Private equity continues to make headlines, and not in a good way, despite industry efforts to spin otherwise. The latest shoe to drop is that private equity firms are trying to rewrite some well-established fund terms to allow them to continue to rake in egregious profits even as the returns of most funds have underperformed the stock market.
One of the recent dirty secrets in the industry is that returns aren’t what they used to be. That’s before you get to the fact, as we’ve discussed at some length, that conventional measures of private equity returns overstate them, and properly measured, private equity doesn’t outperform. Not only is that true on a risk-adjusted basis, widely-used approaches fail to incorporate the cost to investors of accommodating private equity’s requirements that investors accommodate its not-predictable investment timing demands. Incorporating that cost would likely show that private equity underperforms.
Private equity stalwarts try to argue that recent years of underwhelming returns are a feature, not a bug, that private equity should be expected to underperform when stocks are doing well. To put that politely, that’s novel.
The reality is uglier. The private equity industry did a tsunami of deals in 2006 and 2007. Although the press has since focused on the subprime funding craze, the Financial Times in particular at the time reported extensively on the pre-crisis merger frenzy, which was in large measure driven by private equity.
The Fed, through ZIRP and QE didn’t just bail out the banks, it also bailed out the private equity industry. Experts like Josh Kosman expected a crisis of private equity portfolio company defaults in 2012 through 2014 as heavily-levered private equity companies would have trouble refinancing. Desperation for yield took care of that problem. But even so, the crisis led to bankruptcies among private equity companies, as well as restructurings. And the ones that weren’t plagued with actual distress still suffered from the generally weak economic environment and showed less than sparkling performance.
Thus, even with all that central help, it’s hard to solve for doing lots of deals at a cyclical peak. The Fed and Treasury’s success in goosing the stock market was enough to prevent a train wreck but not enough to allow private equity firms to exit their investments well. The best deals for general partners and their investors are ones where they can turn a quick, large profit. Really good deals can typically be sold by years four or five, and private equity firm have also taken to controversial strategies like leveraged dividend recapitalizations to provide high returns to investors in even shorter periods.
Since the crisis, private equity companies have therefore exited investments more slowly than in better times. The extended timetables alone depress returns. On top of that, many of the sales have been to other private equity companies, an approach called a secondary buyout. From the perspective of large investors that have decent-sized private equity portfolios, all this asset-shuffling does is result in fees being paid to the private equity firms and their various helpers.* As Eileen Appelbaum and Rosemary Batt put it in their book Private Equity at Work:
Thus, some LPs are concerned that while secondary buyouts may be less risky investments, the high valuations in a secondary buyout, along with the transaction fees, limit the returns that can be earned. In addition, the secondary buyout gives the operating company’s management team the opportunity to cash out their ownership shares in the company, raising questions about their commitment.
As the Financial Times reports today, the response of industry leader Blackstone is to restructure their arrangements so as to lower return targets and lock up investor funds longer. Pray tell, why should investors relish the prospect of giving private equity funds their monies even longer when Blackstone is simultaneously telling them returns will be lower? Here is the gist of Blackstone’s cheeky proposal:
Blackstone has become the second large buyout group to consider establishing a separate private equity fund with a longer life, fewer investments and lower returns than its existing funds, echoing an initiative of London-based CVC.
The planned funds from Blackstone and CVC also promise their prime investors lower fees, said people close to Blackstone.
Traditional private equity funds give investors 8 per cent before Blackstone itself makes money on any profitable deal – a so-called hurdle rate.
Some private equity executives believe that in a zero or low interest rate world, investors get too sweet a deal because the private equity groups do not receive profits on deals until the hurdle rate is cleared.
Make no mistake about it, this makes private equity all in vastly less attractive to investors. First, even if Blackstone and CVC really do lower management fees, which are the fees charged on an annual basis, the “prime investors” caveat suggests that this concession won’t be widespread. And even if management fees are lowered, recall how private equity firms handle rebates for all the other fees they charge to portfolio companies, such as monitoring fees and transaction fees. Investors get those fees rebated against the management fee, typically 80%. So if the management fees are lower, that just limits how much of those theoretically rebated fees actually are rebated. Any amounts that exceed the now-lower management fee are retained by the general partners.
The complaint about an 8% hurdle rate being high is simply priceless. Remember that for US funds, the norm is for the 8% to be calculated on a deal by deal basis and paid out on a deal by deal basis. In theory, there’s a mechanism called a clawback that requires the general partners at the end of a fund’s life to settle up with the limited partners in case the upside fees they did on their good deals was more than offset by the dogs. As we wrote at some length, those clawbacks are never paid out in practice. But the private equity mafia nevertheless feels compelled to preserve their profits even when they are underdelivering on returns.
And the longer fund life is an astonishing demand. Recall that the investors assign a 300 to 400 basis point premium for illiquidity. That clearly need to be increased if the funds plan slower returns of capital. And recall that we’ve argued that even this 300 to 400 basis points premium is probably too low. What investors have really done is give private equity firms a very long-dated option as to when they get their money back. Long dated options are very expensive, and longer-dated ones, even more so.
The Financial Times points out the elephant in the room, the admission that private equity is admitting it does not expect to outperform much, if at all:
The trend toward funds with less lucrative deals also represents a further step in the convergence between traditional asset managers with their lower return and much lower fees and the biggest alternative investment companies such as Blackstone.
So if approaches and returns are converging, fees structures should too. Private equity firms should be lowering their fees across the board, not trying to claim they are when they are again working to extract as much of the shrinking total returns from their strategy for themselves.
The good news is key investors appear to be seeing right through this ruse:
So far, some of the biggest sovereign wealth funds which are the target investors for these funds say they are lukewarm about the idea. Many of them are becoming more ambitious to do transactions themselves at a time when the industry no longer talks about 20 per cent to 30 per cent returns. There are also questions about conflicts of interest among funds.
The real threat to private equity is indeed having investors backward integrate and run their own funds. Canadian pension funds have done so and shown better returns by virtue of not paying private equity firm fees and charges. Unfortunately, investors are a conservative lot, and most in the US are also very much drunk on the private equity Kool Aid. But as it becomes more evident it becomes that private equity’s claims to superior performance are hollow, the harder it will be to justify their high-handed treatment of investors and their egregious fees.