CalPERS’ staff, in particular its Chief Investment Officer Ted Eliopoulos, have been talking up a private equity industry investment theme as if it were a new bright shiny object, or at they like to tout, “innovative”. We’ll discuss at some length in a later post how the last CalPERS Investment Committee meeting revealed that CalPERS’ plans are not only poorly thought out but also are at odds with what Their showcased expert, Ashby Monk of Stanford Global Projects Center, was recommending.
Today, we’ll focus on a Wall Street Journal story that talks up an idea the private equity industry has been selling hard and has apparently won over CalPERS, that of longer-lived, or even “permanent capital” funds. Sadly, the lead writer, the normally astute Dawn Lim, either missed or chose to ignore why big private equity firms are pushing a different fund structure now.
The short answer is that this new gimmick is meant to give investors hope in the face of deteriorating private equity returns. That results from too much money chasing too few deals, a situation unlikely to correct itself any time soon as investors are if anything increasing their allocations to private equity.
And this isn’t our point of view: industry leaders, such as Blackstone, started warning years ago that private equity returns were going to be even less attractive in the future than they had been in recent years and proposed longer-lived funds as a coping mechanism, since they would blunt the effect of lower gross returns by offering somewhat more favorable fees.1
Worse, the Journal reporters, as well as CalPERS, give the impression that they do not understand that longer-lived funds in many cases won’t hold individual companies longer than now. Misleading comparisons to Warren Buffett, who holds the asset management industry in contempt, appear to have addled the brains of even seasoned reporters.
Not only does the Journal story promote a basic misconception of how these funds would work, it also sells this fad as a new idea when it isn’t. For instance, General Atlantic and Sutter Hill Ventures have had evergreen fund structures for decades. Finally, the article also glosses over some key motivations for general partners to promote these fund structures.
And most important, the piece ignores obvious reasons why this approach isn’t sound for investors. That’s so important we’ll start there.
Why Long-Lived or Worse, “Permanent” Private Equity Funds Are a Bad Deal for Investors
Trees do not grow to the sky, nor will the vast majority of private-equity owned companies deliver superior performance more than for a certain number of years. A fund structure that will accommodate longer holding periods will allow private equity fund managers to keep a superior investment for more than the average four to five year ownership period. That could allow for some improvement in returns, but it’s misleading to think that it’s anything more than a portion that will maintain outperformance if retained longer.
To justify giving fund managers an even longer holding period, you need to get a much higher premium over stocks than private equity funds deliver now. The Research Director of the Stanford Global Projects Center, Ashby Monk, who presented at CalPERS last week, wrote in Institutional Investor earlier this year:
Recent research by Francesco Franzoni, Eric Nowak, and Ludovic Phalippou shows that the unconditional illiquidity risk premium, at least for private equity, is 3 percent annually — meaning that if your private equity manager isn’t earning 3 percent above public markets every year, then he’s literally doing nothing of value. Other research by BlackRock’s Andrew Ang indicates lock-ups should be associated with a specific premium: If you are locked up for a year, you should earn an extra percent per year. If it’s a decade lock-up, you should get an additional 6 percent per year.
Read that again. Investors need to get 6% more than the comparable-risk stock market index to adequately compensate for the risk of tying up their funds for ten years. That is a full 3% a year more than they ought to get, and generally aren’t getting, from private equity now.
Remember that even though private equity funds are expected to return all the money they invested in 10 to 12 years, they draw down the money in chucks over time, and pay it back as they sell companies, so the weighted average time that the committed funds are being deployed is more like five years.
And if the lockup period is longer than ten years, the return premium needs to be even higher.
In other words, since the private equity industry isn’t delivering high enough risk adjusted returns now, the much higher return requirements for tying up your money longer mean that investors are almost certain to double down on failure.
Mind you, investors do not have to make “permanent” or even necessarily longer-term commitments to get the benefits of an “evergreen” structure. which also gives the fund manager the ability to hold companies longer when that looks like the best approach.
But the breathless tone of the Journal story, with a lack of detail as to what “longer-lived” and “permanent capital funds” amounts to, certainly gives the impression that the central feature of these whiz-bang new “longer” funds is that investors are parted from their funds for more years, and they are supposed to see that as a really good thing. As Dr. Monk stresses, it’s a desirable outcome only if you are paid enough more in return, and that “more” is a lot more.
And CalPERS’ Ted Eliopoulos has similarly told the press of fifty to sixty year time frame with respect to the new vehicles he is eager to foist on CalPERS. So we aren’t misreading what CalPERS is being sold.
By contrast, no one seems to be interested in tested models such as General Atlantic or Sutter Hill which gave investors flexibility while allowing fund managers to hold companies longer. As the Kauffman Foundation explained in 2012:
Evergreen funds are structured to better align the incentives between GPs and LPs. They have just one annual management fee (not a series of fees that accumulate from subsequent funds), and raise capital from a limited number of LPs on a rolling basis. Investors receive gains from successful exits, which they can choose to reinvest. The fund restructures every few years (usually every four years) and investors can decide whether to continue investing or withdraw their investment based on current values.
Evergreen funds are open-ended and therefore not subject to the fixed timeframe of a ten-year fund life or the pressure and distraction of fundraising every four to five years. Without the pressure of regular fundraising, evergreen funds can adopt a longer timeframe, be more patient investors, and focus entirely on cash-on- cash returns, rather than generating IRRs to market and raising the next fund.
The failure to use terminology like “evergreen” and “open-ended” suggests that a big reason for persuading investors that they need to commit their funds for even longer to allow fund managers to hold companies longer, when that in fact isn’t at all necessary, means tying up the monies is a major, if not the major, of these new fund structures. Why not get your hands on as much capital as possible during Peak Private Equity Froth?
We’ll now turn to some explanations for this general partner sales push.
Why Are Private Equity Firms Pushing This “Longer-Term” Fad Now?
Even though the idea of longer-lived funds is not new, and Blackstone said in 2014 it was launching one, as CVC already had, why such a flurry now? The Journal describes how KKR already has amassed $8.5 billion for one such fund, and Vista, BlackRock, and Atlas Partners are also raising money.
That raises the question of why private equity fund managers, who above all are most interested in their personal bottom lines, have jumped on this bandwagon to the degree that one industry old hand deems it to have become a crowded space.
It turns out, despite private funds routinely failing to provide an adequate return over the past ten years, investors have been so desperate for anything that might make their results look better, irrespective of whether the choice was sound, that they’ve been throwing even more money at private equity, to the degree that fund managers have been getting even more favorable terms as well as cutting back collectively on how many offer management-fee-free co-investments.
So what are the motivations?
Responding to the new era of lower returns. Blackstone ‘fessed up that the aim was to lower total private equity costs somewhat, since investors would rebel against the prototypical 7% total fees and costs per annum as gross returns continue to fall. This is what some would call getting in front of a mob and calling it a parade.
But bear in mind, as we point out in our first footnote below, that private equity never gives without taking away. The new funds were expected to put in place lower hurdle rates.
However, the Journal article mentions only the idea of avoiding paying excessive fees because the same company is flipped from one private equity investor to another. In other words, there’s no indication that the fund managers intend to lower their charges (although we need to see fund terms to see what the tradeoffs actually are).
Combatting the trend towards investors bringing private equity in house to lower costs. Even though private equity firms are awash in capital right now, and are finding it even harder than ever to buy good companies at anything below nosebleed prices, the new structures allegedly reduce total charges. Not having seen a fee structure, I’m not sure how that comes into play, aside from lower average transaction and financing fees due to somewhat longer average holding times.
It is important to understand why the private equity firms would be strongly motivated to discourage large institutional investors from setting up in house operations. Right now, firms like McKinsey correctly say it is hard to do, and one of the big reasons is circular: not many people have done it, so there are few players who have experienced staff and also have figured out the nuts and bolts of building and managing these teams. The more investors that go this route, the more people there will be for aspirants to hire away. In other words, as more and more big investors build up in-house capabilities, the lower the actual and perceived barriers to doing private equity yourself will become.
Selling a differentiated product to respond to market demand. The article notes in passing that sovereign wealth funds, many of which are not very savvy, were interested in having funds hold companies longer. Notice that there is no evidence that longer holding periods will in fact produce better results; private equity firms famously “sweat the asset” in order to generate attractive-looking returns.
The real problem is that these investors want private equity to be bond-like. Tell me how that works, exactly. In the hoary old days, firms with long term liabilities like life insurers and pension funds would buy bonds because they could match their interest and principal payments against their expected obligations.
Equity of any form is vastly more uncertain, yet these long-term fund investors seem to have convinced themselves that the world is awash in companies that suit their pet desires, namely, ones that will deliver stellar cash flows for decades. As the Journal puts it:
To keep these long-term investors satisfied, firms managing permanent-capital funds typically purchase businesses with recurring revenue—examples could include a dental-services chain with regular customers or a software company with licensing agreements—that can flow back to the funds’ investors as fee income for decades
Help me. Do you seriously think the current licenses of any software company will generate income for decades? The fact that the folks hawking this idea can’t even come up with concrete examples is telling.2
And on top of that, companies that generate high and stable cash flow have been the prime target of private equity firms from the very inception of the business. Buyers could readily pile a lot of debt on companies like that, and if they’d didn’t wreck the business, the high underlying cash generation meant they could also whittle down the borrowings readily. So how is creating even more demand for the most sought after type of companies supposed to lead to better returns?
As Eileen Appelbaum the co-author of the landmark book, Private Equity at Work, confirmed our reservations by e-mail: “Okay – so where is the alpha? The excess returns?”
CalPERS in particular has become besotted with the idea that these not-really-very-new private equity investment schemes are “innovative”. They should heed this warning of former Fed chairman Paul Volcker to board members:
I hear about these wonderful innovations in the financial markets and they sure as hell need a lot of innovation. I can tell you of two — Credit Default Swaps and CDOs — which took us right to the brink of disaster: were they wonderful innovations that we want to create more of?
You want boards of directors to be informed about all of these innovative new products and to understand them but I do not know what boards of directors you are talking about.
I have been on boards of directors and the chances that they are going to understand these products that you are dishing out or that you are going to want to explain it to them, quite frankly, is nil…
I found myself sitting next to one of the inventors of financial engineering who I did not know, but I knew who he was and that he had won a Nobel Prize, and I nudged him and asked what all the financial engineering does for the economy and what it does for productivity. Much to my surprise he leaned over and whispered in my ear that it does nothing. I asked him what it did do and he said that it moves around the rents in the financial system and besides that it was a lot of intellectual fun…
The most important financial innovation that I have seen the past 20 years is the automatic teller machine, that really helps people and prevents visits to the bank and it is a real convenience. How many other innovations can you tell me of that have been as important to the individual as the automatic teller machine, which is more of a mechanical innovation than a financial one?
Shorter: Be wary of financiers bearing “innovation”.
1 From a 2014 post:
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 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.
Private equity groups do not receive profits on deals until the hurdle rate is cleared.
2 I struggle to come up with an example besides hair color, where Clairol and L’Oreal have a duopoly, and the product is made for pennies a box and sells for dollars a box. They’ve enjoyed fat margins and good growth for decades. They are helped by the fact that there is bona fide chemical technology in hair color which the companies go to considerable lengths to protect. In addition, professionals are very reluctant to switch products (they do not want to risk frying a client’s hair; it has to grow out in case of a mishap).