Buy-Out Firms Shooting Blanks
During the golden age of the mega-buyouts in the mid-2000s, when banks were lending like drunken sailors, and private equity firms were taking the practically free funding to shoot at almost every company in sight, it’s no wonder managers of these funds were “high-fiving” each other. Unfortunately for the participants, the music ended in 2007, and the heavy debt-loaded guns that previously were killing large elephant deals got replaced with harmless toy guns shooting blanks at phantom transactions.
Peter Morris, a former Morgan Stanley (MS) banker and author of the scornful report, “Private Equity, Public Loss,” took a critical eye at the industry pointing to the reasons these high risk-taking private equity firms are underperforming the S&P 500 significantly. Bolstering his underperformance assertions, Morris points to 542 deals in the Yale endowment that underperformed by -40% once fees were subtracted. The Center for the Study of Financial Innovation, which is affiliated with Morris, cites a 2005 paper by Steven Kaplan (University of Chicago), and Antoinette Schoar (Massachusetts Institute of Technology). The paper shows the average buy-out fund underperformed the S&P 500 index from 1980 – 2001.
Another factor that Morris feels should not be ignored relates to risk. Morris feels the excessive risk profiles associated with these private equity funds have not been adequately considered by many unknowing investors and public taxpayers. Pensioners are vulnerable to these underperforming, risk-adjusted returns, while unassuming taxpayers could also be on the hook if risky private equity bets go bad. Under certain scenarios these potentially rocky private equity investments could bring a financial institution to its knees and force governments to use taxpayer bailout money. The Financial Times features a $6.5 billion investment made by Terra Firma, which was subsequently written down to zero, to make its point about the inherent risk private equity plays in the overall financial system.
Heads We Win, Tails You Lose
What makes the purported underperformance more scathing is the fact that these funds should bear higher returns to compensate investors for the additional liquidity risk and leverage that is undertaken. Like hedge funds, most private equity funds charge a 2% management fee, and a 20% performance fee for results achieved above a certain hurdle rate. The problem, that many outside observers highlight, is that the private equity firms have very little skin in the game, for example as little as 2%. With not a lot of their own dough in the game, the fund managers have a built in incentive to swing for the fences, because a profit windfall will filter to them should they hit it big. Morris characterizes this conflict of interest as “heads we win, tails you lose.” Another knock against investors revolves around return calculations. The opacity surrounding returns makes private equity less attractive, since valuations are only truly accurately reflected upon sale, which often takes many years.
Have all these shortcomings scared off investors? Apparently not. Just recently Blackstone Group (BX) raised a new $13.5 billion fund, the firm’s 6th fund, fresh off of its 5th fund that raised a total of $20 billion. The focus of the new fund will be on Asia and North America. In the short-run, Europe will occupy less of the fund’s attention until the region’s economy recovers.
To the extent more of these studies garner traction, I’m sure the private equity industry will react with a forceful response, especially with billions in potential fees at stake. One thing is for sure, investors have become more demanding and shrewd post the financial crisis, so if private equity managers want to earn the rich fees of yesteryear, they will need to do better than shoot blanks.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in MS, BX, Terra Firma or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.