t been fully realized because of improper incentive sets. Sales tools aren’t implemented because of training is difficult or simply not done by employees.

4.) Capital structures have not been optimized to the fullest extent possible, brinkmanship tactics haven’t been used with lenders, cash probably still sits on the corporate balance sheet. Tax/entity optimization probably hasn’t been performed.

These assumptions are loose. But the evidence that these tactics work is staggering. Plenty of mediocre private equity sponsors have become incredibly wealthy in 1-3 vintages of 15%+ “IRRs” (with very happy LPs!). If you have any experience dealing with private businesses, you know that much of this is true. The personality type of the CEO at these businesses is very patriarchal: they probably know they’re overpaying their employees, but they’re family. They probably know they could expand into new markets, but he wants to stay local so he can see his kids’ little league games at the end of the day. He knows he’s overpaying some of his suppliers, but they golf every third Sunday and he likes being schmoozed.

Identifying targets here is the hard part: where is it going to be easiest, where is the product going to carry the water vs. the employees, what lenders are dumb enough to lend on this collateral etc. Many of these SMB assets are “good until reached for”: human capital abandons ship after the new boss comes in, your best employees start competing services businesses at tougher price points, customer stickiness starts to wane when you fire the overpaid, schmoozy salespeople. So the degree of difficulty is much harder day-to-day vs. the public markets investor. This is self-evident but worth spelling out. In an economic sense public market investors *should* have advantages over private equity buyers: Ultimate liquidity, transaction cost advantages, better pricing in an open outcry market etc. But the ability to control operations is of course a wild card that can range from a negative value component to billions of future value.

One mistake I see investors make is confusing inefficiency at public companies with incompetence. Just because a company does have private jets, bloated marketing budgets, DEI departments or other icons of bureaucracy doesn’t mean that management is blind to competition or easily had by a rival or a generalist. The example that comes to mind, of course, is Visa and MasterCard, both of whom have thrown billions at acquisitions, internal R&D, marketing, all to defend an electronic network that hasn’t fundamentally changed since the 1970s. There’s plenty of counterfactuals where they could have lost their market to Diner’s Club, or China Union Pay, or maybe even still to WeChat or WhatsApp, but for now they’re on top by continued blunt force of monopoly. It’s an inefficient way of operating, but the companies are thorough at identifying threats and weaknesses. When you start arguing that Olive Garden should stop salting their pasta water to widen margins, you’ve lost the plot. Find a perennially underpriced monopoly to glom onto (Buffett-style) or find a NAV discount to your teeth into. Leave the margin squeezing to private equity.