Private equity managers have some useful techniques to impart to public investors. Market timing isn’t one of them, says Tawhid Ali, portfolio manager at AB. “They bought a lot of public equity back in 2006 and 2007,” he notes. “Interestingly, it coincided with the top of the market and they disappeared. As a value investor, I was surprised at that. I had thought that the time to deploy would be when asset prices were really low and taken out of the market. They didn’t do that.”
Still, the buyout funds are back, and they’re sitting on $1 trillion waiting to be deployed. Some of that is money that has been allocated away from public equities. With so much money to be deployed, valuations are frothy, and leverage is on the upswing. Some key tenets of classical private equity investing are worth reflection. For one thing, it’s not about multiple expansion — hoping the market will take you out at a higher price. It’s about cash flow.
Follow the cash flow
There are four things that drive stock price returns over time, says Ali: cash flow earnings growth; the multiple you’re willing to pay or the multiple expansion; capital restructuring (if you’ve taken value from bond holders and given it to equity holders and vice versa); and capital returns (buybacks and dividends).
This kind of mathematical mindset encourages a shift in thinking, away from benchmarks, which, he argues, “have a very destructive influence on public equity management.” Instead, there is a move to a more relevant metric. “IRR — internal rate of return — is a metric private equity uses well, and it’s a very interesting way to think about the return potential of the capital allocations that you might make in the public equity space,” Ali adds.
This is part and parcel of the private equity mindset: thinking like a business owner.
“They own the whole company,” he says. “They think about what they would do with the company if they managed it. In public equity, you get the same option. When you buy a share, you become a fractional owner of the company. Many of us have forgotten that. You’re not renting that share. You can act like an owner, you can think like an owner, and you can investigate the business like an owner.”