It’s perverse that it takes a Mitt Romney presidential bid to shed some long-overdue harsh light on the private equity industry.
It was not as hard as you might think to do well in the private equity business in the 1990s. Rising equity markets lift all boats, and PE is levered equity. A better test of the ability to deliver value is how they did in more difficult times.
The Financial Times reports on a wee study it commissioned to look into who reaped the fruits of private equity performance. Its findings:
From 2001 to 2010, US pension plans on average made 4.5 per cent a year, after fees, from their investments in private equity. In that period, the pension funds paid an average 4 per cent of invested capital each year in management fees. On top of those, private equity often collects a variety of other fees and a fifth of investment profits
“Assuming a normal 20 per cent performance fee, this would amount to about 70 per cent of gross investment performance being paid in fees over the past 10 years,” said Professor Martijn Cremers of Yale.
Now some readers might argue that even with fund managers feeding at the trough, 4.5% per annum returns were still better than the S&P 500, which delivered 1.7% compounded annual returns over the decade. But they are missing several things. First is that the S&P is extremely liquid and tolerates trades in size. By contrast, when you hand your money over to a PE fund, it is an expected 5 to 7 year commitment, and if the fund does badly, they will hold on to your money longer hoping a rally will allow them to unload some garbage barges at a decent price. I have no idea what rules of thumb are used to adjust returns to allow for extreme illiquidity and a lack of any control over exit timing, but in the stone ages when Goldman would value illiquid securities for estate purposes (a task that fell to junior investment bankers), we’d apply a 20% to 40% haircut.
A lot of investors, notably university endowments, took big hits when they put too much in private equity and found they were stuck in the crisis during 2007 to 2009. Some actually tried selling PE stakes in a pretty much non-existant secondary market and took huge haircuts. In addition, there were widespread complaints of the PE funds publishing phony valuations of their portfolios during that period. Bigger swings in value mean more risk, which mean worse Sharpe ratio, which is one of the benchmarks used by the pension fund
So where are the customers’ yachts? The release of Mitt Romney’s tax returns, which show $21.7 million of income in 2010 and $20.9 million for 2011, demonstrate he could buy a fleet of yachts. Wonder how often he takes his clients for a ride, in both senses of the word.