The 86 Biggest Lies on Wall Street by John R. Talbott

Author:John R. Talbott
Language: eng
Format: epub
Publisher: Seven Stories Press
Published: 2010-06-11T04:00:00+00:00

CHAPTER 6

Lies About Other Investments

Lie #42 Private equity firms create value by taking a long-term perspective and growing the businesses they invest in.

Until very recently, private equity firms have enjoyed very good returns on their investments. By buying companies in the public market at a premium and taking them private they have been able to garner returns to their shareholders in excess of 20 percent per year.

The current financial crisis has dramatically lowered these returns to private equity firm investors. Many private equity firms are now experiencing decreases in the value of their portfolios, not increases. They will be slow to recognize these losses as they do not have to until they sell a portfolio company or take it public. It is the nature of the business that they take their more successful companies public or harvest them through sales first, and leave the dregs, the problem companies, behind on their balance sheet to linger.

But private equity firms have been successful for so long that it bears examining how exactly they made all these profits over the years. It is doubly surprising because, as I said earlier, it should be very difficult to buy publicly traded stock at a premium and generate an adequate return to a private investor. The reason is that the public stock has great liquidity, which you give up when you take the firm private. Thus a private investor demands a higher return for making a private investment than for investing in a publicly traded stock with good liquidity. All other things being equal, this means that the company should be valued less, not more, in a private transaction. If the cash flows from the company don’t change, and a private investor demands a higher return, that must mean that the value of the company to him is less to generate the required return.

So how did the private equity firms do it? The answer is that they dramatically increased cash flows. The public market has been criticized for a long time for taking a very short-term approach to running their businesses in order to satisfy the quarterly earnings reports so thoroughly perused by Wall Street research analysts. Public companies supposedly run their business quarter to quarter. I know this isn’t true. The whole idea of having a publicly traded stock value is that the stock price reflects all the future dividends paid by the company to its shareholders. There is no way a company could have a value equal to thirty-three to fifty times its current dividend if investors were only interested in this year’s cash flow. No, public investors take a very long-term horizon approach when investing in the stock market, and actually give credit to dividends one hundred years in the future when performing a present value computation to arrive at the value of a common stock price.

It turns out private equity investors are very short-term thinkers. They are focused on cash flow this year because they have to pay back the enormous amounts

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