Private Equity: Who Wins?
Is it is worth sacrificing the transparency and liquidity of public equity markets for the promised additional returns and supposed diversification benefits of private equity? Not according to a new study.
Private equity is an asset class in which investers purchase stakes in operating companies that are not publicly traded on stock exchanges.
Private equity managers sell as their skill the ability to buy and transform underperforming, fledgling or unproven companies, while financing their acquisitions with significant amounts of debt.
Investers who provide equity capital to these ventures get to share in the profits, although they must lock up their money for at least three years and sometimes up to 10 years before they see an actual result.
Apart from the allure of strong returns, the other selling point for private equity is its use as a diversifier due to a supposed low correlation with traditional asset classes such as listed equity and fixed income.
But a new study by former banker Peter Morris1 finds that private equity managers often charge excessive fees (typically a 2 per cent annual fee and 20 per cent performance fee) and overstate potential returns.
“Calculating returns on private equity is not a trivial issue,” Morris says. “The most widely used measure, the internal rate of return, is misleading and often overstates realised returns. This creates room for uncertainty, at best, and, at worst, manipulation.”
As well, Morris questions the extent to which the returns that the managers do deliver relate to their own skill and the extent to which they come from what the market would have provided anyway and to the leverage involved.
For instance, his study analysed the returns on 110 deals in the UK and Europe over a decade from 1995 to 2005. The average internal rate of return in those deals was 39 per cent, of which debt accounted for 22 per cent and a rising stock market 9 per cent.
The other 8 per cent was the contribution of the private equity managers. But given that the average annual fee in private equity was at least 8 per cent, this meant the investors who provided the bulk of the money would have done just as well investing in the market directly and borrowing from the bank.
These findings echo comments by leading academics Eugene Fama and Ken French, in which they note that insofar as private equity managers add value through the application of their skills, this additional return tends to go to the human capital – that is to the managers themselves.
As well, Fama and French dispute that private equity is a diversification tool, with estimates of market beta for private equity at 1.0 or higher. This is another way of saying that the type of targets chosen by private equity – small companies and start-ups - tend to be highly sensitive to the market.
The third point is that returns to private equity also tend to have a large “idiosyncratic random” component, which means a wide range of outcomes is likely. As these will be driven by chance, it makes it hard for investors to discern whether the returns they are paying for are due to skill or luck.
Another recent European study3 looked at cash flows from more than four thousand liquidated private equity investments and found the “alpha”, or return over what the market would have delivered anyway, was zero.
This study inferred an historical risk premium from private equity of around 18 per cent, of which about 10 per cent was the market premium, five per cent was the value (or book-to-market) premium and the remaining three per cent was the premium from liquidity risk – the risk of not being able to sell out of the asset sufficiently quickly to avoid a loss.
So while private equity can generate good returns, once these returns are adjusted for market risk, value or small cap risk, and liquidity risk, there is little sign of the managers adding any additional value through their own skill.
In any case, the size of the fees involved suggests that what additional spoils are on offer tend to go to the managers, not the investers.
1. Peter Morris, ‘Private Equity, Public Loss?’, Centre for the Study of Financial Innovation, July 2010
2. Eugene F. Fama and Kenneth R. French, ‘Public Equity vs Private Equity’, Fama/French Forum, July 7, 2010
3. Francesco Franzoni, Eric Nowak and Ludovic Phallippou, ‘Private Equity Performance and Liquidity Risk’, Swiss Finance Institute, June 17, 2010