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Swensen Exposes LBO Flaws

The paradoxes begin to appear early on in the second edition of “Pioneering Portfolio Management,” a tour de force of an investment-advice book from David F. Swensen, chief investment officer of Yale University, and required reading for any private equity professional.

Swensen espouses unconventional and unorthodox thinking at every turn. Yet his investment philosophy—rooted in a bias toward equities, diversification,and strict adherence to target allocations—has become conventional wisdom for many in the portfolio management business.

The publication of the first edition of the book in 2000 enabled rivals to try to emulate the Swensen approach. Yet, as of June 30, 2007, the university was still able to best the competition when comparing investment returns for the one-year, five-year, 10-year and 20-year periods, according to a Cambridge Associates study of colleges and universities.

Readers might conclude, after finishing Swensen’s chapter on alternative assets, that they should run far, far away from private equity and not look back. Yet Yale itself as of mid-year 2006 had an exceptionally high target allocation to private equity of 17 percent; and buyout funds have delivered excellent results for the university.

So what is Swensen’s beef with leveraged buyouts? One complaint is that many of these investments offer limited diversification, whereby different asset classes respond to the same market conditions in different ways. “In fact,” Swensen writes in the second edition, “in transactions driven solely by financial engineering, buyouts simply represent turbo-charged equity, with leverage magnifying the results—good or bad—produced by a particular company.”

True, statistics show private equity returns exhibit less correlation with public equities than you might think. But Swensen has an explanation. Private equity firms don’t value their portfolio companies as often or as aggressively as public companies get valued. “Illiquidity,” writes Swensen, “masks the relationship between fundamental drivers of company value and changes in market price, causing private equity’s diversifying power to appear artificially high.”

Swensen devotes a whole section in his book to the performance of buyout partnerships, and the results aren’t pretty. Citing Investment Benchmarking Reports published by Thomson Reuters (also the publisher of Buyouts Magazine), Swensen finds that limited partners from 1985 to 2005 enjoyed median returns of just 7.3 percent, more than four percentage points less than the 11.9 percent annual return generated by the S&P 500 index over the same period. And that’s only the beginning of the bad news. Because the “riskier, more-leveraged buyout positions ought to generate higher returns, sensible investors recoil at the buyout industry’s deficit relative to public market alternatives. On a risk-adjusted basis, marketable equities win in a landslide.”

Hammering home the point, Swensen points to a study that the Yale Investments Office produced of 542 buyout deals entered into and exited from 1987 to 1998. It happens that these particular deals produced favorable net returns of 36 percent per year. But the comparison remains inapt, according to Swensen, noting that the 5.2 debt-to-equity ratio applied to the buyout deals juiced returns, at the same time raising risks. Apply comparable amounts of leverage to the S&P 500, Swensen writes, and you’d achieve a whopping 86 percent annual return.

Swensen pins at least part of the blame for the industry’s performance on its fee structure—management fees that reward the accumulation of assets rather than stellar returns, profit-shares that don’t discriminate between returns achieved from leverage and those achieved from improving company performance.

I find it difficult to reconcile Swensen’s criticism of the buyout market with his belief in Yale’s ability to construct a portfolio that does offer superior risk-adjusted returns and diversification; the key is maintaining a staff capable of picking top-decile and top-quartile firms that use relatively little leverage, improve company performance, etc. (In an interview last week, Swensen said it’s not easy to accomplish, nor is he necessarily “confident” his team can always pick the best.) Also, I don’t quite buy the analysis purporting to show that returns generated by the S&P 500 on a risk-adjusted basis smash those generated by LBOs. Buyout shops apply their leverage to actual companies. This has real-world effects, such as siphoning off cash flow to lenders that would have gone to other uses, and occasionally pushing some companies into bankruptcy.

In our interview, Swensen acknowledged that the comparison isn’t perfect. However, he said the exercise does serve to make the point that it’s “pretty stunning” how much power leverage has to magnify returns, and that there’s often little difference, other than heavy borrowing, between public companies and portfolio companies.

The first edition of Pioneering Portfolio Management came out just as the Internet bubble was bursting in 2000, the second amidst the worst financial crisis since the Great Depression. So naturally I asked Swensen when the third edition will come out. “No more editions,” answered Swensen. “I’m done.”

So much for my attempt at market timing, which Swensen advises against anyway. But I sure hope he’ll change his mind.