Investors’ appetite for risk has dramatically exceeded that of corporate CEOs, according to the IMF’s annual global financial stability report.
Financial risk premiums have declined steadily since the Great Recession as investors have bid up stock and bond prices, but this has not translated into material increases in business investment. While stock prices are at all-time highs, net business investment remains about 20 percent below pre-crisis levels. This under-investment creates compelling opportunities for private equity investors.
Non-financial businesses in the U.S. rationally responded to the “near-death” experience of 2008 by increasing cash holdings by more than $550 billion. But rather than increase business investment post-crisis, businesses chose instead to channel savings to shareholders. Dividends paid by nonfinancial corporates have grown by 61 percent since 2009, while annual share repurchases have more than doubled.
While some blame misaligned incentives or myopia, the increase in dividends to shareholders looks to be a rational, low-risk way to increase returns to shareholders in a difficult operating environment. How so? The short-run orientation of public markets has created irresistible incentives to pursue dividends and share repurchases, while record low interest rates have generated a “search for yield” that has boosted demand for dividend stocks. The greater a stock’s dividend yield, the higher its current valuation relative to historic averages.
At the same time, the announcement of increased shareholder distributions tends to trigger an immediate increase in the share price. To choose business investment over dividends, CEOs must be willing to forego immediate, high probability increases in the share price in favor of more distant and less certain returns.
Today’s cautious CEOs have, in many ways, reversed the traditional role of private equity investors. In the past, buyouts generally stepped up cost controls in businesses where spending was out of sync with maximizing long-run value (empire building or gold-plating of facilities).
The tendency towards excessive spending was often attributed to misaligned incentives between managers and owners, but stock market demands again played a large role, though the opposite of today. In such cases, an increase in shareholder distributions was a tacit admission the firm had exhausted profitable investment opportunities and its growth rate was soon to slow. When stock markets are assigning high values to expected growth, as was the case in the late 1990s, this was hardly the signal management wished to send. Corporate savings actually turned negative at the end of the 1990s as valuations in many sectors became entirely dependent on top-line growth at the expense of profitability.
Times have changed. Today, value creation strategies employed by private equity firms often begin with increasing business investment.
For example, since the end of 2012, seven of the 10 largest investments Carlyle has completed in the U.S. are predicated on adding value through targeted increases in business investment. Five of these investments involve carve-outs of “non-core” corporate subsidiaries, where conservative investment policies stifled or nearly eliminated necessary spending. Spinning these companies off from their corporate parent allows for a re-set of priorities. Instead of managing the business to hit cash generation targets to fund corporate dividends, former subsidiaries can invest to develop new products, enter new markets, improve production processes, or pursue other growth opportunities.
Despite some recent signs of faster growth, low interest rates, increased risk aversion and elevated corporate savings are likely here to stay. In this environment, significant value can be unlocked by taking on economic risk over an investment horizon that provides sufficient time for business investments to bear fruit.
Private equity investors are uniquely positioned to capitalize on the opportunities created by under-investment and to demonstrate that greater efficiency is not always synonymous with reduced spending.
Peter J. Clare is Co-Head of Carlyle’s U.S. Buyout team, and Jason M. Thomas is Carlyle’s Director of Research.
Photo courtesy of Carlyle Group.