I’m a little slow to write this up because private equity abuses are so pervasive as to fall in the “dog bites man” category. But that doesn’t mean that the public at large, or worse, intellectually captured, credulous investors understand that.
One of the latest abuses to come to light is private equity firms effectively lying about their returns in past funds when dialing for dollars for prospective funds. The overview from Reuters, which broke the story last week:
At issue is how private equity firms report how they calculate average net returns in past funds in their marketing materials, the sources said.
Net returns, also known as the net internal rate of return (IRR) and an indicator of investors’ actual profits, deduct private equity fund investors’ fees and expenses from a fund’s gross profits. Private equity fees are not standard and different investors in the same fund can pay different fees.
Fund investors such as pension funds, insurance companies and wealthy individuals – known as limited partners – pay the fees to the private equity firm. The private equity firm and its managers, called general partners, also typically invest some of their own money into the funds, but don’t pay any fees.
Including the general partner’s money in the average net returns can inflate the fund’s average net performance figure, and the SEC is investigating whether private equity fund managers properly disclose whether they are doing that or not, the sources said.
We’ll put aside an issue that we’ve discussed at some length in past posts, that IRR is a terrible way to measure returns. As McKinsey put it,”…typical IRR calculations build in reinvestment assumptions that make bad projects look better and good ones look great.”
As far as the SEC investigation is concerned, there are actually two issues here, and the SEC is focusing on the worst of the two. One is, as the article notes, is that the some funds are basing their return calculations with general partner capital included, and since the general partners don’t pay any fees, including their funds in the return calculation has the effect of increasing it.
There’s a second issue, and it’s surprising the SEC hasn’t taken interest in it (or maybe it is but hasn’t figured out what to do about it) is that even the use of an “average net returns” will exaggerate prospective returns for many investors, meaning pretty much all the smaller ones. For instance, investors have succeeded in negotiating reductions in fees many general partners charge, the so-called monitoring fees (annual consulting fees charged to portfolio companies) and transaction fees (which are basically double-dipping, since these general partners hire investment bankers who charge merger & acquisition and financing fees of their own). These reductions come in the form of rebates credited against the annual management fees. These rebates typically range from 60% to 100%, with 80% considered to be a representative level. Industry leader CalPERS generally gets a 100% rebate.
The question is whether a small or newbie investor, who is likely to get only a 60% rebate, has the acumen to adjust the “average net IRR” he is presented in his marketing materials to a level to what someone like him would get on a net basis. Note that the magnitude of these fee differentials, and the lack of transparency surrounding fee differences, has turned into a full-blown row in the UK, where limited partners are less captured than in the US.
Industry publication Private Equity International tried to have it both ways, saying that it couldn’t imagine that this level of fudging made any difference in practice, while acknowledging that net IRRs “have become so inconsistent that they’re practically worthless.” From the body of the paywalled article:
But the bigger issue here – and what ought to be behind this ‘focus’, if indeed it isn’t already – is that net IRR calculations have been something of a black box for too long. Different funds calculate it in different (usually self-serving) ways, based on their own fee structures, hurdle rates and various other factors. Everybody always seems to get a trophy when it comes to net IRR – which means that for investors trying to make apples-to-apples comparisons, even within a similar cohort, the figures GPs supply are more or less worthless as metrics.
Another amusing bit is that funds that the SEC has fingered as being fast and loose with these figures piously deny doing anything wrong. Consider this section of the Reuters article on the SEC’s digging into the net IRR calculation matter:
Blackstone Group LP, Carlyle Group LP and Bain Capital LLC, for example, do not include money that comes from general partners in average net IRR calculations, while Apollo Global Management LLC does, the review shows.
In a Reuters article the following day, Apollo admitted to the practice but depicted it as a nothinburger:
Asked about the SEC’s investigation of how private equity firms disclose whether they include their own money in average net IRR calculations, which was first reported by Reuters this week, Apollo Chief Financial Officer Martin Kelly said on the earnings call he was not aware of any IRR-specific investigation and that the New York-based firm was very transparent about its inclusion of its own capital in the calculations.
He added that the increase of the average net IRR by the inclusion of that capital was small. As an example, he cited Fund VII, where Apollo’s capital accounted for 3.4 percent of the fund, and said the inclusion had added two-tenths of a percentage point to the average net IRR figure to date.
It’s true that given the small size of general partner investments in most funds (1 to 3%), that level of game-playing in and of itself won’t have much impact. But even that small a misrepresentation is seeing as absolutely verboten in other types of fund solicitation so it is welcome to see the SEC being bloody-minded on this issue.
Moreover, as the original Reuters article indicated, this isn’t the only variable that the general partners can play with. In combination, a few tenths of a percent here and a few tenths of a percent there together start adding up. And perhaps more significantly, the net IRR fudging illustrates a general partner mentality that is more troubling than the specifics: that of being almost unconstitutionally incapable of being honest with their investors, since cheating is so habitual and so lucrative.