That's one of several provocative questions posed yesterday in a very interesting Wall Street Journal opinion piece by Andy Kessler called The Glory Days of Private Equity Are Over. You may or may not like Kessler's swaggering style, nor the Gordon Gekko-like persona he adopts in his books (the best-selling Eat People is one of those), but he makes a compelling case that the private equity model is, for a variety of reasons, coming to an end. He defines the overall private equity model this way:
You buy a company, putting up some cash and borrowing the rest, sometimes from banks but often via exotic instruments that Wall Street is happy to sell. Then you manage the company for cash flow, making sure you can make interest payments with enough left over for fees and investor dividends. With enough cash flow, you either take the company public or sell it to someone else. And how do you generate cash flow? You can expand the company, but more likely you slash costs, close divisions, cut staff, curtail marketing, eliminate research and development and more. In other words, cutting to the bone.
The...model has worked for the past three decades. But it's a bull-market investment vehicle whose time is done.
The reasons he offers are varied, from interest rates to lending slowdowns and tax reform. However the main issue he cites is a lack of tempting targets. Just as in the world of house flipping, are only so many fixer-upper businesses out there to strip to the studs and re-sell before the market runs out of properties that most firms can afford.
The reality is that the best companies with high-enough cash flow to pay down interest can’t be bought. No one is buying Apple or Google. But this is also true of cash machines Uber and Airbnb or high-growth companies like Snapchat and Pinterest. Private equity can’t afford them. And with the Dow bobbing around 18,000, public companies are increasingly off the table. Maybe the oil patch? Good luck with that.
Capital will still chase increasingly expensive deals. That won’t end well. So it’s back to basics—creating companies rather than squeezing the last life out of old ones. Just like Wall Street shrinking and curtailing once-profitable businesses, private equity will begin a slow decline. Yes, we’ll see more deals and even a few successes. But the returns from private equity won’t match those of the past 30 years. And capital will flow elsewhere—let’s hope to productive and wealth-creating segments of the economy.
The reverse of the private equity model by definition means more spent on growth activities like expansion, hiring, product development and, yes, marketing. Is it crass to hope the model goes down hard — and soon?