The big news in the Carlyle IPO story is that the private equity firm and its founder David Rubenstein dropped a plan that would have prohibited shareholders from filing class-action lawsuits.Great news, right! Buy, buy, buy on Carlyle shares?
Not so fast.
There’s a fundamental problem with investing in public equity private equity firms — and it’s not just Carlyle.
And it’s not just the awful historical track record these investments have displayed. Take Blackstone’s much hyped IPO. Share performance since offering? Down 52%.
There’s something more basic going on that makes the public equity of PE firms bad news—at least if you don’t know what you’re getting into.
There are three ways to get economic exposure a specific private equity firm:
1) Be an investor in a fund. In recent weeks this has been the subject of intense scrutiny on the impact of PE to society and employment broadly.
In terms of returns, most rigorous academic analysis shows that private equity funds, net of fees, return about what the S&P 500 does.
So for group #1, economic return is not terrible but probably not worth the fees.
2) Be a manager of the fund(s) and own controlling equity in the private LLC. Speaking of fees, these are the guys that get the fees. The benchmark is a 2% asset management fee and a 20% performance fee, which generally has some hurdle before it kicks in (say, 8%). These same managers also tend to own some type of controlling equity in the corporate entity itself as well as the funds.
Group #2 makes a killing, especially at the biggest PE firms. We all know their names, how much they’re worth, how many houses and planes they have, etc.
They have access to performance fees, management fees, invest in the funds themselves and if all goes really well, they get to sell some of the equity they hold at the corporate level to the public. It’s a great business model for the managers. Maybe one of the best ever created.
3) Buy publicly traded equity in the manager. Now things get tricky. First of all, the equity you are buying is unlikely to be run of the mill, General Electric-style equity. In Blackstone’s case, you are buying units in a general partnership. But your ‘units’ are generally stripped of governance and voting rights and may even exclude the controlling shareholders (the managers) from necessarily acting in your best economic interests. This is an oversimplification, yes, but a largely accurate one. Please, no angry comments from corporate lawyers.
And a detailed look by the New York Times’ Deal Professor at Carlyle’s share structure makes the case that it’s worse than Apollo, Blackston or KKR in restricting right of owners of public equity. Even with the class action lawsuit prohibition dropped, the fundamental conclusion is stinging:
“Carlyle is taking advantage of IPO [investors’ lack of concern for shareholder rights] to push through what can only be described as a shareholder’s corporate governance nightmare.”
In short, you are along for the ride with the management team and they owe you no responsibility to act in good faith.
So you don’t get a lot of things. What do you get? You get the earnings of the corporate entity once performance hurdles have been met and the managers have been paid their fees and other expenses have been dealt with.
The problem is that the best place to be, economically speaking, is in group #2. That’s not too surprising, since group #2 set up this the economics of this whole thing to begin with.
Group #3 is last in line, economically speaking, as is always the case with equity holders. But what’s different about private equity is that what comes before you as an equity holder is not what comes before an equity holder in GE. Far from it.
It’s a much longer journey for economic value to reach you and there are incredibly effective mechanisms set up to capture as much of value for the managers before it gets to you.
So if you’re buying shares in the Carlyle IPO, your ability to file class action lawsuits should be the least of your considerations.
Rubenstein himself said the point of the IPO was for him to ‘liquefy’ his holding in the firm. This is the point of all IPOs, of course.
The key difference is that when he does liquefy his stack, what investors get in return has largely been stripped of earnings power.