Private equity firms burst into public notice in the 1980s, as portrayed in the classic book on KKR’s takeover of RJR Nabisco, Barbarians at the Gate. Investing with the barbarians can be very lucrative, but is financially possible only for the megabucks crowd—institutions like pension programs and very rich individuals. That type of well-heeled investor becomes what’s known as a limited partner in one or more of a private equity (PE) firm’s funds (each fund has a collection of companies in its portfolio). Plus, a limited partner must be an “accredited investor,” meaning having a net worth of at least $1 million and annual income of $200,000 or more.
For the limited partners, private equity sports a pretty strong track record: It often generates superior returns compared with the overall stock market, and in tough times, PE typically loses less. According to consulting firm Cambridge Associates, over five years ended in 2022, the funds earned an annual 18.6% versus 5.5% for the MSCI global stock index. In the snakebitten year of 2022, they lost just 4.3% as the MSCI index dropped 17.2%.
But those big-time investors pay exorbitant fees for entry to this exclusive club: Typical is the storied “two and 20,” meaning 2% of assets in annual management fees and 20% of the profits when a portfolio company is sold. While those percentages lately have come down a bit, as competition has grown in the field, PE firm honchos still get a very sweet piece of the action.
Which is why it’s surprising more investors don’t take advantage of a backdoor way to invest alongside the big shots. Some of the largest PE firms offer common stock, and three in particular have been performing at close to or better than the pace of PE funds—and you get to skip paying those insane PE fees: KKR (KKR), Blackstone Group (BX), and Apollo Global Management (APO) all fall into this category. Over time, stocks in the threesome mostly tracked (and sometimes exceeded) how their underlying funds performed—and handily outpaced the stock market. While this trio’s common stock lost around 20% in 2022, their annual performances over five years were rewarding: 17.3%, 26.3%, and 22.1%, respectively. Collectively, their 21.9% average beat the S&P 500’s 12.3% showing for the period, by a solid 9.6 percentage points.
PE shares are “the best way to get in there,” says Olaf van den Heuvel, global head of multi-assets and solutions at Aegon Asset Management, who is based in the Netherlands. Nick Atkeson, a principal at Delta Investment Management in San Francisco, has purchased stock in KKR that “has outperformed the S&P 500” over both the short and long term. Thus far in 2023, it has logged 22.4%, while the most prominent exchange-traded fund tracking the broad market index, the SPDR S&P 500 ETF Trust (SPY), rose 16.9%. Over five years, KKR outdid the index fund, 17.3% to 12.3% annually; over 10 years, the score was 13.1% to 12.2%.
And though 2022 was a rough year for price/earnings ratios (P/Es) amid the stock market’s tumble and the bank lending pullback which held down acquisition activity, there’s a silver lining. On a forward P/E basis, the top three all look relatively affordable (defined as below the S&P’s or close to it): KKR at 12.8, Blackstone at 20, and Apollo at 11.9 (Blackstone is only 0.5 point higher than the S&P 500. In 2023’s first quarter, PE firms’ deals cascaded to $92 billion, off 61% from the comparable year-before period, per an EY report. In March, though, deal announcements picked up, sparking expectations for a rebound.
There are a few prevailing tailwinds that make these stocks look attractive now, according to analysts. First, with commercial banks pulling back on lending, the PE firms’ private credit arms will increasingly be tapped by companies who need cash fast. And PE firms should have plenty of appealing targets to choose from in the coming year as economic uncertainly reigns. Indeed, when their “target” companies are cheaper to buy, it means investors will benefit when it comes time to exit those deals via sales to others or an IPO.
How does private equity work?
Private equity’s business model is to buy companies using a lot of borrowed money, manage the businesses for several years in the name of making them more profitable, then sell them for a big gain. PE’s often superior returns stem from its long-term approach (the buyout firms hold their portfolio companies for up to seven years), intensive research into target companies before acquiring them, and diligently reorganizing these businesses, a paper by consulting firm Woodruff Sawyer contends.
Private equity practitioners say they do all this in pursuit of a noble purpose. KKR cofounder Henry Kravis touts PE as the prime engine to improve corporate America’s efficiency for the benefit of investors. Starting in the 1970s and 1980s, Kravis once said, buyout firms like his “changed corporate America [by] holding companies accountable, and for the first time managers started thinking like owners.” Hilton Worldwide Holdings (HLT) is an oft-cited example of a dowdy business that PE titan Blackstone revamped. The firm spruced up Hilton’s operations, overhauled its onerous debt structure, and expanded its reach overseas. In 2018, after 11 years, Blackstone sold its stake in the lodging company for a tidy profit.
To some, however, private equity operators are a bunch of scoundrels. That case gets a thorough airing in a new book, These Are the Plunderers: How Private Equity Runs—and Wrecks—America, by journalist Gretchen Morgenson and financial analyst Joshua Rosner. For instance, they describe how PE ownership drove nursing-home chain HCR ManorCare into bankruptcy in 2018, amid many health-code violations.
The top 3 PE stocks for 2023
Blackstone The company, launched in 1985, took its name from the surnames of its founders, Stephen Schwarzman and Peter Peterson, who had worked at Lehman Brothers. When it went public 16 years ago, Blackstone raised over $4 billion. Like other buyout organizations, it expanded into lending and real estate. Last year saw a decline in its earnings, partly owing to a drop in its property business’s valuation and rising interest rates—and the stock was halved from its $141 peak in late 2021.
Nevertheless, Blackstone has continued to pull in new investment dollars, and the stock price has partly recovered, to $92. In this year’s first quarter, the company had a $40 billion investment inflow, and CEO Schwarzman said it had amassed $200 billion in cash available for new deals, known as dry powder, which he touted as an industry record. In March, it announced the purchase of Cvent Holding, an events and hospitality technology provider, for $4.6 billion. Bank of America Securities rates Blackstone a buy, arguing that the market underestimates its future earnings growth.
KKR Kravis, Jerome Kohlberg, and George Roberts formed the company in 1976, and it went on to gain a reputation for tackling big deals—most famously RJR for $25.1 billion in 1988 and energy provider TXU, for $32 billion in 2007, allied with other PE funds. For a time, both deals were ranked as the largest buyouts in history. (Elon Musk’s takeover of Twitter now holds that distinction.)
Both RJR and TXU, which filed for Chapter 11 in 2014, proved to be money losers for KKR. But the firm has enjoyed many successes along the way—for example, life sciences group LGC, food delivery service DoorDash and life insurer Global Atlantic. It has shifted strategy to focus on buying stakes, sometimes minority ones, in fast-growing health care and tech companies.
Like others in the field, KKR has taken a pounding, with a loss for 2022 and a tumbling share price. But it returned to profitability during the past two quarters, and the stock has moved up from last September’s $43 recent low. While deal activity remains tepid, Deutsche Bank notes that its fee income is good and its cost controls effective. The bank rates KKR a buy and, at current levels, “an attractive entry point.”
Apollo This firm’s stock has fully recovered from the dive it took last year, as encouraging first quarter earnings amid strong fee income restored optimism about the company. Finding bargains in the wake of recent market turmoil, Apollo has agreed to purchase chemical manufacturer Univar Solutions and industrial parts maker Arconic (ARNC). One of its boldest moves was last year’s absorption of insurer Athene, an all-stock transaction that increases Apollo’s capital and earnings potential.
Apollo, launched in 1990, also is rated a buy in Deutsche Bank’s estimate. The firm is “driving solid growth on the asset management side, despite a more challenging environment for PE broadly,” DB says in a report.
One caveat: Smaller private equity stocks don’t tend to do as well as the KKR-Blackstone-Apollo triumvirate. Look at the S&P Private Equity Index, which has 80 constituents, to include the top three. Weighed down by the record of smaller players in this collection, the index’s loss last year was more painful (28%) than the leading three’s dip, and over five years the PE index logged just 9.7% annualized. PE stock performances “skew to the larger funds,” observes Andrew Krei, co–chief investment officer at Crescent Grove Advisors in Milwaukee.
But overall, as private equity dealmaking bounces back, and given acquisitions made in iffy times tend to do the best, a report from consulting outfit Bain & Co. finds, PE stock should be headed upward anew. Good news for those in this elite realm—and anyone investing alongside them.
