Ah, memories. Remember when endowment-style investment was all the rage? You know, before the market meltdown of 2008-2009? Those were the days when investors clamored for portfolios that looked like those managed for the benefit of Harvard and Yale universities. Yale's chief investment officer, David Swensen, in particular, was elevated to guru status by alums and envious investors for his two-decade streak of stock market outperformance. (We examined Swensen's style in our July 2007 article, “Illiquidity Is Beautiful For Some.”)
Yale and the other Ivies, of course, weren't entirely insulated from last decade's market swoon. Correlations spiked across most all asset classes, so even broadly diversified portfolios like the endowments took big hits. Thankfully, the bespattering of Yale Blue and Harvard Crimson was quickly mopped up. The dramatic post-crash rebound in the Yale portfolio's value, in particular, was largely due to a growing commitment to private equity.
At 33 percent, private equity is now Yale's largest asset allocation. The Elis have built up their commitment by ratcheting up exposure in stair steps from the 17 percent level in 2006. Private equity took primacy mostly at the expense of the endowment's hard asset investments. (The comparably nimble Harvard endowment has kept its target allocation to private equity steady at 13 percent over the past few years.) The Yale and Harvard private equity investments are outsized compared with those of other educational institutions which average a 10 percent allocation to the asset class.
The universities' private equity investments consist of participations in venture capital and leveraged buyout limited partnerships. Yale, for its part, has big expectations for its managers, which include venture capitalists Greylock Partners, Kleiner Perkins Caufield & Byers, and Sutter Hill Ventures, as well as buyout specialists Bain Capital, Berkshire Partners, Clayton Dubilier & Rice, and Golden Gate Capital. The aggregate real return generated by the partnerships is targeted at 10.5 percent with a 27.7 percent risk (annualized standard deviation).
Such high falutin' returns come with an equally heady buy-in. There's a six-figure threshold for partnership interests, certainly doable for a $19.4 billion portfolio like Yale's, but clearly out of the reach of everyday investors. That doesn't mean that Main Streeters are necessarily foreclosed from private equity, though.
Publicly Traded Private Equity Firms
There are a handful of private equity firms that are — paradoxically — publicly traded. Could some of private equity's recent good fortune have trickled down the balance sheet to the benefit of small shareholders?
Most of these entities are organized as business development companies (BDCs). BDCs raise money through equity and debt issuance, much like merchant banks, to fund loans to medium-sized private companies. A BDC's objectives are income generation and capital appreciation though, as we shall see, these objectives aren't often realized. Essentially, a BDC offers investors an opportunity to buy many businesses with a single purchase.
BDCs are required to pay out 90 percent of their earnings as dividends which are taxed as ordinary income for shareholders. This makes BDCs particularly attractive for dividend-hungry tax-deferred accounts. Ideally, BDCs should combine high yields with relatively low leverage.
Volatile Investments
BDCs are very volatile investments. Their stock performance, like that of their pass-through partnerships, suffered mightily in the 2008 market slump.
In the general sell-off, the private equity market faced a killer combo wrought by the implementation of Financial Accounting Standard 157 and skepticism of the underlying companies' values. As a result, many BDC net asset values were sent to the canvas.
Dividends headed south or, in many instances, were eliminated entirely. Some companies attempted to salvage their balance sheets through equity issuance, to differing effect. Those with track records that could justify a premium over book value offered accretion to existing shareholders, while others merely diluted investors' interests. The differential effect on share values was dramatic.
A BDC's debt-equity mix largely determined its post-crash performance. The heavier the debt weighting, the more the investment acted like a leveraged bond fund. With that in mind, investors and advisors are wise to use a BDC's total annual expense ratio as a measuring stick.
A BDC's investment mix also determines its potential return. The return on a debt-weighted portfolio is essentially capped at the interest rate and doesn't offer upside exposure to portfolio companies' operations. The formula for big gains in an anticipated economic rebound is equity participation.
So, what choices do investors have? Six publicly traded investment firms and an exchange-traded fund (see Table 2) stand out as exemplars of private equity performance over the past five years.
A Baker's Half-Dozen
Fortress Investment Group LLC (NYSE: FIG) — New York-based Fortress has invested $21 billion of equity capital in 17 investment vehicles in the transportation, financial, healthcare, real estate and energy sectors, among others.
Market volatility has hit Fortress particularly hard; the company's share price has withered at a 30 percent rate since 2007. Profits fell 60 percent in the fourth quarter of 2011 alone. Still, there's some light on the horizon. In March, Fortress paid its first dividend since 2008. FIG's forward dividend rate is now 5.5 percent.
FIG closed the quarter with dwindling yet persistent debt in its balance sheet; book value was $1.1 billion. Cash and investments, net of debt, were about $2.15 a share when shares were trading at the $3.50 level.
American Capital Ltd. (Nasdaq: ACAS) — Headquartered in Bethesda, Md., American Capital manages $68 billion in assets. The firm invests in manufacturing, services, and distribution companies with a special focus on the energy sector.
In 2008, the steep decline in the company's worth violated standing value and income covenants, forcing the company to pay default-rate interest. During the first quarter of 2009, American Capital traded as low as $0.59 per share on fears that its earnings couldn't support its defaulted debt. The fair value of American Capital's investment portfolio still hasn't rebounded to its 2009 level, but new investment bookings have nearly tripled. Net asset value per share finished 2011 at $13.87, compared to a per-share market price of $6.73.
The company's market value has dropped more than 26 percent annually since 2007. Dividends were suspended in 2008 and haven't yet been reinstated, though American Capital repurchased 17.6 million shares in 2011 at an average price of $7.61.
MCG Capital Corporation (Nasdaq: MCGC) — MCG's target investments include small- to mid-sized companies taking up acquisition and growth financings as well as funding for recapitalizations and leveraged buyouts. Arlington, Va.-based MCG only invests in domestic companies. The company shies from investments in volatile industries, but that doesn't mean an investment in MCG shares will let you sleep at night. Over the past five years, MCG's stock price has lost more than 16 percent a year with its annualized volatility just north of 100 percent.
Despite its share price wobbles, MCG has a better dividend record than Fortress and American Capital. Dividends were reduced in 2008 and suspended altogether in 2009, but were restored in 2010. Payouts have since grown to a hefty 16.6 percent forward rate for 2012, facilitated by a share price languishing in the $3-$5 range.
MCG reported a net loss of $49 million, or 64 cents per diluted share, in the fourth quarter of 2011, compared with a net loss of $17.8 million, or 23 cents per diluted share, in the prior-year period. As part of its plan to return to profitability, the company intends to reduce its payroll by as much as 45 percent by the end of 2012.
Apollo Investment Corporation (Nasdaq: AINV) — Apollo also invests in middle market companies by providing direct equity capital, mezzanine and senior secured loans as well as subordinated debt. Apollo's investments are widespread, including interests in the building materials, business and financial services, media, consumer products and manufacturing sectors, among others. The company's investment horizon is usually five to 10 years.
Apollo's share price has eroded at a 9 percent annual pace over the past five years. At one point in March 2009, the dividend-adjusted price had plunged to the $1.45 level, a swoon of 81 percent in just one year's time. Shares now trade around $7. As volatile as that might seem, Apollo's risk is rather middling among the business development companies. The stock sports a standard deviation of 65 percent.
More important, though, is Apollo's dividend. Payouts weren't suspended to Apollo shareholders in the wake of the market meltdown, though they have been reduced in absolute terms. Still, AINV pays a forward annual dividend of 80 cents a share presently, representing a yield around 11.8 percent.
Apollo is one of those companies that seeks additional equity issuance below NAV. Recently, in fact, the company announced plans to raise $200 million in fresh capital through a syndicated deal or rights offering.
Apollo's earnings, not surprisingly, are as volatile as its dividend payouts — as are the consequences. After an earnings miss in early 2012, the company shook up its executive suite by dismissing its president and chief operating officer.
The Blackstone Group LP (NYSE: BX) — Speaking of dividends, Blackstone has had some volatility in its payouts as well. The company currently pays 88 cents a share for a 5.9 percent annualized yield. Before the 2008 market break, dividends amounted to $1.20 a share. Blackstone, like Apollo, continued to pay dividends to its shareholders after the break, albeit at a reduced rate.
Blackstone's private equity business is conducted through a half-dozen funds which finance leveraged buyouts, growth equity or start-up businesses, minority investments, corporate partnerships, distressed debt, structured securities, and industry consolidations. A third of Blackstone's private equity portfolio is financings of small- to medium-sized buyouts. Another third is committed to start-up and growth positions.
The Street, for its part, believes in Blackstone's growth. The company's shares now trade at the $16 level on expectations of a $19 target. Forecasts are based on estimated 2012 earnings per share of $1.74 vs. $1.25 for 2011.
Traders also seem bullish on Blackstone. Markets are being made cheaply in BX options. At last look, the volatility implied in contract premiums was well below the stock's 20-, 50- and 100-day historic levels and, in fact, is at the lowest level in the past two years. (Volatility typically balloons in market downturns and contracts when a stock moves higher.)
Ares Capital Corporation (Nasdaq: ARCC) — Ares Capital is the only one of our baker's half-dozen that has managed to post a five-year gain in its share price. (See Chart 1 and Table 2.) That's not to say that ARCC has always stayed above water, though. The stock, now at $16 a share, was perilously close to $2 in the spring of 2009. Still, ARCC's 53 percent standard deviation makes it the least volatile of the business development companies.
A key contributor to Ares Capital's upside is its modest leverage. Its debt-to-equity ratio is less than 1. At 11x earnings and a price-to-book ratio around 1, ARCC is a fairly low-priced stock as well. Ares Capital has pulled off earnings surprises for the past two quarters, exceeding consensus estimates by 20 percent on average.
The median one-year price target for ARCC is $17.30, according to Thomson/First Call. Given the stock's current price, its upside seems modest at best, but is complemented by a forward dividend rate of 9.1 percent. Ares Capital's dividends have been the highest and most consistent of all the BDCs.
And the Winner Is …
All told, Ares Capital stands head and shoulders above the other BDCs, though its stock might be close to being priced to perfection. Keeping in mind the illiquidity of the underlying portfolio, ARCC may be a fairly reliable high-yield alternative to junk bond funds for risk-tolerant accounts.
Speaking of funds, there's an exchange-traded fund that tracks the private equity market. The PowerShares Global Listed Private Equity Portfolio (NYSE Arca: PSP) is based on an index of three to five dozen listed private equity companies, including business development companies and other financial institutions.
The ETF's diversified portfolio certainly dampens its price volatility but, so far, has offered less than middling returns. (See Table 2.)