Is Private Equity Bad for Broker-Dealers?

Majority vs. Minority Ownership

Lovell Minnick’s 1 year, 10 month ownership of First Allied was an example of the downside of majority ownership by private equity vs. minority equity ownership.

Less than a month after Lovell Minnick’s ownership of First Allied, they announced a back-office staff layoff, with two more subsequent layoffs before the firm was sold in June 2013. The accumulation of staff layoffs came to approximately one-third of the back office.

The greatest disappointment with the layoffs was that much of the brain trust, which at the time of purchase made up much of the attraction of First Allied, was gone.

The Lovell Minnick experience of PlanMember was a positive one, but Lovell also had a minority interest in the broker-dealer while the majority stake in First Allied gave them the ability to be a bull in a china shop in terms of back-office staffing levels. This was a textbook, cost-cutting financial engineering PE story.

Why the Surge in PE Activity?

For institutional investors, private equity delivers two substantial advantages: better returns with less volatility and less regulation.

In Jim Grant’s May 30 interview with Dan Rasmussen, the founder of Verdad Management with prior work experience at Bain Capital and Bridgewater Associates, he discussed the swell of private equity activity.

Elaborating on the attraction to private equity, Rasmussen explained, “If you look at the time series of private equity returns, it’s less volatile, not only less volatile than the S&P 500, it’s less volatile than high-yield bonds.

“In terms of percentages of down years, private equity is actually less volatile than Treasury bonds, because it turns out that when experts do the appraisal accounting, they don’t think the market valuation has changed very much each quarter.”

In an Aug. 28 podcast by USA Watchdog, Danielle DiMartino Booth, founder of economic consulting firm Money Strong and author of the book “Fed Up,” had this to say about regulation.

“When Dodd-Frank was implemented, what Wall Street did was say, ‘Now that they are going to regulate this corner of investment banking that was the most lucrative, we’ll move all our most lucrative business outside of traditional investment banks that are now overly regulated and move to the private equity world,’” she said.

DiMartino Booth continued, “There are trillions and trillions of PE dollars in this country that are not regulated by any entity, which can cause problems in and of themselves. Nobody is looking over private equity, so in essence, the fox is back in charge of the hen house, which is what keeps her up at night. What Countrywide was in the 2000s, PE has taken their place as this new shadow banking system.”

Gauging the future of private equity appears to depend on where you think interest rates are trending. A bullish assumption of PE rests on low debt servicing costs, which does not instill great confidence, according to an article on Valuewalk.com titled “Dangerous Trends in Private Equity.”

PE firm Thomas H. Lee Partners is focusing on less cyclical growth businesses, which are better positioned to weather a downturn that could have a similar magnitude to the last financial crisis.

Additional caution was expressed by Frode Strand-Nielsen, founder of PE firm FSN Capital. He explained that the next five years could be a tumultuous environment for private equity and leveraged debt. This is especially the case for buyouts that featured the use of incredibly cheap debt.

If you want to delve deeper into the different kinds of private equity and how they operate, see my Investment Advisor article  “Is Private Equity IBDs’ Savior or Sorcerer?”