How to Invest Like a Private Equity Firm

We all see the same ads and get the same emails. Invest like this guy. Trade like this legendary trader. Buy what this big mutual fund manager is buying.

While some of that can be useful, and I do track what the famous hedge fund managers are buying, there is a class of investors that have outperformed the market by a pretty wide margin over the past few decades, and no one pays any attention to them at all.

These investors are all billionaires a few time over but you rarely, if ever, hear anyone talking about how they invest and what they are buying at a given moment in time.

Who are they?

They are private equity funds, and they have clobbered the stock market indices and continue to do so.

According to an article by the American Investment Council, private equity funds have almost doubled the stock market’s returns over the past decade.

The Yale Endowment Fund is a big investor in private equity as well, and they reported that from 1973 to 2006 that their private equity portfolio averages a little better than 29% a year. In comparison, the S&P 500 has averaged just 6.92% over the same time frame.

When I tell people about my fascination with private equity firms, the usual response is that most people cannot invest in private equity funds so why should they care what private equity fund are doing.

You do have to be a wealthy individual or large institution to invest in most private equity firms. But I am not looking to invest in a PE fund. I want to know how they are racking up these big returns and what sectors and themes they think are important right now.

What PE is buying

The big four private equity firms — Apollo (APO) Blackstone (BX), Carlyle Group (CG), and KKR (KKR) — are all public companies, and all have conference calls with analysts and investors every quarter.

They talk at length about what they are buying, what they are selling and what they think lies ahead for the economy and the market. I think reading these transcripts every quarter can teach you more about investing that any business school.

Apollo CEO Leon Black said on his first quarter conference call that the reason for his firm’s success was that, in a world where most takeovers are taking place to a 10 to 11 times earnings before interest, taxes, depreciation and Amortization (EBITDA), his firm was only paying a multiple of 5 or 6 times EBITDA for the companies they acquired.

Blackstone COO Hamilton Evans James made similar comments on his firm’s second quarter call.

Translation: They’re buying assets when they’re cheap.

Private Equity Firms are the ultimate value investors as their primary mission is to buy assets and earnings at bargain prices and sell them at some point in the future at inflated valuations.

The other part of the secret sauce is time.

Private equity firms hold the companies they own for a long period of time.

According to Bain and Company’s 2017 Private Equity Report, the average holding period of a private equity investor is about five years. Compare this to the average holding period of just eight months that Ned Davis Research discovered when they investigated investor behavior in 2015.

Longer holding periods are a critical part of how private equity funds consistently outperform the stock market.

Sectors in demand

In addition to discussing how they are beating the market, the PE executives will often disclose what sectors and assets they like at a given point in time. Common themes in the big four second quarter calls included healthcare, real estate infrastructure and energy.

Once I know that I can set up a screen to look for companies in those industries that trade at low multiples of earnings or asset values and put together a pretty solid list of companies that I investigate as private equity style investing candidates.

Riding the coattails

There is another way to put together a portfolio of private equity style stocks.

All of the big four invest in public companies as well as making private equity deals so we can go the 13F filings every quarter and see exactly which companies they are buying and ride their coattails to long-term gains.

It is pretty easy to see which stocks they are buying and selling and use that information to put together your own private equity portfolio of companies.

Private Equity Firms have used the combination of time and value to outperform for decades now. Paying attention to what they are doing and adopting more of a private equity mindset should also help us make a lot more money in the stock market.

Tim Melvin

Written By Tim Melvin

As a 30-year veteran of the financial services and investment industry Tim Melvin served as a broker, advisor, and portfolio manager. He’s combined this nearly three decades of experience with a love of value investing in order to help investors worldwide to multiply profits and build their nest eggs. As an avid value investor, Tim...