What is Private Equity?

Almost everyone would have heard about the Private Equity industry in some form or another.  If you are young and interested in finance, the chances are that you have seen it mentioned on message boards as the holy grail of jobs to get.  If you are a bit older you may have seen many businesses that you worked for, that were listed on the stock exchange or that you patronise being bought out and changed by private equity firms.

This post will take a very high level look at the private equity industry - what they do, where they come from and how they make money.

What are private equity firms?

Private equity firms are essentially fund managers that, instead of buying shares in publicly traded companies, buy whole companies (whether public or private) using a significant amount of leverage (debt) and then pay down the debt from the operations of the business and then on sell the company at a later date.

Private equity firms typically raise their funds from pension or superannuation funds, who give the funds to the private equity business for ~5 years to make a return.  Although the structures vary, it is relatively normal for the private equity firm to have a 2/20 type model.  They charge 2% of the funds under management and 20% above a certain benchmark return rate (much like hedge funds).

Who typically works at private equity firms?

The core of private equity firms are usually ex-investment bankers or management consultants (depending on the firm).  Because the main feature of private equity is the way in which the business is financed when it is taken private they will often have significant experience when it comes to both capital and debt markets.

Although employees of private equity firms will always sit on the boards of companies they own and control, they will almost never get involved in the management of the business.  When they buy a business, private equity firms normally use one of two management approaches

1. They buy the business with existing management (often called a Management Buy-Out) in which case the existing management stays in place
• There are a few reasons why private equity firms will not change the management that is in place
• If it is a well run company there is no reason to.  Why would you change the way a cash generating successful business is run if you do not have to?
• Those participating in the management buy out are particularly well rewarded and so management has an incentive to help the private equity firm take over the company through the provision of detailed information and data rooms as well as business plans
  
2. They replace the existing management with a 'first in class' management team
• If the business is a cash cow but not particularly well run then it is quite common for Private Equity firms to hire the best operators in the world to run the business
• They attract these people because of the pay opportunities and upside they offer them

How exactly do they make money?

At it's core the private equity model is relatively simple (although the execution of this can get particularly complex).  Below is a pretty standard way for a private equity firm to make money:

1. Private Equity firm buys business A for $100 which represents a 10x multiple on their free cash flow ($10)
2. They finance the acquisition with $20 of equity and $80 of debt at a debt cost of 8% (i.e. the debt costs them $6.40 per year)
3. They cut costs brutally in the business and all non essential capital expenditure is removed to improve the free cash flow position of the business.  The free cash flow of the business is now $12.50.
4. Every year the private equity firm uses the free cash flow to pay down the debt in the business. Assume they hold this business for 5 years
• In year 1 they pay $6.40 in interest and pay off $6.10 in debt
• In year 2 they pay $5.91 in interest [(80-6.1)*8%] and pay off $6.59 in debt
• In year 3 they pay $5.38 in interest [(73.9-6.59)*8%] and pay off $7.12 in debt
• In year 4 they pay $4.82 in interest and pay off $7.68 in debt
• In year 5 they pay $4.20 in interest and pay off $8.30 in debt
5. At the end of year 5 they have a business that is still making $12.50 a year but because they have been paying down this debt so aggressively they only have $44.21 in debt left
6. They sell this business at exactly the same free cash flow multiple they bought it at however they get more money for it because they cut so many costs out.  They also have much less debt than they started with
• They receive $12.50 * 10.0x = $125
• They repay the $44.21 in debt
• They are left with $80.79 for investors
7. The return they earned on their invested capital is (80.79 / 20)^(1/5)-1 = 32.2% p.a.

As competition for these high cash flow

Yellow Brick Road's 1.15% discount is good...but not a game changer

There as a splash recently in both the financial and regular press about a 'fifth pillar' entering the Australian banking system.  The press lauded the entry of this competitor as great for consumers and finally providing some competition to the big four Australian banks.

Who is this new competitor?

The new competitor was Yellow Brick Road, a financial services company with 130 retail stores across Australia, which had recently struck a deal with Macquarie, an Australian based investment bank to use it's balance sheet to provide funding for Australians looking for home loans.  Their headline rate seems staggering - they are offering a 1.15% discount to the standard variable rate which is a discount rate almost unheard of in the Australian banking environment.

Yellow Brick Road is a company founded by Mark Bouris, the host of Australian's version of The Apprentice.  He was also the founder of Wizard Home Loans, a mortgage provider he later sold to GE Money for A$500 million.  With Macquarie's balance sheet backing him this venture is unlikely to be a 'here today, gone tomorrow' type operation so it should be something that those looking for a loan should consider.

However there are risks of a new competitor like this which you need to consider BEFORE you refinance you loan with them

Although the deal seems great, there are actually several draw backs and 'false' comparisons which many hyping this product have failed to point out.  These include

• The 1.15% discount is for the first year only.  This then reverts to a 0.86% discount.
• Generally promotional or 'sweet heart' rates are targeted at those who only look at the first year and do not consider what rate they are likely to be paying later on.  Given that home loans last for 20 to 30 years, it is the 'normalised' rate that you should be considering - not the sweetheart rate
• To be fair to Yellow Brick Road - they do provide what the rate will be over the life of the loan on their comparison table
  
• The comparison table is flawed - ALL banks offer significant discounts if you ask for it
• The standard discount on a loan of more than $250,000 is 0.70%.  This table does not take into account this discount
• For example they have the NAB rate at 6.08% however I am only paying 5.91% on my loan (which is not very different to the 5.79% offered by YBR)
  
• Although you get a discount to the Standard Variable Rate (SVR), you do not know whether YBR will reprice their SVR to a rate higher than the other major banks
• There is no 'standard SVR' - banks can make this whatever they like
• Over time you can see that the major banks track their SVR's relatively close to each other however there is no such proof for a new competitor.  If they want to increase their profits they can increase this SVR to a point where they are actually charging you more than the major banks even if your discount is larger
  
• There are no ongoing fees BUT this is a very basic product so you do not get many of the bells and whistles that are standard on other banking products
• Banks often charge a 'package fee' for the loan that they provide.  Mine is $120 p.a. and for that I get an offset account linked to me loan, fee-free credit cards and discounts on significant other products
• The YBR does not charge the fee but you have NO option to have an offset account, they do not offer fee free credit cards or any of the other benefits that come with having a 'package deal'
• For me, the offset account is one of the most critical tools that I have in managing my finances so personally this is what killed the idea for me straight away
  
• As this is a basic product you should compare apples with apples
• As mentioned above YBR's comparison table compares it against the major banks and their standard home loans.  
• However this is a

No guaranteed 9% return, some major draw backs...but not as bad as originally imagined

In a previous post I had questioned the validity of a 9% guaranteed return being offered by Collins & Kent International (CKI) for an investment in art.  From their advertising and after trawling their site quite thoroughly I could not work out how this investment worked - this is never a good sign.

I had received several questions about this investment for several months after I uploaded my original post but it was only a recently that a reader sent me the relevant contracts which set out how the arrangements actually work.  Those documents very clearly outlined how the arrangement worked and I am happy to say that this investment is not as bad as it first seemed - but the advertising is still misleading and there is no way they are guaranteeing a 9% return

So how does it work?

The investment proposition is actually rather simple:

1. You either buy a piece of artwork from CKI (or presumably you can bring along a collection of your own - I did not see anything in the contracts restricting this to art works sold by CKI)
2. They assign the artwork a value
3. You get a fixed percentage return on this initial valuation for the life of the agreement
4. CKI then loans this asset to their clients making a spread on the rate they lend it out at

It is actually just a simple rental / loan type agreement where you are providing the asset and in turn you are being compensated for this (much the same as a return on a rental property).  

Why do I think the advertising is misleading?

The original advertisement that I had seen had, as the most prominent part of the advertisement a guaranteed 9% return.  In reality what you are getting from this arrangement is a rate of interest on a predetermined art work for a predetermined period of time with.

What is wrong with this?

• As an investor in art (or indeed any other type of investment) the rental yield is not your only form of return.  Indeed in property and art it is typically not your primary form of return.
• The primary form of return is the change in capital value associated with the asset
• There is no guarantee in this arrangement as to capital value and so the investor is not getting a 9% rate of return on their investment - in fact it is almost guaranteed NOT to be 9%
• This is because if the value of the investment moves your effective yield is moving; and
• This capital value movement forms part of your return

What are the other drawbacks?

There are several other drawbacks from this type of investment (and also from the contracts that I had a look at)

1. There is always a risk that you overpay for an asset when you are buying it as part of a 'bundled' return 
• There is a risk (although I am not saying they do this) that CKI offers the high rate of return on an inflated price in order to 'prove' the value of the original price they sell the asset for
• I do not know if art dealers typically do this however it is quite common in commercial real estate where you are buying a piece of property from a party that is going to be your tenant for a specified period of time - there is a risk that you capitalise too high a number
• Again I have no insight into how objective their valuation and pricing process is so this is just outlining a risk
  
2. For someone inexperienced in art - their forgery provisions seem quite onerous
• I know nothing about art and I would be trusting that an art gallery was selling me the real deal when I was investing with them
• However when you buy a piece of art from CKI you have less than a month to get it evaluated by two separate independent experts to see whether it is a forgery to get a refund from CKI
• I have no idea whether this is industry standard or not but from an outsiders point of view it seemed quite onerous
  
3. It does not de-risk art investment - but some may assume that it does
• The biggest risks around art investment is around paying too much for something that is in vogue which then loses capital value
• CKI provides no protection against this so their scheme is not for 'beginners' investing in art
  
4. No rent escalation clauses
• The rent is not linked in any way to the capital value so in the event that your artwork's value shoots through the roof you are not getting an appropriate rental for it - the original rent stays the same for the life of the agreement

However - this scheme CAN be handy for those who were looking to invest in art ANYWAY

The more I thought about this investment proposition I realised that it would be very useful for those who

Playing the lottery - Is it your ticket to dream?

I have never been much of a gambler.  Went I went to Macau for a weekend I was content to stop playing the tables when I had won enough to cover my boat ride back to Hong Kong.  It came as somewhat of a surprise to me, when I found myself entering (for only the second time in my life) the lottery for tomorrow's draw (Oz Lotto).

The amount of ordinarily rational people that play the lotteries astounds me - one investment banker repeated that old catch line of 'you have to be in it to win it' while explaining that he bought a ticket every week.  While strictly speaking this is true everyone knows that the odds are truly stacked against you.  However the more I thought about it, the more I realised that in big draws your expected value may actually be greater than 1.

That is for every dollar you invest in the lottery, purely statistically speaking you should expect to receive something greater than one in return.  Below are the calculations:

• For every entry you have a 1 in 45,379,620 chance of winning
• The cost per entry is $1.20
• To buy up every single possible combination it would cost you $54,455,544
• The jackpot is $100 million (you will see soon why this only works for the big prizes)
• Therefore your expected return is
• Sum of the probabilities * expected outcomes
• 1 / 45,379,620 * $100,000,000 
• $2.20036
• If you then subtract the cost of entry you get your expected winning
• $2.20036 - $1.20
• $1.00036

However before you rush out and buy all the tickets remember that your potential winnings are diluted the more people enter the game.  You need to reduce this expected return by the proportion of people that are expected to win the jackpot.  To know this you need to know the number of tickets sold which they do not disclose.

Also you need to remember that this is a purely theoretical exercise - your chances of actually winning are still only 1 in 45 million.  As an exercise while writing this post I got the ticket I had bought which had 36 different entries.  I then went to last weeks draw to see how many of my combinations even got close to the winning combination - in none of my picks did I get more than 2 of the drawn numbers.  People who play expecting to win the lottery should keep track of how successful they are every week and then perhaps spend less money on it.

However having bought a ticket this time around I realised that the advertising folks may have got it right - I know I'm not going to win but I keep imagining what I would do if I won the $100m.  It most definitely is your ticket to dream - though what the advertising people do not include is that after you dream you have to wake up and get back to your normal life and finances.

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October 2012 Expenditure Tracker

Item	Oct 2012	Target (new)	Over/(Under)
Share Investments	+$1,032	+$3,100	-$2,068
Offset Acct.	+$2,700	+$1,300	+$1,400
Personal expenditure	+$2,757	+$2,000	+$757

This will be the first time that I provide my performance according to my reset expectations only.  Although I am still not meeting all of my expenditure goals I am moving towards them as I am more conscious about controlling my expenditure and am breaking some of the bad habits that I had previously.

In terms of share investments, I invested a significant amount of money in the FKP rights issue (as discussed several times before), however as the funds for this were already held in my share trading cash account the amount allocated to share trading did not change at all for the purposes of the expenditure tracker.  I also continued to contribute to my employee share plan which made up the bulk of the net investment this month. Although it looks like I under invested in shares this month I am still well ahead of my objective as can be seen from the cumulative table below.

I over allocated funds to my offset account this month to account for the fact that I am well below where I want to be due to the allocation of funds from this account to my share account.  As interest rates in Australia continue to decrease the effective return I earn on these funds decreases and so I am comfortable with this state of affairs.

The big story for me this month was around personal expenditure.  This is the first month where I overspent less than $1,000.  Although the overspend was still well above my limit,  regular readers would know that I regularly blow through this amount very easily and so I was very happy not to this month.  This was a combination of several factors

• Spending less money on taking lunches to work
• No major expenses during the month
• No major events (such as weddings or gifts) during the month

November 2012 is likely to be a very positive month but this is due mainly to significantly increased income due to my bonus being paid and receiving my tax return.  However in this month I will be:

• Transferring a significant amount of unused share capital from my share trading account back into my offset account
• Paying for my car servicing bill 
• Starting to purchase Christmas gifts

Below I have included the cumulative expenditure performance (from July 2012 only)

Item	Jul 12 - Oct 12	Target (new)	Over/(Under)
Share Investments	+$54,432	+$12,400	+$42,032
Offset Acct.	-$40,872	+$5,200	-$46,072
Personal expenditure	+$13,676	+$8,000	+$5,676

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October 2012 Net Worth

September 2012 Expenditure Tracker

Resetting my budget expectations

October 2012 Net Worth: $268,000 (+2.8%)

	Value	% Change
Assets	$621,000	+1.2%
Liabilities	$354,000	0.0%
Net worth	$268,000	+2.8%

Once again I was very happy with my absolute performance this month as some of my investment strategies started to pay off and I managed to keep my expenses well under control this month.  However as with my September and August Net Worth posts I noticed that the value of my investment portfolio always seems to be lowest at month's end - I'm not sure what the reason for this is but it certain impacts how I think I am going every month.

This month was impacted by a few large events.  Some of them were quite positive and others were mildly negative. These included:

• Being allocated more shares than I expected under the FKP rights issue
• I have posted about this before in detail but what it did was reduce significantly the loss I was carrying forward on these shares
• At the moment I am 5% below my weighted average purchase price for these shares however they are very depressed at the moment so I am holding onto them
• This was the biggest positive impact for this month
• I held onto my ESIP shares a little longer than I should have
• I am still holding on to my ESIP shares which I had originally meant to sell very quickly
• These shares reached all time highs however have now come off quite a bit.  The decision to hold makes sense but if either the currency or share price moves back in my favour I'm going to take the cash and run
• This had a marginal positive impact over the whole month but probably a mildly negative one over the last few days of the month
• My expenditure was as controlled as it has ever been
• I will provide more detail on this in my expenditure tracker post tomorrow but this month I somehow did not end up spending much money at all (even though I did a weekend away)

For those who read this series from month to month there are several items that were pretty consistent

• My monthly allocations to my employee share plan and my superannuation increased my savings without me having to think about it
• My home loan offset account increased as I started to rebuild my balance post significant transfers to my share trading account

Last month I said I would

• Start putting aside money for my overseas holiday over Christmas - I totally forgot about this so have not done it
• Doing my taxes for the 2012 financial year.  I have booked in an appointment with my accountant for next week so I should get the refund in November

For November 2012 I forecast that my Net Worth will be affected by the following

1. I gave my car in for servicing which cost my $700.  I have yet to pay this bill but this will have to be paid this month.
2. I should get my 2012 bonus paid into my account this month which will should see a significant increase in my net worth.  Note though that I had already set aside the majority of this for my new sports car which I plan on purchasing
3. I should get my tax return for the 2012 financial year
4. I am going to edit the way in which my net worth is calculated to take into account future tax payable on unrealised gains in my share portfolio - this will give a more accurate picture of my net worth

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Real Estate Investment Trusts: An alternative to direct property investment

Over the past few months I have gone through the pros and cons of investing in real estate and how to go about buying your own investment property and then all the things you need to know about to effectively own an investment property.

In this post I will outline an alternative to direct investment property - the Real Estate Investment Trust (commonly referred to as a REIT).    I will not cover every aspect to REITs in this post however I hope o cover some of the salient features with a few to providing more detail in future posts.

What is a REIT?

Broadly speaking, a REIT is a vehicle where several investors pool funds to invest in property.  It is essentially a managed fund which invests exclusively in real estate.

Below are some of the points which commonly define REITs (although they are not necessary for something to be classified as a REIT):

1. There are several investors (large, or listed REITS can have thousands of investors)
2. There is usually more than one property in the REIT
3. They are usually structured around specific types of property (e.g. office, industrial, residential, retail etc)
4. There is a manager who takes a management fee

Beyond these general characteristics, REITs can take on so many different forms that you can basically search for and invest in exactly the type of product you are looking for - there are listed and unlisted REITs, some of which are open ended and some of which are closed.  There are also REITs focused on growth and those focused on income and heaps of other features as well.

If you are thinking about investing in a REIT - make sure you understand exactly what you are investing in because it is not as standardised as many other financial products.

Benefits of investing in a REIT

There are several benefits associated with investing in a REIT (relative to direct property investment).  These include

• The entry costs are much lower
• Investing in direct property costs a lot of money up front.  This includes the amount for a deposit, taxes and a certain amount to cover the interest until the property is rented out
• REITs do not have these costs - you generally invest a minimum amount (which can be as low as $1,000) and you get the same proportionate return as everyone else
• Your risk is spread over several assets
• Single asset investing is inherently risky - all your eggs are essentially tied up in one basket
• Investing in a REIT gives you exposure to the property sector but spreads your risk among several properties - see my post on diversification
• It requires very little effort
• Once you decide to invest, other than keeping track of the performance of the manager and whether they are doing anything particularly dumb - you do not need to do anything

Downsides to investing in a REIT

Investing in a REIT is not the golden solution to property investing (although during times when the property market is on an upswing people assume it is).  There are several risks and downsides to investing in a REIT including

• You have to pay a management fee
• This fee can vary quite a lot but generally you are paying 1% - 2% of the totally amount you have invested each year for the manager to manage the portfolio - this can really add up over the long run
• You have no control over the asset or what assets are invested in
• When you invest in property directly you have a lot of control to make sure that the property is being looked after the way you want and that you get the property you want
• If you let someone else do this you are hoping that they will do it right
• You do not take as great an interest in the fundamentals of the investment as you would if you were managing the asset
• When you have an investment property you know absolutely everything there is to know about that property - the tenants, the upcoming expenditure requirements - everything
• Although you should keep track of your REIT investments the fact is that most people trust the manager to do it right and only look at it once a year (if at all)
• It is quite hard to know if and when things are going wrong until it is too late

Overall

I think that REITs have a place in every investor's portfolio.  They offer access to investments that would be out of the reach for normal investors (e.g. office buildings) and at various points in the cycles can be great value.

I hold both direct property and REITs.  I use REITs to hold those property forms that I am not comfortable investing on my own - that is development properties, commercial properties and retail investments.

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