The Public/Private Equity Industry consists of specialty finance companies and alternative investment managers. Firms operating in this industry invest in other companies, fixed income securities, and various assets, usually collecting management and advisory fees, interest income, and investment gains. Competition is keen, as private equity funds, hedge funds, asset managers, and other financial institutions search for attractive investments and seek to retain top talent.
In times of economic growth, the number and size of these companies grow, as credit is usually readily available to support investment. When credit dries up, however, the focus shifts toward maintaining liquidity, a healthy balance sheet, and a high quality investment portfolio. Therefore, during economic downturns, companies with sufficient liquidity and performing assets may be able to take advantage of available opportunities, making investments at favorable terms, while competitors pull back or exit certain businesses.
Alternative Investment Managers
These firms usually raise funds from clients to be invested in a range of assets, including real estate, debt and debt-backed securities, equity, commodities, currencies, and other private equity and hedge funds. The managers earn two fees—one based on assets under management and another on the performance of their funds. Performance-based fees can come with a claw back provision, wherein fees are returned if performance is not realized, or a high watermark provision, which requires fund values to achieve prior levels following periods of underperformance before new performance fees are paid out. Because income is based on assets managed, earnings will be hurt during times of generally declining asset values as well as when the funds experience large client redemption requests. Some companies also make principal investments in their own funds, and receive interest and other distributions from such funds as another source of income.
Specialty Finance Companies
These firms are typically organized as business development companies (BDCs). They seek to take positions in a number of small and middle-market companies via various forms of debt issuance, which may be supplemented by equity investment. BDCs provide managerial, operations, or other business advice, and usually attain board representation. In addition, BDCs may also receive warrants for ownership rights in their portfolio companies. Depending on the relative attractiveness and availability, BDCs usually borrow funds, though they can sell shares, to fund investments, seeking to make their return on the spread between borrowing and lending rates. They can exit positions through secondary sales, or if the underlying company retires the debt, merges, or undergoes a public offering. Again depending on market conditions, BDCs may also bundle a number of their loans to be sold to other investors, in order to pay down debt or fund further portfolio growth.
These companies usually choose to be taxed as registered investment companies, meaning they must distribute at least 90% of their investment company taxable income (generally ordinary income plus short-term capital gains) to avoid being taxed on the distributed amount. Because of the importance of this dividend, stocks of these companies usually trade based on their anticipated dividend yield. That is, the stock price will vary depending on the size of the distribution that is seen as likely. A metric for cash flow available for distribution is net investment income, as opposed to GAAP earnings, since the GAAP figure includes both realized and unrealized gains and losses. Usually, BDCs plan to hold their securities to maturity, and unrealized charges are not cash flow items, whereas interest income and other received fees are.
Leverage and Earnings
A company that carries its portfolio investments at market value will tend to have low Earnings Predictability, because the periodic variability in asset values will be recorded as gains or losses. Although these items may not affect the current distribution, they should not be disregarded, since they may act as an indicator for those investments that can either be sold at a profit or amounts that may not be recovered when exiting the position.
When combined with leverage, asset valuation variability will also increase earnings volatility. During periods of generally rising asset prices, the use of borrowed funds can magnify gains on investments. In periods of declining values, however, losses may exceed the amount invested. Too, companies with excess leverage may be forced to sell assets as they drop in value in order to meet collateral requirements or to avoid tripping debt covenants. For example, BDCs may generally borrow as long as assets are at least two times debt and preferred stock. As a portfolio is written down, the company may need to pay down the outstanding debt with funds that might otherwise be invested or paid out as dividends.
Overall, investors should be aware of the general economic climate, a company’s underwriting/investing track record, and the industries included in its underlying portfolio investments. For business development companies, proceeds from the issuance of debt or from the sale of shares should be followed by growth in the loan portfolio, as interest income will need to be higher to service the debt load, and dividends will need to be paid to an increasing shareholder base. Similarly, sales of investments should also be invested back into the portfolio. Because these stocks will often trade on the sustainability of the distribution to shareholders, investors should pay attention to the source of earnings and other cash flow measures, as well as the company’s ability to cover the dividend.