Client Update, August 20, 2024: The Private Equity Pause

In most letters, we focus on the characteristics that attract us to a particular position. We’ve spoken at length, for example, about Google (NADAQ: GOOG) and Amazon (NASDAQ: AMZN), two of our long-standing favored positions. We speak less often about the kinds of investments that don’t appeal to us, but there may be some value in explaining why we sometimes keep our distance from certain opportunities. Private equity (PE) represents a good example.

To be clear: private equity investing can be very lucrative for the right people under the right circumstances, with ample success stories. Perhaps one of the most legendary is the Hilton Hotels (NYSE: HLT) acquisition by private equity firm Blackstone Inc. (NYSE: BX), which made some $14 billion off the deal. A well-executed PE deal can richly reward its investors.

So, why would private equity give us pause? Quite simply, the underlying business model is a poor fit for a value investor approach that emphasizes buying undervalued but still healthy assets and holding them for a long period of time.

Worse, not every private equity deal works out as well as Hilton’s. Far from it: the past few years have seen ample examples of private equity acquisitions that have seemingly fared poorly afterwards.

Let’s take a step back. If we look at how private equity gets involved with companies, it typically involves a lot of leverage (debt), using very little of their own equity, to acquire businesses that are struggling. Then, they’re looking at a short two- to four-year exit plan. We prefer using no leverage and ideally look at an exit plan spanning decades, if not forever, as famed value investor Warren Buffett puts it.

The challenge is that leverage adds a fixed cost into an already operationally stressed business; that fixed cost gets even worse if rates go up, adding to the financial stress even further. If the business is struggling enough to need capital from a PE, there are likely underlying issues. If nothing else, they may not have the in-house expertise needed to make the turnaround from melting ice cube to success story. Consider retail: Macy's might have originally wanted to maximize the value of their brand, so they brought in people that were more retail-oriented, but as that side of the business continued to struggle, there might have been more value in their real estate holdings instead of the brand itself. But that’s a huge shift, and it’s hard to make that kind of turnaround on their own.

Then, inherent in a PE model is a put option, so if the value of the business dips below the money the PE investors put in, the PE firm can push the business back to its creditors. As a result, the business itself and its creditors bear more risk than the PE investors.

Ideally, injecting a lot of capital into the business will rejuvenate it, and/or a disciplined PE team will be able to rework the underlying business, e.g., developing new revenue streams so that the debt will be more serviceable over time. They are essentially taking on a known financial risk today in the hope that the income statement in the future will have improved enough to support the added leverage.

But how do you tell the difference between a business that has simply reached maturity (there’s no more income to squeeze out) versus one that just needs an infusion of capital or some other PE-driven correction? The ability to answer that question correctly, time after time, is what spells the difference between successful PE groups and unsuccessful ones. There are few who can do it consistently. Additionally, the PE firm is essentially proposing to act like business owners, at least temporarily, which means they need to have the right expertise to identify and execute different strategies for the business’ turnaround.

That doesn’t mean the PE model can’t produce tremendous successes, as described above. If we’re trying to build a bridge from where the business is at today to where they need to be tomorrow, PE can be a conduit and can bring in the funding needed to make the transition.

But even then, what about when the PE firm takes the business public? Here, the foundation of the business may not actually be any stronger than when the PE firm started. Most of these PE-acquired companies will have taken on even more debt while private, with the PE investors focused on getting their own equity back as fast as possible. If they buy the business for $5 billion, with $4.5 billion in debt, they’re going to want to get their $500 million in equity back first. To that end, they might take on more debt or restructure the business for short-term returns, using free cash flow to pay themselves dividends. Unfortunately, these tactics are likely to damage the underlying business in the long-term.

That’s not an attractive option for a firm like GDS Investments. There’s just too much short-term thinking built into the PE model to fit our philosophy. PE is not trying to create a business that has longevity but instead a business that will pay out as quickly as possible, sometimes no matter the damage done. As a result, this is just not a field we play in. We are debt averse and avoid highly leveraged companies, managed according to short-term goals, focused on paying special dividends to private owners, while potentially undermining the company’s long-term prospects for that short-term payout.

Running Toward a High-Value Future: NIKE, Inc.

So, if the private equity business model risks undermining the long-term prospects of acquired businesses, what might be an example of an investment that does offer a lot of long-term potential? A recent acquisition of ours showcases this situation perfectly: NIKE (NYSE: NKE).

Far from a business that’s overleveraged, sometimes we can find a business that may actually be under-leveraged. That’s a situation that both speaks to how the management team thinks and also offers a lot of optionality. That business will have the ability to generate a lot of value for shareholders without the added pressure of (and subsequent inflexibility caused by) lots of debt. NIKE is a great example. The company has been down at multi-year lows but continues to show long-term staying power.

NIKE is not without issues. They perhaps put too much emphasis on NIKE Direct at the expense of more traditional channels like retailers. There’s also ongoing concern around challenger brands. Faltering sales have hurt brand perception, with the result that shares fell sharply in July.

However, the underlying business is still strong. Mike Armstrong, global managing director of British sports and fashion retailer JD Sports Fashion PLC (JD:LON), recently said, “Anybody that writes NIKE off probably needs to go back and look at the history of NIKE in the market place over the last sort of 30, 40 years. NIKE will be just fine.”

Armstrong also said that this is an industry with a constant stream of challengers and upstarts. What’s rarer to find is a brand with true staying power, which NIKE offers.

This comes down to NIKE’s long-term brand equity. It remains the most valuable brand in sports apparel with dominant market share, where it has been growing steadily for years (surpassing 35% in 2024 globally and even higher in North America specifically). Even better, they have net cash on the balance sheet, with $23.6 billion in liabilities but $38 billion in total assets. They have averaged around 25% return on invested capital (ROIC) for years (23.25% as of May 2024), versus an average ROIC of only 15.29% across the apparel industry as a whole.

Altogether, their financial standing gives them the ability to think and invest for the long term as the company deals with their current turnaround (something they’ve dealt with before) and how it impacts capital allocation decisions.

That math is very attractive to us.

First, when you have a business with 25% ROIC that wants to grow at 10%, they will need to invest 40% of their free cash flow into the business just to maintain that 10% growth rate. But then, they can use the other 60% in ways that benefit shareholders today. So, they can buy back stock, which they do; they can pay out dividends, which they do; they can invest in new innovations and product lines, which they do; and they can acquire other companies, which they have done (to a lesser extent). In truth, though, it’s not the specific actions they take that matter so much as how their huge free cash flow cushion gives them a lot of optionality to reward investors today without jeopardizing the future.

Second, NIKE is currently trading in the bottom quartile in terms of historical free cash flow and sales per share. As a result, we can make 10-12% even if they get no multiple expansion, along with a strong moat around their ROIC in terms of brand perception, asset building, and supply chain relationships. Very few stocks have grown per share since 2018 or 2019 (pre-COVID) but remain at their 2018/2019 prices. NIKE, however, has grown considerably more equity, offers similar operating metrics compared to its 2018/2019 performance (except it's 8% to 9% per annum bigger than then), but its per share price is largely the same. It's hard to find companies with this level of stability that are at 5- to 6-year lows. Those two variables together make NIKE an extremely attractive position right now for generating long-term value.

On Our Desk: The Federal Reserve and the Future of Interest Rates

Finally, let’s shift gears and briefly touch on a hot topic this month: the Fed rate cut trajectory. This has been a frequent topic of discussion on earnings calls recently. We’re not going to say anything new here (you can refer to previous letters for more in-depth discussion of the Fed and the current/recent rate cycle), but because it’s become topical again, it’s worth re-iterating: sometimes investors can just get too wrapped up in rate cycles.

Let's not forget that the market is a leading indicator, and it’s tough to position portfolios around things happening today because the market is already discounting some of the (anticipated) upcoming quantitative easing (QE) cycle. This is an exact corollary to rate increases, because when higher rates started to materialize and permeate the economy, equity markets had already reacted well in advance.

This is why we don't get macro-oriented in general; everyone needs to build into their investment approach a certain level of expectations and discounting when it comes to interest rates. The best hedge is to avoid companies that are over-reliant on interest rates either directly or indirectly. Instead, invest in companies that have strong balance sheets that can weather virtually any interest rate environment.

Of course, identifying such positions with long-term value potential—and then waiting until those assets grow cheap relative to value, like NIKE—is easier said than done. As always, at GDS Investments, it is our job to continually assess our portfolio and ensure that we hold only the best combination of valuation and quality. We continue to adhere to that strategy on your behalf.

As ever, I remain grateful to you for your ongoing support.

With warm regards,

Glenn