The exorbitant privilege enjoyed by private equity firms
Fee structures encourage excessive debt and transfer too much value to insiders
One of the consequences of shrinking public stock markets is that investors now route ever more of their money through private market vehicles.
It is a switch that has permitted an extraordinary increase in the size of private equity funds. Their net asset value has grown more than seven fold since 2002; twice as fast as global public equities, according to recent data from the consultants McKinsey.
And there is little sign of this trend flagging. Investors have placed 14 per cent of their assets in private markets, according to Willis Towers Watson, a risk management firm. It predicts this will rise to 20 per cent over the next 10 years.
There was a recent reminder of how lucrative all this is for private equity insiders when Oxford university revealed its biggest single donation “since the Renaissance”. Stephen Schwarzman, the billionaire founder of US buyout firm Blackstone, coughed up £150m to fund research into the humanities.
But a more important question is whether it is a good deal for the pension funds that put up most of the cash. The frictional costs of private equity are both higher and less transparent than those on public markets. That is because of the high management fee and 20 per cent profit-share structure, as well as the need for periodic liquidations.
Ludovic Phalippou, a professor at Saïd Business School, has estimated that over the long term, buyout fees have equated to 7 per cent a year — way higher than the charges of less than 1 per cent typically levied by active fund managers. The issue is whether those additional costs can be justified by what private equity firms actually do.
One way to answer this question is to break down the returns on buyouts into different parts. First there is the bit that comes from stock market performance — the “beta” you can get simply by sticking your cash into quoted equities. Then there is financial engineering; mainly the additional debt that private equity firms pile on portfolio companies.
And lastly there is the “residual”, which is a mixture of bits and bobs. True, these might include superior operational performance. But they can also lump in any benefit from buying low and selling high. Pension funds make this easier by committing cash for ten years. This free option allows buyout bosses to buy when other investors are selling, and vice versa.
Research from both the British Private Equity and Venture Capital Association (BVCA) and academics suggests that the returns from private equity break down roughly equally between these three components.
So take a hypothetical situation where a buyout deal generated a £1bn cash gain over four years. Some £200m of that would go to buyout firm insiders as their profit share or “carry” — the reward that is supposed to align them with external investors.
Now if we use our crude split, we can see that £333m of that £1bn gain comes from beta, and the same again from extra leverage with the remaining £333m from the “residual”.
This leads to the key question: what are those slices worth to external investors? Logically, it would be odd to pay more for beta than a passive management fee of, say, 0.5 per cent annually, and maybe 1 per cent for leverage. After all, beta is a mechanical outcome, and while extra debt requires some skill, financial engineering does not grow the overall economic pie.
Plug in those percentages over four years and the rewards for beta and leverage come to about £11m. That leaves some £189m of the performance fee to reward the “residual” of £333m. Which in turn implies the buyout firms are carrying away at least 60 per cent of the true “performance”.
Aside from being grossly disproportionate, there are other reasons to worry about this outcome. The majority of buyout firms’ incentives have nothing to do with running businesses better.
There is no consensus view about the extent to which private equity returns exceed those on public markets, given the complexity of measuring returns. But fees are stubbornly high, whatever the performance.
Take, for instance, a case study by independent researcher Peter Morris looking at Gondola, a British restaurant chain taken private by Cinven in 2006. Despite Gondola underperforming a similar, quoted rival, TRG, over the eight-year period of the buyout, investors in Gondola via private equity paid all-in costs that were three times as much as if they had simply bought TRG stock.
With such rewards on offer, it is hardly surprising that so many quoted company bosses want to go private. Or why, given the high rewards for leverage, so many buyout bosses load up companies with risky debt.
Private equity does sometimes run companies better. But current fee structures encourage excessive debt and transfer too much of any real benefit that is achieved from millions of pension fund members to a few buyout firm insiders, thus helping to drive social inequality. Private equity contracts need redrawing to ensure these excesses are curbed.