Wednesday, April 25, 2007

Private Equity Envy??

The world of private equity hedge funds is a fairly rarefied world. The vast majority of these funds are organized as limited partnerships (LP) where the investors are principally institutional investors such as pension funds, banks, and high net worth individuals.The general partner (GP) identifies the opportunity, calls money from its lLP's (also called a drawdown or takedown) up to the amount committed and can do so at any point until the fund is liquidated. When an investment is liquidated, the GP distributes proceeds to the LP's in kind or in cash. The compensation from LPs to GP's consists of a management fee, plus a fraction of the profits called the carried interest.

This is a league of very big money and very big players. Most of us don't have the wherewithal to play this game. How envious should we be?

According to a just-released paper by the Research Foundation of the CFA Institute, it ain't quite as rosy as it looks. This literature review by Ludovic Phalippou of the University of Amsterdam shows that the average investor has obtained very poor returns from investments in private equity funds, largely because of excessive fees.

Much of the original work on private equity fund performance comes from seminal work of Steve Kaplan and Antoinette Schoar who reported that the performance of 746 private equity funds in their sample was close to that of the S&P 500, net of fees. Subsequent work by Phalippou and Gottschalg (PG)found the performance of private equity funds was below that of public stock markets.

Given the illiquidity of such investments and the leverage risk that they entail, the result is unattractive.

PG also noted that a number of the funds reported high values for their non-exited investments. The residual value of "living deads"- those companies that had not changed their residual values for some years were not yet ready to be taken public again, may in fact be considerably less than the book value stated. If these residual values were properly written off, then the performance of these private equity funds would decrease even further.

After making the appropriate adjustments, PG estimate that on average, private equity funds under-perform the S&P 500 by more than 3% a year. Despite these adjustments, PG believe that their estimate is still optimistic because additional costs incurred by investors were not measured.

An interesting fact is that the performance gross of fees was substantial.The typical 2 and 20 cost structure seems innocuous at first, but results in fees that can be very high in practice, according to Swenson at Yale, about 12 percent a year, according to PG about 7 percent.

Much like John Bogle of Vanguard or Charlie Ellis have opined. fee structures have a lot to do with performance. As PG conclude, the total rent (i.e. fees) captured by private equity funds is probably excessive and is probably behind the counterintuitive result of low net-of-fees performance.

The data of the industry leaves much to be desired as it contains extraordinary survivorship bias...there is an overwhelming mention of successful investments compared to reality. Only completed transactions get mentioned...less successful deals stay in buyout portfolios for years.

PG also report that the correlation between fund performance and duration is highly negative...the funds with longer duration perform worse, a function of the residual values of the non-exited deals.

Be aware of the real agenda , it may not be to maximize your returns. One study reports that investments were made in private equity funds to establish a commercial relationship with GPs....to increase the likelihood that the funds will purchase services that the LP's corporate parent has to offer.

There are many risks inherent in being an LP. Selling stakes in the partnership is sometimes forbidden, and when it is not, can be sold only at deep discounts and only with the authorization of the GP. Past performance is often top secret. LPs have limited rights to influence or direct funds' activities. The problem of information asymmetry arises in this hyper-secret world.

Fees are typically charged on the amount of capital committed at inception, again typically only 16% of committed capital actually is invested by the end of the first year, after five years, only 80% of the capital committed is invested. A n extraordinarily high tariff in my view.

Intermediate valuations are described in this paper as "sluggish." There is a reluctance to write-off unsuccessful investments and a propensity to mark-to-"market"upwards those investments that are panning out. But "market" is ill-defined, it can be an arbitrary multiple of EBITDA or stock market comparables.

Overall, the article is well worth reading. In general returns have been less than that of an index fund after fees. Governance structures are poor, risks are high, disclosure is barebones. There is no reason to be envious of many of these private equity operators.

Some of the trade unions have been quite envious of the wealth building that is transforming the ownership structure for the companies that employ their members. A new study was brought out yesterday by the Service Employees International that is quite interesting as well. Please see SEIU Behind the Buyouts

We have ranted about the unfairness of some of the deals that we have seen on numerous occasions. Here is a set of recent Value Discipline links:
Falling out the First Storey Window
Observations on Risk
Yankee Candle Darn It's Going Away
A delicious Irony:Lots of Dollars Little Sense
Private Equity, Hedge Funds and the Struggle to Spend Cash

A few other interesting links apropos to the topic:

Financial Services Authority UK Risk Outlook


and

IMF Warns of Private Equity Boom







2 Comments:

At 11:31 AM, Blogger Eric J. Fox said...

Thanks for the plug on my blog...there was an article today in the New York Times that supports your view of private equity.

 
At 11:32 AM, Blogger Eric J. Fox said...

Here's the link to it

http://dealbook.blogs.nytimes.com/2007/05/01/private-equitys-own-private-debt-bubble/

 

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