Private equity has long been an established part of the Australian investment landscape. Historically its focus has been on venture capital and mid-market transactions, providing an alternative source of financing, outside listed markets, for small and medium-sized companies to grow. However, in the past two years there has been the advent of large leverage buyouts, most notably Coles and (the now defunct) bid for Qantas. This has catapulted private equity firmly into the lexicon of Australian equity markets.
Private equity-backed leverage buyouts are clearly a benefit in the short term for equity markets. Announcements of private equity transactions are associated with significant increases in stock prices of target firms on the day of announcement (Australia: 14.5 per cent, US: 17.2 per cent), with (somewhat surprisingly) private equity-backed management buyouts offering even greater premiums. Yet while private equity provides the promise of attractive returns in the short term, it presents a long-term challenge for active Australian equity investors, introducing a new dynamic into the pricing of securities – one that is wholly unsystematic and unpredictable. The performance of National Australia Bank (NAB) in 2004 and Coles (2007) provide an example of how the dynamic in equity markets has changed.
Both companies issued profit downgrades of similar magnitudes (-10 per cent) in 2004 and 2007 respectively. Both had been laggards in their sector for some time with Coles underperforming Woolworths (-27.6 per cent) over the three years to the announcement; and NAB underperforming Commonwealth Bank of Australia (-12.4 per cent), Westpac (-14.3 per cent) and ANZ (-26.3 per cent) over the three years to the announcement. When NAB announced a poor profit following the currency trading scandal, its shares sold off sharply (-13.4 per cent). Investors may have rightly assumed a similar fate for Coles. Yet the Coles board, which had previously rebuffed private equity consortia, put the company on the block for sale to private equity. The effect on prices is illustrated in the graph.
While it is clear that not every company will be a target of private equity upon underperformance, it is probable the spectre of private equity will impact on the price of many companies. For instance, some investors, rather opportunistically, will respond to underperformance by ‘ambulance chasing’ underperforming stocks into their portfolio, anticipating that private equity will come to the rescue. This will have two implications for active investors.
Firstly, poor stocks may not fall as much as their fundamentals justify, making it more difficult for managers (most notably value managers, who typically target such stocks) to justify purchasing these stocks. The anticipation of such private equity activity thus provides a floor for stocks and the market.
Secondly, private equity may purchase stocks that are midway through restructuring, pitching bids below investor expectations of fair value and restricting alpha opportunities. While the price gap may be narrowed by shareholder activism (advocating higher bid prices), this has only recently become pronounced (for example, APN News and Qantas). It is no doubt difficult for managers, which are judged by the market and rewarded (by their parent companies) for short term performance, to resist the temptation to acquiesce to guaranteed short-term performance in favour of long-term non-guaranteed returns.
How then should investors respond? Diversification of alpha sources remains critically important for investors in the next phase. It is likely that in periods of market downturn alpha’s importance, much maligned in an environment of 20 per cent returns, will become heightened. Over the past century, Australian equities have offered the richest of risk premia in the developed world, higher than the United States, United Kingdom, Japan and Germany . The good advice about diversifying sources of return (beta and alpha) was (in retrospect) best ignored. However, given private equity is likely to reduce alpha in the Australian market, the case for diversification needs to be revisited by clients and advisers alike.
It is likely the alpha opportunities will be narrower in the next phase as the spectre of private equity introduces a new driver into the pricing of stocks. While private equity is global, the effects on the Australian market are likely to be more pronounced than peer international markets owing to the shallowness of the opportunity set. The solution for clients is to look abroad and to new asset classes and strategies to diversify alpha sources.
