ZIRP and QE victims like pensions fund, life insurers, and other long-term investors, responded as central banks knew they virtually had to super-low interest rates: commit even more funds to high risk strategies in the hope of eking out an adequate return.
But as these monetary ministrations merely produced more speculation, rather than investment and resulting growth, all the pursuit of more investment risk has done is bid down returns for strategies like private equity. And that’s before getting to the fact that private equity has generally not been delivering returns commensurate with its risks for the last ten years.
Even CalPERS, which like many public pension funds has clung to private equity as a possible salvation from its bleak investment landscape, is having to admit that its great hope was really hopium. From Bloomberg:
First it gave up on hedge funds. Now the largest U.S. pension fund isn’t sure how much it can count on private equity.
“We anticipate it may be moving from a gusher to a garden hose and then maybe even a trickle,” Wylie Tollette, chief operating investment officer of the $305 billion California Public Employees’ Retirement System, said this week in a telephone interview…
The private-equity industry, which makes long-term investments such as leveraged buyouts in operating companies, shows signs of coming off its best years after distributing a record $443 billion to global clients in 2015, according to Preqin.
Now investments are shifting to early-stage pools that throw off less cash. At the same time, buyouts, the majority of Calpers’s private-equity portfolio, are rising in cost as firms with an unprecedented $1.47 trillion in stockpiled cash, known as dry powder, compete for acquisitions — a trend that could further crimp returns.
CalPERS moved away from smaller private equity investments as part of a strategic review, deciding to greatly prune its total number of private equity investments so as to invest more in fewer funds. That pretty much rules out early-stage investments. The logic behind CalPERS move presumably is that private equity funds increasingly have tiered pricing, with investors that make larger commitments getting lower management fees.
We’ve also been pointing out for well over a year that general partners are paying record multiples for acquisitions, higher than the former peak, right before the onset of the crisis. Bloomberg draws the obvious conclusion, that this movie is not likely to have a happy ending:
Buyout funds paid a record 10.3 times cash flow in 2015 and a 10.1 multiple in the first half of this year for U.S. companies, according to S&P Global Market Intelligence. Deal leverage is lower than before the 2008 financial crisis because of regulatory restrictions, another factor likely to reduce returns, according to Marina Lukatsky, a director at the firm.
“If you pay a lot more these days versus a couple of years ago and you have to put a lot more equity in, in theory when you sell it, it does impact your ultimate return,” she said.
Last year, an MBA, Pamela Morris, pointed out in a statement at a CAlPERS board meeting that CalPERS’ own data showed that there was too much private equity money chasing pretty much the same number of deals, as private equity rose from 2.7% of global equity in 2005 to 5.6% in 2014.
And as we’ve pointed out, the heads of private equity firms have been warning not to expect great returns in the future:
Instead of 20 percent to 25 percent net internal rates of return, private-equity investors are now accepting closer to 15 percent, according to David Rubenstein, co-chief executive officer of Carlyle Group LP, which manages $176 billion.
As someone in a senior role at a private equity firm said by e-mail:
David Rubenstein is practically guilty of securities fraud to suggest that he is targeting 15% net returns with his fund. Almost certainly, he is promising a lower number privately to LPs, but he and they need for him to keep hyping the higher number publicly to keep public support.
The Wall Street Journal, in its Pro (even higher paywall) section, joined Bloomberg in presenting insider warnings of lower returns, including the inconceivable notion of urging investors to commit less to private equity right now. From the article The Pitfall of Private Equity’s Success:
When the head of private equity at one of the world’s biggest buyout firms says the biggest mistake investors can make is committing too much money to private equity this year, you know the industry is in a weird place.
Earlier this month at the WSJ Pro Private Equity Conference, Blackstone Group’s Joseph Baratta said that “overallocating to the vintage” was the biggest blunder an investor could make right now.
Another private-equity veteran shared a similar sentiment across the Atlantic. Marc St. John, head of investor relations at one of Europe’s biggest buyout firms, CVC Capital Partners, voiced concern at an industry event last week about the “scary” amount of money that investors are trying to put into private equity.
Investors are pushing money into the asset class at record rates and prices for assets are only going up, a recipe for falling private-equity returns.
The industry is slowly coming to terms with the effects of this supply and demand imbalance.
It’s revealing and predictable that none of these stories mentions the elephant in the room: private equity fees, costs, and pilferage. The estimated all-in cost of private equity of 7% is indefensible given that private equity has been failing to deliver enough in the way of return to justify its extra risks, and the situation is only getting worse. Yet private equity investors have conned themselves that they can somehow be a Warren Buffett and out-pick everyone else. That in turn is the justification for not ruffling the feather of general partners by insisting on better terms: they might exclude you, and “hot” fund managers have even more ability to say no.
The fallacy of this logic is that limited partners can’t identify winners based on track records; even if they could identify who a top quartile fund manager really was (limited partners are asked to invest in new funds years before the results are in for recent funds), they do worse on average by investing in them than by merely throwing a dart. So the randomness of performance says they’d do better to try to get back 1% to 2% of fund costs a year out of what they pay to general partners rather than engage in the fool’s errand of chasing illusory top managers. But that makes too much sense for that to ever happen.