Busting the myth that you need leverage to get decent returns

As the financial markets began to deleverage in 2007, private equity firms were among the first group of borrowers to feel the pinch.

As the financial markets began to deleverage in 2007, private equity (PE) firms were among the first group of borrowers to feel the pinch. As the deleveraging process was completed last year, the doomsday crowd then announced that this heralded the end of private equity as we know it, since PE managers would no longer be able to generate the 20 per cent returns to which investors were accustomed.

Although I agree that talentless managers, of which there are many, will no longer survive, I disagree that the returns cannot be maintained. In fact, I believe that talented managers will continue to generate such returns, if not higher. The basic premise of my argument is that leverage (the use of borrowed money to partially finance an investment) was needed to generate returns over the past few years since assets were overpriced. If you buy something expensive, then you will need to leverage to generate the equivalent return as if you had bought the asset at a fair value.

Consider a company; let's call it the Real Economy Company (REC) that, based on your analysis, would be worth Dh160 (US$43.56) per share five years from now. If the market today was overheated, and you could buy REC only at Dh100 per share, then this would mean that your compounded return would be 10 per cent annually. For a PE manager, 10 per cent would barely make it worthwhile getting out of bed. Until the recent troubles in the credit markets, PE managers in this situation would have had to rely on leverage to supercharge the return to the expected 20 per cent. Typically, the manager would borrow at a rate of two to one; for each Dh1 he invested, he would borrow an additional Dh2. If the PE manager's cost of debt was 5 per cent annually, then his return on equity would increase to the required 20 per cent.

Now that leverage is basically no longer available, what is a PE manager to do to continue using the private jet, living in multiple penthouses and driving a warehouse full of Ferraris? Well, let's remember that although leverage has disappeared, market prices have also adjusted by 50 per cent or more. Using our example of REC, if the price has fallen from Dh100 to Dh50, then a PE manager would generate a 26 per cent annual return when he sold it in five years at Dh160 per share. The astute reader will point out that it might be unreasonable to expect that REC will still be worth Dh160 in five years. Fair enough. But even if REC fetched Dh125 instead of Dh160 the PE manager would still make a 20 per cent compound annual return.

It is important to understand that I am not advocating a blind approach to buying assets simply because they are relatively cheap. I have no doubt that this will be the new mantra of investment managers around the globe, but a good price is only part of the equation, albeit an important one. Just as important is value. Here, the adage of caveat emptor, or in local parlance, old souq haggling rule, applies. If you are offered a 70 per cent discount on something, make sure you are not being sold damaged goods.

For a complete exposition on value investing, I'd recommend Graham and Dodd's Security Analysis. As a first step, let me outline some basic ideas when searching for value. First and foremost, you need to look at the management team. It is usually not possible for an economy to grow faster than the available talent pool. In our region, oil has created just such an anomaly. This gap only increases the effect that competent management has on equity returns. When the sum total of a company's management is the two people pitching the idea to you, take that as a warning sign.

Second, consider the visibility of operational cash flow. It should be clear how the company is going to continue to generate cash revenue. One would think that this goes without saying, but it is amazing how many projects were funded without this question being asked, let alone answered. There are, or were, as the case may be, several well-known investment companies, whose main business seemed to be to give birth to shell companies, and then convince otherwise rational people to invest in them. Remember, just because a company has raised Dh1 billion in equity, does not mean that it will be profitable. The pundits will no doubt poke holes in my example. I know it is simplistic, but it illustrates the key point: private equity investing does not require leverage in order to generate exceptional returns, just hard work and the right questions.

Of course, if a manager wants to cut corners and buy overpriced companies using borrowed money, that's his prerogative. Just don't ask me what to do when things go horribly wrong. I am too busy investing in companies with an experienced management team, operating in the real economy. Dr Sabah Hamad al Sabah al Binali is a principal and chief investment officer of Saffar, a regional financial services company