Private Equity industry and the buyback dilemma

Overview

The seven publicly listed U.S. alternative asset managers are facing a complex decision: how to put their cash to use. The news is that, in addition to the usual buyout picking process, some firms are now considering investing in their own stock through a buyback. With global markets flailing, the share prices of the big buyout firms have underperformed the S&P over the past 12 months by 31%.

Indeed, while the S&P 500 declined 13% since its May 2015 peak, Blackstone fell 43%, Carlyle 61%, Apollo 39%, KKR 45% and Fortress 47% in the same timeframe. The repurchase plans of KKR, Apollo, Carlyle, and Fortress total more than $1bn, while Blackstone and Oaktree decided to avoid the stock buyback for now.

A Look into a Share Buyback

Why do companies repurchase their shares? Listed private equity firms – like any corporation – can use their earnings to return cash to shareholders, as dividends or stock buybacks, or they can keep the profits inside the company in the form of retained earnings, to invest in the company’s projects and development. What if these investments do not produce high enough returns? A corporation can put the cash to use by repurchasing its own shares. This is a signal that instead of pursuing operational expansion, a better return can be achieved with the stock itself. In this way, the float is reduced – as there are now fewer shares held by the public – thus increasing the earnings per share, given constant profits.

Apart from boosting financial ratios and paying out cash flow to shareholders, retiring outstanding shares can also be beneficial because of undervaluation and ownership consolidation. If management believes the market is undervaluing the stock – which is currently the case, according to Carlyle’s Co-CEO Rubenstein – the company can repurchase some of its shares at this reduced price and then potentially re-issue them once the market is valuing it more fairly, thus increasing its equity capital without dilution. Furthermore, if float is not needed, management or majority owners do not see the point of having more dividend-seekers shareholders than necessary and decide to consolidate the ownership of the company. In this way, investors can be paid off while reducing the overall cost of capital.

A share buyback can be structured in different ways, the most common being the open-market one: a firm announces that it will repurchase some shares in the open market from time to time, as market conditions dictate, while maintaining the option of deciding whether, when, and how much to repurchase. These plans can span months or even years, and the market perceives them as a positive thing, which often causes the share price to shoot up. An alternative is that shareholders may be presented with a tender offer by the company to sell their shares within a certain time frame.

Defined by The Economist as “corporate cocaine” in 2014, share buybacks present some drawbacks as well, such as a short-term focus and indebtedness. Indeed, if a manager’s compensation depends on EPS targets, he may be tempted to overdo buybacks, foregoing long-term investment projects that could be a better use of extra cash. Moreover, some companies may end up borrowing too much to sustain the stock repurchase plans. American multinationals in particular could try to borrow heaving in the U.S. to pay for buybacks (while keeping cash abroad) to avoid the American corporate tax rate.

Market Conditions

The year just ended left to investors a turbulent market. PE’s stocks were hit by probably one of the worst drops in value of the recent years. Since the beginning of 2015 the world’s biggest private equity firms have seen a decline in market confidence, if compared with the previous years. In the private equity industry, normally the shape of market price movements is waved. Looking at the PEs’ past performance, in 2014 there was a peak in terms of commitment amount and stock price. Market commitments more than twice the post financial crisis amount and reached USD 372 billion overall. In addition, the world’s largest private equity companies’ price skyrocketed, Blackstone’s share price rose to a peak of $43, KKR to $24, Apollo to $19, Carlyle to $30 and Oaktree to $55. The following year, this growth in prices was followed by a general market drop, especially for those companies operating in PE industry.

Indeed, while the S&P 500 declined more than 10 percent from its 2015 peak, Blackstone fell 40 percent, Carlyle and Apollo lost more than 60 percent of their value, KKR slumped 45 percent and Fortress lost more than 40 percent. Also Berkshire Hathaway share price decreased by more than 12 percent, even though its profit increased to USD 24.1 billion from USD 19.9 billion in 2014 and it was made its biggest deal ever. The reasons to the price falls of these
companies have to be found in the skepticism of investors. During the last years the buyout industry has reaped record amounts of cash from its activity.

Investors may fear the boom has ended alongside the hangover in the stock market, with investments being made now years away from generating good fees. Indeed, the whole 2015 was characterized by the fall in oil price and therefore a decrease in portfolio performance drive by the exposures to energy market investments, and the increasing lack in investment opportunities. The latter needs to be explained better.

A way to understand if the PE is exploiting the commitments he succeed to obtain, is looking at the current dry powder amount. The dry powder is the difference between the commitments obtained by the fund and the actual investment done. A big difference in these two values could mean an incapability of the fund in finding profitable investments or in lack of investment opportunities. Indeed, from the chart it is possible to see how the dry powder has increased for three years, exceeding also the amount reached during the financial crisis.

The reasons are several and the main ones could be summarize in the expansive quantitative easing launched by the main central banks and the high valuation of companies. The first one affects market liquidity, increasing the amount of liquid assets; this, combined with the low rates, brings to an overabundance of resources. The second reason can be seen as the lack of investment opportunities. Indeed, if PE firms believe the potential targets are overpriced it will be difficult to invest in these companies, since there is no potential gain from the operation. Therefore, overabundance of resources and the belief that there are no investment opportunities have as a clear consequence an high dry powder.

Buyback dilemma

Market turmoil and low share prices have brought private equity groups to consider for the first time their own shares repurchase as a possible profitable strategy to exploit current environmental conditions. As said before, turbulent markets brought down PE stocks’ value. In this framework it is normal for ordinary listed companies to buy back their own shares when prices slump and the company is undervalued. Of course this is true only if the price is not the right one and the slump is due to undervaluation or to an overreaction of the market. Nevertheless, private equity firms are not ordinary companies and buyout executives have usually preferred to focus capital on their own deals. Now that public investors are driving down their stock some of them have changed their mind. Among the seven publicly traded U.S. alternative-asset managers, four have unveiled share buyback programs, with the repurchase plans collectively valued at more than USD 1 billion. Others have so far decided against it.

The first group includes KKR, Apollo, Carlyle and Fortress. KKR already bought back USD 270 million worth of its own shares, as part of a USD 500 million share buyback announced at the end of the last year. Apollo’s planned buyback for an amount up to USD 250 million followed KKR’s announcement. With regard with this strategy the co-founder Leon Black said that Apollo’s market value has fallen to a level that “to us is kind of an absurdity” but offers “an opportunity in terms of repurchasing shares”. The other two firms, Carlyle and Fortress, announced a buyback of USD 200 million and USD 100 million respectively, hoping to boost the stock price by reducing share count and showing confidence in the companies’ future value.

On the other hand there are the other three giants of the PE industry, Blackstone, Oaktree and Ares, which have been eschewing repurchases as a possible choice. From this point of view, Chief Executive Officer of Blackstone Steve Schwarzman said buying back firm’s stock would compromise its ability to invest in its business and he would prefer to have all of its cash available to make strategic acquisitions and seed new funds and products. In addition, also Berkshire Hathaway decided to not repurchase its own shares.

What could be the solution?

We saw that there are two different views on carrying out or not a buyback. The decision is a very tough one. One of the possible reasons that pushes some firms to repurchase their shares could be the willingness to try to boost the stock price and use it as a protections against the “bears”. A market is bear if prices of securities are falling, and widespread pessimism causes the negative sentiment to be self-sustaining. As investors anticipate losses in a bear market and selling continues, pessimism only grows.

A downturn of 20% or more in multiple broad market indexes over at least a two-month period, is considered an entry into a bear market. From this point of view what a buyback can do is to reduce the number of shares in a company held by the public. Because every share of stock is a partial share of a company, the portion of that company that each remaining shareholder owns increases. In the near term, the stock price may rise because shareholders know that a buyback will immediately boost earnings per share. Over the long term, a buyback may or may not be beneficial to shareholders.

On the other hand a buyback has two prerequisites which are connected with each other in order to be successful. Firstly the firm’s value has to be underestimated by the market and secondly the timing of the operation. If one of the two misses the buyback is likely to bring to a failure.

What the data are currently showing is that the decrease in PE industry profits is small if compared proportionally with the decrease in stock prices. Moreover stock prices have stopped to decrease and are starting to slightly increase again. For instance, Berkshire Hathaway stock price, after the drop of more than 10 percent in 2015, has risen by almost 12 percent since the end of January 2016. Therefore the hypothesis of an investors’ overreaction to the market turmoil (high volatility of the markets due to China slowdown and Brexit concern for example) during 2015 is concrete. If this the case, then the heavy fall in prices is not justified by fundamentals and firms’ value should raise again and the eventual buyout will be successful.

Now if we want to properly answer to the question “what could be the solution?”, clearly, there is no right answer ex-ante and only time will show us which firm will have chosen the successful strategy.

Sources: press release, Dealbook, FT, Bloomberg, Bain, Prequin