Zachary is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
As the US economy slowly rebounds from the financial crisis, private equity companies are capitalizing on new opportunities. These companies are uniquely positioned to capture profits through their highly-leveraged business models.
Investing in the funds that these companies manage will likely yield attractive returns over the next several years. But investing in the stocks of the private equity firms themselves provides potential for a much larger investment gain.
Today, we'll take a look at three private equity stocks that should offer tremendous returns over the next several quarters.
The business model
Private equity companies are different from many other asset management firms because of the multiple streams of income these companies have access to. The typical private equity company makes money from three primary revenue sources:
Management Fees: When investors place capital in the funds managed by private equity groups, the companies typically charge a management fee. This fee might represent 1% to 2% of assets on an annual basis. When you consider the billions of dollars invested by these groups, the management fees can be quite lucrative.
Incentive Allocations: Private equity groups typically charge their customers a percentage of profits known as an incentive allocation. If the group manages a $10 billion dollar fund and posts returns of 15% ($1.5 billion dollars), the group might charge investors 20% of those profits. In this example, the incentive allocation would be $300 million.
Return on Capital: When private equity companies launch new investment funds, they typically put their own capital to work alongside their investors. So if the investment fund turns out to be profitable, the company realizes a return on their on investment (on top of the fees that they charge their investors).
All three of these income streams work together to make private equity companies very lucrative businesses. As an investor, I would much rather use my capital to buy shares of a private equity company (giving me access to all three of the revenue streams) than invest my capital into one of the funds managed by these groups.
The business structure basically allows the private equity companies to generate tremendous profits when their investments perform well, while at the same time, the companies aren't forced to accept a significant amount of risk if the investments lose value.
As investors in these stocks, we can have the same asymmetric risk profile (maximum gains when profitable, minimal loss when unprofitable). Here are three private equity groups you should consider buying.
Diversified for maximum exposure
Investors in The Carlyle Group (NASDAQ: CG) benefit from the company's broad exposure to many different markets and asset classes. The group manages 114 different investment funds, with exposure to nearly every corner of the global economy.
On the corporate side, The Carlyle Group has been responsible for bringing some great companies to market. One great example is Dunkin' Brands. Dunkin' was a company struggling to grow until Carlyle purchased the restaurant chain.
Carlyle revamped the company's growth strategy and got the restaurant back on track. Then Carlyle issued an IPO, selling shares of Dunkin' Brands to public investors. The stock has continued to do well since the IPO, and Carlyle has profited handsomely.
Analysts expect Carlyle to earn $3.10 per share this year. Currently, the stock is trading around $27, or less than 9 times earnings expectations. Given the company's broad exposure to the global economy, I expect Carlyle to generate impressive profits over the next several years.
A real estate powerhouse
The Blackstone Group (NYSE: BX) has recently been focusing on the residential real estate market. Over the past year, Blackstone has spent billions of dollars on residential real estate, buying foreclosed homes and renting them out.
The investment approach makes a lot of sense, given the recent rebound in home prices across the country. Rental rates have also increased which helps the company generate strong cash flow from its portfolio of assets.
Over time, Blackstone will eventually sell many of these houses for a significant profit. When it does, the company will be able to assess incentive allocations from investors in the funds that purchased the homes. Of course if you are an investor in Blackstone, these incentive allocations benefit you as a shareholder.
Blackstone is currently trading at just under 10 times expected earnings for this year. The company also pays a 5.8% dividend yield, making it a very attractive investment.
Shares of Kohlberg Kravis Robers & Co. (NYSE: KKR) are trading at a very attractive multiple, currently less than 8 times this year's expected earnings. The discount may be due to the longer-term portfolio the company is building (which may take longer for incentive allocations to kick in).
KKR (as the company is often referred to) is currently active on the acquisition front. Just this month, the company announced it's first European property purchase - a 430,000 square foot portfolio of retail locations.
The company is also active in acquiring entire companies as well as specific divisions of conglomerates to build out its portfolio of investments.
Even though investors may have to wait some time before KKR realizes incentive allocations, the company still pays a 5.8% dividend. So investors are being paid very well to wait for profits to accumulate through the company's various private equity investments.
Taking advantage of discount pricing
The private equity industry has fallen out of favor after the sector faced significant challenges during the financial crisis. Shares are currently trading at low valuations as skeptical investors are unsure whether the companies will successfully grow their investments and be able to charge incentive allocations.
The global economy certainly faces challenges, but these firms should still generate reliable profits. I expect management fees to continue to pour in, with incentive allocations adding boosts to profits whenever large transactions occur (such as an IPO or major sale of property).
These three stocks represent a tremendous value and you should check them out before the market begins to account for their growth opportunities.
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