By Nanea, a private equity insider, and Yves Smith
This is the first in a series of postings on the private equity industry (“PE”) and will serve as an introduction to private equity investing.
Private equity practitioners, including most famously Mitt Romney, often depict their sector as the epitome of private enterprise. These claims are false. Private equity firms not only depend directly and substantially on government support, they have also actively cultivated links to the state.
Some readers may know that private equity relies heavily on tax subsidies. Private equity firms engage in debt-leveraged buyouts of public and private companies, and the interest charges on this debt are tax deductible. But most members of the public do not know that close to half the investment capital in private equity funds is contributed directly by government entities. In this respect, private equity is little different than companies like Fannie, Freddie, and Solyndra that are regularly criticized in the media as recipients of government subsidies.
Their decisions to invest government funds in private equity reflect assumptions by government officials that have gone unchallenged and, we contend, are quite likely incorrect. Moreover, virtually all of the important details of the private equity investments made by these state investors are kept secret at the insistence of PE firms, in striking contrast to every other type of government contract.
Our discussion and analysis will range across the full spectrum of private equity but will mostly focus on the activity that was formerly called “leveraged buyouts” and is now generally called “buyouts.” This investment approach involves buying generally mature and usually profitable businesses, typically with the acquirer borrowing about half the money used for the acquisition. A broad definition of private equity refers to investing in non-publicly-traded equity securities (the “private” in “private equity” means “not publicly-traded”). So, when a small businessperson buys a restaurant from someone else, he or she is engaged in a “private equity” transaction. Practically speaking, the private equity “industry” excludes all these mom-and-pop transactions and, instead, refers only to the investments in private equity securities made by capital that is organized into “private equity funds”.
Some writers distinguish “venture capital funds” from other types of private equity funds (“buyout funds”). Venture funds make small, non-controlling and unlevered investments in relatively new, unprofitable or barely profitable companies. Despite these differences in the types of investments they target, buyout and venture funds are both private equity because they both have a long time horizon, make illiquid investments and have similar fee arrangements and fund structures.
Private Equity Investments: Numbers and Examples
The private equity industry has over $2 trillion in funds under management. A conservative assumption of $1 of fund equity for every $1 of borrowings translates this figure into over $4 trillion of buying power. By way of comparison, the subprime market reached roughly $1.3 trillion at its peak, the municipal bond market is approximately $3.0 trillion, and the total market capitalization of the US stock market was $15.6 trillion at year end 2011.
The single largest source of capital to the private equity industry is governmental pension funds. According to Preqin, a commercial database that tracks investment in private equity, approximately 30 percent of capital in U.S. private equity funds was contributed by governmental pension funds. Governmental pension funds are more often referred to as “public” pension funds, but this can be confusing because it doesn’t make clear the basic reality that, in the U.S., the funds are essentially always administered by government employees and governed by officials who are directly elected by the public or appointed by elected officials. For example, the New York State Common Retirement System is administered by employees of the New York State Comptroller’s Office, and the Comptroller is the sole trustee for the fund and is elected state-wide by the people of New York. In these posts, we will refer to public pension funds as governmental pension funds.
A second major type of government investor in private equity funds is sovereign wealth funds, such as the Abu Dhabi Investment Authority, the Australian Future Fund, and Singapore’s Temasek. Preqin estimates that sovereign wealth funds comprise approximately 10 percent of the capital in private equity funds.
Public university endowments play a smaller role as sources for private equity investments, probably no more than a couple of percent. They are typically not run directly by elected officials and are not as directly a part of the state govenments that sponsor the universities, thus they can seem more “quasi-public” in character.
Preqin provides a wealth of information about governmental investors in private equity funds. For Bain X (Bain “Ten”), Bain’s most recently established fund, Prequin produces the following list of governmental investors:
Alaska Permanent Fund Corporation
California State Teachers’ Retirement System (CalSTRS)
Employees’ Retirement System of Rhode Island
Illinois Municipal Retirement Fund
Indiana Public Retirement System
Iowa Public Employees’ Retirement System
Maryland State Retirement and Pension System
Massachusetts Pension Reserves Investment Management Board
Michigan State University Endowment
Pennsylvania Public School Employees’ Retirement System
Pennsylvania State Employees’ Retirement System
Purdue University Endowment
Regents of the University of California
San Diego County Employees Retirement Association
State Teachers’ Retirement System of Ohio
University of Michigan Endowment
University of Oklahoma Foundation
University of Washington Endowment
Although this list may seem long, readers should bear in mind that Bain’s level of government investment has historically been below industry averages due to the fact that Bain charges much higher fees than is typical (in particular, Bain charges a 30% upside fee while the industry norm is 20%).
In any case, this list is likely to be incomplete Throughout the world, the PE industry has been amazingly successful at shielding information on PE funds from disclosure by governmental investors. In the U.S., governmental investors are normally required to divulge in which funds they have made investments; in other countries, even this information may not be consistently available. It’s also worth noting, and we will examine this in great detail in later posts, even U.S. governmental investors have been exempted from almost all of the general requirements of state Freedom of Information laws, which means that one typically can’t learn much beyond the names of the funds and a few other somewhat useless facts about the funds that governmental investors commit to.
The Structure of Private Equity Investments
Readers might wonder why private equity relies so heavily upon the deep pockets of state entities for its funding. The reason is basic: governments are among the very few investors that can accept the uncertainty about both when a fu nd may demand capital contributions or when they will give back the money.
Private equity funds are highly distinctive in their design. First, they are almost always “blind pools”, which means that at the time when you commit as an investor, you have no idea what the fund will end up owning.
Second, when a given round of fund raising has been completed (in industry parlance, at the “closing”), you generally do not hand over the full amount of money that was agreed upon. Instead, you make a contractual “commitment” to send in portions of that amount whenever the PE fund “calls” for it.
Third, the investment manager will give your money back (together with your share of the profits, if any) when it suits him – there is no specified schedule. While the PE investors typically start to receive meaningful “distributions” of capital starting around year four or five, and most of the money will typically be given back within eight or nine years after the investor commitment was made, it’s not at all uncommon for some distributions to be made a dozen years or more after the closing.
Because of all this uncertainty about cash flows, private equity has much less appeal to wealthy individuals than hedge funds do. For the most part, only the mega-wealthy (people like Bill Gates or the Walton siblings) can accept the uncertainty of either having to pony up large portions of their fund commitments on short notice or waiting indeterminate amounts of time to get their money back.
In addition, the PE funds need to be sure that investors will be good for the money when they call for it. That restricts which investors the funds will welcome. For the fund, the best possible investors are extremely credit-worthy, supremely liquid institutions – and so governments often fit the bill.
Why It Matters
While some might be opposed to the status of private equity as a government-sponsored enterprise for philosophical reasons, others would be less concerned as long as they were convinced that PE firms produce real benefits for the public. PE industry organizations and various of its defenders do, in fact, claim that private equity yields considerable social benefits.
First and foremost, industry advocates frequently assert that private equity produces impressive returns; some even claim that governmental investors will be unable to meet their commitments without the boost to their returns that PE can deliver.
Private equity supporters also contend that by improving the management of companies they control, PE firms make the economy more efficient, lowering the prices of goods and services and creating jobs.
Unfortunately, there is ample reason to doubt these claims.
Far from being a sort of steroids for weakened investment portfolios there is substantial academic evidence that private equity net returns consistently underperform lower risk public market alternatives. As we will discuss at some length, the industry uses methodologies for calculating their returns that result in much higher reported returns than studies that are based on actual cash flows. There are many important implications of this finding, one of which is that private equity managers may receive as compensation more than 100 percent of any net returns they generate relative to lower risk alternatives.
Ultimately, these findings raise hugely important questions about whether the result may be extractive and socially destructive. Potentially overstated private equity returns are used to justify enormous state commitments to private equity investments. PE firms engage in large scale cost cutting, including many examples where they have reduced private sector worker pay, pensions, and health care benefits, all in the name of “productivity increases.” Their power to exert these changes depends on the government, not only for capital, but also because interest on acquisition debt remains tax deductible, although the intent of those sections of the tax code was of course to facilitate borrowing for investment, and almost certainly did not anticipate its use for financial engineering, liquidation via underinvestment, or rent extraction.
Unlike America’s high growth, low unemployment period of the 1950 and 1960s, the benefits of these sorts of “productivity increases” appear not to have been shared with workers, despite the claims of some private equity managers that the public benefits via their pension fund investments. Rather, it appears that they accrue mainly to the buyout fund managers. If the claim doesn’t hold up of high returns for governmental investors, there appears to be no justification at all for the collateral damage of job losses, underinvestment in portfolio companies, and economy-wide distortions, not only of capital allocation but even of policy priorities as a result of the industry’s attempts to justify itself.
The public should be concerned about so much capital winding up in the hands of so few players, particularly when they have gone to extreme lengths to bar public inspection and oversight. And, as we peel the layers back over the course of this series, we will show how many other widespread industry practices, like “transaction fees” do not stand up to scrutiny.
Next Up: An Introduction to Private Equity Fund Terms