One of the reasons that private equity has managed to flourish is that its biggest investor group is what is traditionally referred to as dumb money: public pension funds, which account for 25% of industry assets. Readers may recall that even CalPERS, widely considered to be the savviest public pension fund, recently had a public board meeting where the questions asked of prospective gatekeepers, the pension fund consultants, were, with one exception, softballs. And that question was the only one to address the SEC’s revelation that private equity firms have been engaging in large scale fee-skimming and other forms of grifting. And remember, the SEC also stated that the investors in these funds, known in industry nomenclature as limited partners, have done a crappy job of negotiating their agreements.
But in predictable fashion, as one group of marks, um, sales targets, starts to dry up, private equity funds, aka general partners, are hunting for new ones. And having gone very systematically after every conceivable large pot of money, the only place left for them to go is down market, in terms of size and sophistication. As private equity industry expert Eileen Appelbaum explains in The Hill, both public and private pension funds, another big money source for private equity, are shrinking as pensions generally are under attack. So the prize for private equity is to get its hands on retail investors, namely, even lower tier wealthy and 401 (k) plans.
Before we get into how this is happening, we need to step back and underscore why this is a terrible idea. Private equity returns, even for institutional investors, are exaggerated. These reported returns do not beat stocks on a risk-adjusted basis. And that’s even when you use a measure that flatters private equity, with is internal rates of return. As we’ve discussed, IRR is known by anyone with a even a smidgen of finance training to be a terrible measure. One of the big reasons why is it overstates performance relative to better metrics, such as the widely used gold standard of discounted cash flows, or one that some academics view fondly, called public market equivalent.
So understand this: private equity’s entire raison d’etre is its allegedly superior returns. If that is bunk, the rationale for investing in private equity collapses. The other justification for investing in it, that its profile of returns doesn’t covary much with other investments, is highly sus, given that private equity is essentially levered equity. Many experts believe that the supposed differentiated pattern of returns depends heavily on private equity “smoothing” as in not marking their portfolios to market at times when markets are terrible.
In fairness, there have been historical periods when buyouts, the main type of private equity deals (accounting for 85% of industry assets) produced sparkling returns for investors, such as in the 1980s, when there were lots of overdiversified large companies selling at conglomerate discounts. Making money in leveraged buyouts then was like shooting fish in a barrel, provided you could hire an investment bank to run a hostile takeover. Simply buying the company with a ton of debt (and achievable leverage levels were also higher back then, amping up returns), breaking it up and selling off the parts was an easy winner. Selling off other assets, like headquarters properties, the corporate art collection, and surplus jets, helped too, as did thinning out an often-bloated corporate center.
But looking dispassionately at the data shows that PE’s claims to better returns don’t hold up. And that’s before you get to factoring in issues that astonishingly, academics have managed to ignore despite them being blindingly obvious omissions. For instance, when an investor signs up for a private equity fund, he is contractually obligated the minute the ink is dry. Yet the general partner won’t begin making capital calls for months, sometimes starting as much as a year later. Those capital calls continue typically until year three or four after the commitment date.
The convention in the industry is to calculate returns ONLY when the money has left the investor’s pocket and gone over to the PE fund. Yet if you read limited partnership agreements, capital calls have very short notices. Five to ten days is the norm. The consequences of missing a capital call are draconian. Generally speaking, you lose the money you’ve put in. And even if you simply miss your first capital call (as in you lose no actual dollars), that general partner will never invite you into a fund again. If you are a typical limited partner that thinks getting into funds, particularly the illusory “better” funds, is important, that alone is a terrible sanction.
So that means the investors need to make sure they have enough dough on hand to meet capital calls. That means they need to be in liquid, hence generally lower-return investments. The cost of being in lower-term investments early in the life of private equity investments to accommodate general partner capital calls, which is inherent to investing in private equity, is not factored into return calculations. Low returns in the early years of any investment severely dampen total returns.
We anticipate being able to perform some analyses of this issue. In the meantime, a paper by Oxford professor Ludovic Phalippou is coming out shortly that looks at this issue on a theoretical level (as in not working from a specific data set). He told us that his conclusion is that the cost of being in lower-return investments is roughly 300 basis points a year.* Note that 300 basis points is conventional wisdom as to how much PE outperforms public stocks using its current dubious metrics (and that is before risk adjusting it for its illiquidity, which is also conventionally depicted as 300 to 400 basis points**).
So the reason to allow smaller investors to get into private equity at all looks spurious on its face, particularly since private equity returns have been declining in recent years. And remember, the return picture will look even worse for small investors than for the big boys because they will pay more in fees, more in expenses (pretty much inherent to smaller investments) and are also just about certain to be steered to at least some less than stellar funds. A New York Times article last month flagged some of these issues (emphasis ours):
Carlyle’s new vehicle, called Carlyle Private Equity Access 2014, whose existence has not previously been disclosed, is just one of several efforts by the industry to attract checks in the tens of thousands of dollars rather than in the hundreds of millions. In addition to annual fees paid to their wealth manager, investors pay Carlyle 1 to 2 percent of their capital plus 20 percent of any profits, in line with the industry standard….
Morgan Stanley, for example, was recently gathering capital from wealthy clients for a new Blackstone energy fund that is expected to exceed its $4 billion target when it finishes raising capital this year. It took the bank a single day to raise its entire $500 million feeder fund, which was about four times oversubscribed, people briefed on the matter said….
Traditional feeder funds can also allow investors to commit as little as $250,000, but the new Carlyle product is intended to provide a more diversified investment, including private equity funds focused on Japan, Asia and Europe, as well as an international energy fund…
Other firms, acting as middlemen, are allowing the private equity giants to attract a lower stratum of wealth. One firm, the Central Park Group, gives investors indirect access to Carlyle funds. It caters to so-called accredited investors, who have at least $1 million in assets not including their primary home. Because it is an intermediary, the firm charges a fee as high as 1.8 percent and an additional 0.55 percent for expenses, on top of the 1.3 percent of assets charged by the Carlyle funds in which it invests, according to marketing materials and a person briefed on the matter. Still, it has raised more than $500 million since its debut last year, this person said.
We’ll discuss in a later post why these hot energy funds look to be a particularly successful version of private equity picking investors’ pockets.
If you look at how the Carlyle funds that CalPERS has invested in have performed (and remember that CalPERS in theory can do a better job of fund-picking and can negotiate lower fees), you will see that on the whole, the foreign funds have performed less well than the flagship domestic funds. So “more diversified investment” appears to be seller talk for “putting you in funds with lower odds of payoff because we have less of an information advantage.”
Appelbaum explains why this downmarket trend is particularly troubling:
While private equity hasn’t tapped workers 401(k)s yet, Carlyle and other PE firms are currently developing new financial products that will let individual investors write small checks to PE funds.
This new focus on individual investors is facilitated by the Jumpstart Our Business Startups Act (JOBS Act) that went into effect in the fall of 2013…The rules that implement the JOBS Act do not incorporate basic investor protections…It is, however, still the case that individuals that participate in a PE fund must be “accredited investors.”
To be an accredited investor, an individual must have a net worth — alone or with a spouse — greater than $1 million, not including the value of his or her home. Alternatively, the individual can be an accredited investor if they have an annual income of $200,000 or more (or $300,000 with a spouse). These income thresholds were set in 1982 when $200,000 meant you were a lot richer. If these wealth and income thresholds had been adjusted for inflation, an accredited investor would have to have a net worth of $2.5 million or an annual income of $493,000 (or $740,000 with a spouse).
Granted, very few of us will ever qualify as an accredited investor. Still, about 8.5 million people meet the current criteria. And that includes many professionals, especially in two-earner households, who may head toward retirement with a million dollars in their 401(k)s. To put that in perspective, a million dollars in a retirement savings account comes to $40,000 to $50,000 a year in pre-tax income during retirement.
The kicker here is that the $1 million in net worth can include investment in retirement accounts. And as Appelbaum stresses, having a decent personal balance sheet or income does not mean someone is financially savvy.
What goes unstated is why the mythology of these superior returns goes unchallenged, when that legitimates the rush to syphon funds out of retail chumps. The fact is that private equity has effectively bought off, co-opted or cowed the very people who ought to be minding the store.
As we indicated with Harvard, which is also considered to be a sophisticated investor, its law firm, which is one of its most important resources in cutting deals with private equity firms, is more loyal to private equity kingpin Bain. This pattern is repeated across the industry, where private equity limited partners simply don’t pay remotely enough in fees compared to private equity firms to get the best legal talent on their side. This pattern is most obvious with attorneys, but it applies to all the other supposed gatekeepers who are afraid to rock the boat with PE firms because they’ll simply refuse to deal with them (remember, the gatekeepers, such as the supposedly independent consulting firms, need to get information from the private equity firms to do their job. And the consultants no doubt correctly fear that they would be frozen out of limited partner engagements if PE firms reported that they were difficult or implies that their information demands reflected a lack of sophistication, as opposed to well-warranted skepticism).
This situation is even worse as far as the mythology of superior returns is concerned. Key employees at private equity limited partners benefit directly from PE funds reporting exaggerated returns. Even at CalPERS, cetain members of the investment office get bonuses based on performance relative to benchmarks. At CalPERS and public pension funds, these bonuses are so small as to arguably not be terribly motivating, but at other opinion leaders, such as universities like Yale and Harvard, the performance bonuses are significant. And they are also much more meaningful at private pension funds and insurers, both large investors in private equity.
We’ve noted how the use of IRR exaggerates the return side of the performance equation. The benchmarking is often flawed too. For instance, Thompson Reuters is one of the most popular services for private equity benchmarking. It also happens to show the lowest returns. An industry insider tells us that Thompson Reuters is in the process of exiting this business, forcing limited partners who used Thompson to find new benchmarks. The replacement services, such as Cambridge Associates, use benchmarks that show returns that are sufficiently greater than the one Thompson showed as to call into question whether bonuses paid to investment staffers in prior years were deserved. One doubts that any fiduciary will have the nerve to try to claw back payments, or reduce going forward bonuses in light of what now looks like excessive prior payouts, but the differences are great enough in some cases as to be giving boards and trustee fits.
And to complete this sorry picture, last week, Private Equity Manager reported that the investors’ association, the ILPA, had stated in effect that limited partners were circling the wagons, and wanted only more transparency between themselves and the general partners. So to the extent any reforms take place (and don’t hold your breath), small fry players won’t benefit. That, as we often say here, is a feature, not a bug.
* Looking at illustrative or better yet actual capital calls will allow for much more granular analysis, as well as looking at the impact over the lives of various funds, which is the most important measure. Moreover, we are not sure a one-size-fits-all story on managing pre-capital call liquidity is the best way to look at this. Wealthy individuals and smaller investors like universities and foundations would need to keep most or all of their committed money in low-risk investments like cash equivalents or short-term, low-risk bonds to avoid missing a capital call. Note that in the dot-bomb era, when wealthy investor lost boatloads on their stock portfolios, defaults on private equity capital calls were widespread. Similarly, in the crisis, Duke famously missed private equity capital calls. Similarly, CalPERS was widely criticized for dumping stocks during the crisis. It is widely rumored that the reason was not panic but needing to meet private equity capital calls. However, a CalPERS nevertheless has much more money flowing in and out on a routine basis, and thus larger investors such as the bigger pension fund and endowments could be assumed to do somewhat better, in return terms, in managing their fund so as to accommodate private equity capital calls.
** We are not certain the 300 to 400 basis point illiquidity discount is the right way to look at this issue. Private equity investors face a high degree of uncertainty as to when they get their money back. They have effectively given the general partners that option. Long-dated options are extremely valuable. We suspect this option is worth more than 300 to 400 basis points.