Let’s take an investment proposition whose model is to pay a significant premium to current market rates for acquisitions, throw in lots of leverage, charge enormous fees, and which allows the investment manager to value a company using basically any measure that they choose. Are you as an investor ready to take the plunge and commit your savings?
Well what I have just described is Private Equity (PE), formerly known as the LBO business .1 Those that currently are invested in PE, as well as those who work in PE, point to the superior returns of this sub-asset class2 in the past. Yet in aggregate, what have those returns really been? Of equal importance, what do investors really think their returns will be going forward based on the dynamics I outlined in the first sentence?
My skepticism over historical returns in PE, is derived from a number of factors. One of the most significant is that unlike the stock market and hedge funds, there is no easily definable and frequently cited index. Equity markets have the most ubiquitous ones, such as the S&P 500 and Russell 2000, which are quoted daily in newspapers, radio, and TV, and can be brought up in real time on any financial website: Yahoo, Bloomberg, WSJ, etc. Hedge funds also have easily obtainable indexes that are updated monthly soon after the funds report returns. Here are two that are quickly googleable: HFRX and Barclay’s HFI. While I would be the first to admit that these indexes are imperfect as they lump together a lot of completely different types of investment strategies under the vague moniker of “Hedge Funds”3, and may have many other imperfections4, at least third-party organizations have taken the time to painstakingly quantify a general number on a regular basis. Furthermore, these indexes have increasingly been cited in the financial press, mainly to note how poorly hedge funds have been performing recently relative to other investments, and to question the large fees being paid out for this under-performance. While PE supposedly also has third-party organizations compiling returns, just try and actually see them – it’s absolutely not going to happen on Google. Worse, any institutional investor one talks to just assumes that recent returns, say in the last decade, for PE overall are in the 12-15% range, without any substantiation.
If turning a blind eye toward the real returns in Private Equity and being given a huge assist by the lack of data/indexes isn’t enough, the biggest charade is the belief that they exhibit less volatility than other asset classes. Of course they do, because unlike publicly traded securities, whose current price is based on actual transactions, companies held in private equity partnerships are priced by the firm managing them. Now while the methodologies that these firms employ may hold some water5, any institutional investor who uses the lack of reported volatility in PE funds as a rationale for upping his allocation to the sector is delusional. Private Equity funds are simply heavily-levered, unhedged long equity positions whose underlying businesses are highly correlated to the markets and the economy.
Sure, there are some spectacular investments. The NYT used the incendiary title of “How the Twinkie Made the Superrich Even Richer” and then went on to describe how they turned a $186 million investment in Hostess and cashed out for $2.3 billion less than four years later. Unfortunately that type of return in PE is the exception rather than the rule, with the downside exemplified by a WSJ headline several weeks after ‘Twinkie’s’ entitled “Avaya: How an $8 Billion Tech Buyout Went Wrong.” The story went on to relate how the P/E firms, or actually their investors, went on to lose their whole $2 billion investment. As expected, leverage evinces these types of binary outcomes.
Next up are the fees that Private Equity charges. Just like hedge funds, they are on average close to 2% management fees and 20% incentive fees. Back of the envelope, if one assumes a 15% gross return, as PE investors falsely do and are wont to spout, then the incentive fees add up to an additional 3% of assets under management a year. Thus, incentive fees combined with management fees mean a PE manager has to outperform equity markets by more than 5% per annum6 to truly outperform (2% management fee + 3% incentive fee).7 In a competitive marketplace such as the U.S., a PE manager’s ability to overcome that handicap and outperform requires a serious suspension of disbelief by those placing money in a private equity fund.
The tremendous investment interest in Private Equity, and hedge funds for that matter, is derived from the enormous need for expected return by institutions such as municipalities, states, and corporate pension funds. They are willing to overlook the conceptual premise and under scrutinize the overall historic returns in order to maintain the fallacy that their liabilities will be funded. A decade or two from now when there’s no more money in the till, the decision makers will be long gone, and trying to ascertain who’s responsible will probably not fall on the shoulders of a previous allocator who dedicated 10, 20, 30% of a portfolio to Private Equity. In the meantime, these allocators will not be blamed for placing OPM (Other Peoples Money) with such esteemed firms as Blackstone, KKR, & Carlyle, or even lesser lights in the PE business.
Furthermore, when the day of reckoning comes, the disappointing returns will (hopefully) be just that, disappointing, and therefore be buried in the back pages of the WSJ. Not in big bold type on the front page everywhere a la Madoff. Thus there’s really only one savior who can tell-it-like-it-is and possibly curtail the masses: So, what do you think about Private Equity Mr. Buffett?
- Sure, I know that PE encompasses so much more than LBO’s these days, but whether a PE firm is buying a whole company in the public markets or a private company or a division of either public/private, it still usually entails a bidding process w/ the winner paying the highest price. Leverage/fees/valuation methodology all still apply. This goes for real estate, distressed situations, credit, and all the other assets lumped into PE [↩]
- Alternative Investments is the usual moniker given to the full asset class, though really when you break it down PE is simply leveraged equity. Furthermore, I fully concur with the sentiment that Alternatives are a compensation scheme, masquerading as an asset class [↩]
- Where do I even start w/ this term: first off, some completely hedge, and some very transparently do not at all, and some do so to varying degrees. Some use leverage, some do not, and then some use massive amounts. About the only similarities that most hedge funds do share is that they charge much higher fees than conventional money managers, and are predominantly invested in publicly traded securities [↩]
- are they weighted by AuM or not? Survivorship bias? [↩]
- yet in really bad times there seems to be a considerable change to these methodologies [↩]
- that’s 1/3 of the expected 15% gross return! [↩]
- oh, and here at TSB we are very aware that unlike hedge funds, management and incentive fees are not the only fees incurred by LP’s in PE. Others dings include operating fees, acquisition and disposition fees, financing fees, private jet fees, etc. [↩]