A private equity caution flag

The thing we’re told most often about alternative investments is the importance of due diligence. The complexity of these products is such that advisors put themselves and their clients in a vulnerable position if they make poorly researched recommendations.

This is somewhat counterintuitive, given the value many of these products offer from a risk management perspective. But their complexity — and in some cases their lack of transparency — makes them a poor fit for many investors.

Advisors know that alt bets can go sideways, just like traditional assets. What’s important to know is what that looks like on a product-by-product basis. Because they often don’t behave like traditional assets when they do.

So, pay attention to the contrarians. They’re worth hearing out.

A hat tip to our friend Ken Kivenko, president and CEO of Kenmar Associates and an important investor advocate, for introducing me to the work of U.S. economist Eileen Applebaum. She is co-director at the Center for Economic and Policy Research, a Washington think tank. Since 2010, Applebaum has focused on private equity’s part in the financialization of the global economy — specifically, the sector’s restructuring of companies for profit.

Applebaum coauthored Private Equity at Work: When Wall Street Manages Main Street with Rosemary Batt, Alice Hanson Cook Professor of Women and Work at the ILR School at Cornell University.

When we spoke earlier this month, Applebaum made it clear she’s not anti-private equity.

“We have never been against private equity as an asset class,” she said. “We just want them to do what they say they do.”

Which is to say, buy companies and make them better.

“There are plenty of examples where private equity comes in and improves things,” Applebaum told me. “They buy these small companies and they modernize them really quickly.”

They bring in finance, marketing and other experts. Board members are added, efficiencies found. But too often, Applebaum says there’s a tension between what’s best for the company and what’s in the best interest of the private equity firm.

“Private equity always has an extra plan,” she said. “They have a strategic buyer in mind that they hope to sell to. They have to improve the company — make it more profitable and get it big enough to be of interest to a larger company.”

Sometimes that means loading the company with debt. Particularly, Applebaum said, when the large private equity firms are involved.

“The concern about private equity, when you have those big companies come in, is that they load the company they bought with debt,” Applebaum said. “They charge them a monitoring fee. ‘I’m going to look at everything you do, and you’re going to pay me millions of dollars a year to do that.’”

Those fees can satisfy the private equity firm’s financial interest regardless of whether or not the purchased company achieves greater success or attracts a buyer.

“They say that they’ve come in, they’re going to restructure the company,” Applebaum said. “They’re going to make it much better. And that is not what they do. What they do is figure out how they can enrich themselves.”

It’s a sweeping critique — but not without truth, when it comes to bad actors in the sector.

Not all private equity shops are alike, of course. And no-one is suggesting you abandon private equity any more than you would a traditional asset class.

Consider this a caution flag, and another reminder on the value of due diligence.