Private Equity Funds: Investment Enigma So Caveat Emptor

Limited partners (“LPs”) are not rewarded with abnormal returns in all private equity (“PE”) deals.(1)  The California Public Employees’ Retirement System (“Calpers”) has just now begun its sale at losses in the secondary market for forty-three PE funds purchased in 2007.[2]  CALPERS and other state pension funds reveal excessive fees paid to PE firms.[3]  Calpers recently disclosed that it had paid $3.4 billion dollars in fees based on $24.2 billion dollars in profits since 1990.[4]  Can general partners (“GPs”) charge the fees without opening up and showing their funds’ performances and bases of their decisions?[5]  Although net gains[6] usually characterize PE, limited partners puzzle over the complexities of the agreements so they must carefully vet fund sponsors. Agency costs are alleviated somewhat in the management contract, but LPs favor higher ownership interests by GPs so as to diminish agency costs (Robinson and Sensoy 2763, 2773). Despite the complexities PE remains an attractive investment for savvy LPs.

Typically, non-public companies receive PE capital. PE funds are different from hedge funds because investors in PE have to wait until exit while hedge fund investors can withdraw periodically.[7] PE investors have to wait for years before their gains are realized-via initial public offerings (“IPOs”) or when buyers appear.[8]  Since these PE funds are not publicly-traded, the Securities and Exchange Commission does not oversee their financial statements.[9]  Nevertheless, college endowment funds and other institutional investors seek out PE opportunities as long-term investments in order to diversify from the traditional stock-bondcash portfolio.[10]  The most common types of PE investments are leveraged buyouts (“LBOs”) and venture capital (“VC”). Large investors in PE with superior access to successful fund managers generally incur lower costs and higher net returns per year (Dyck and Pomorski 43).

Cumming, Siegel, and Wright argue that PE investors institute governance mechanisms that lead to enhanced returns (445); while Gillan and Starks opine “more research is required for the validation of performance and governance improvements” (69). PE firms are activists so they seek out undervalued private companies that can be purchased using debt for interest tax shields; and after obtaining majority control, they may install different management incentive systems (Cumming, Siegel, and Wright 441). With majority control as the objective, PE activists need deep pockets to investigate their targets, and then convince astute limited partners to commit their funds (69). What do the studies indicate about the different aspects of PE performance?

Once limited partners invest they become vigilant about whether the general partners (“GPs”) game the returns.[11]  Brown, Gredil, and Kaplan find that GPs do not want to draw the ire of regulators (they are presently unregulated), and they do not want to be caste as manipulators (5). The researchers juxtapose the returns of PE funds against comparable public equity firms. One study analyzes “1,400 private equity funds and finds that the average U.S. buyout fund has exceeded the performance of public market equivalents since 1984” (Harris, Jenkinson, and Kaplan 1852). These authors find that VC funds outperformed during the 1990s, but underperformed in the most recent decade.[12]  Kaplan and Schoar in an early hallmark study (2005) emphasize that good performers can usually raise follow-up funds (1817). They also found that performance increases with fund size (1821). Korteweg and Sorensen note that good performers prevail; however, they argue that top-quartile performance when noisy may be due to luck, and not serve as a predictor of future returns (3). This study was the only one that states that VC returns are basically due to luck (3,5). In most specifications under their complex model “the previous fund’s performance strongly predicts the performance of the next fund.”[13]  Phalippou and Gottschalg arrive at a contrary finding: “average private equity underperforms the S&P 500 by about 3% on a net-of-fees basis” (1747). They write that “adjusting for risk decreases performance by about 3% per year, bringing alpha net-of-fees to -6% per year” (1774). With fees averaging 25% per year[14] they believe some investors arrive at incorrect values or these investors may be using PE for other objectives (1773). The studies do not uniformly report net gains so investors also need to research the economies of PE.

A 2015 study finds small LPs should “avoid large-scale PE firms in favor of those more focused and independent” whereas “large LPs should look for less-hierarchical PE firms with large investments” (Lopez-de-Silanes, Phalippou, and Gottschalg 1773). Dyck and Pomorshi aver that “investment scale is a first-order determinant of investor performance” (43).[15]  The “BO business is more scalable than the VC business.”[16] Metrick and Yasuda report that BO funds earn more per partner than VC funds (2305), and VC funds “earn more per managed dollar than BO funds” (2336). Robinson and Sensoy were the first samplers “to combine information on contract terms with cash flows” (2761, 2766). And there is no evidence according to them that any contract term is associated “with the sensitivity of net cash flows to public equity market valuations.”[17]  The higher fixed fee firms “typically earn higher gross fees to offset their higher fees for assets under management” (Robinson and Sensoy 2762). One study reports better results for endowment funds, and attributes those results to better access to superior fund managers (Sensoy, Wang, and Weisbach 341). These authors state that the huge flows into PE have “lowered rents to the GPs.”[18]

Other researchers explore secondary buyouts, intermediated investing, and leveraged buyouts. Secondary buyouts oftentimes occur with funds that are under some kind of pressure-agency problems perhaps or the need to start new funds (Arcot et al. 103-105). Deals under pressure generate less value.[19]  Fang, Ivashina, and Lerner report research results with respect to co-investments and solo investments (160). With co-investments the limited partner plays a larger role and pays a lower fee (Fang, Ivashina, and Lerner 162). Intermediation helps when investors face information problems.[20]  Solo investments do well when compared to their benchmarks, and except for VC funds they outperform co-investments (Fang, Ivashina, and Lerner 176-177). Another form of intermediation is the fund-of-funds (“FOFs”). Harris et al. find that FOFs outperform public market equivalents from 1987 through 2007 (1, 8, 26). Limited partners in FOFs benefit from diversification, fund selection, and monitoring (Harris et al. 4-5). FOFs have higher fees than direct investments and lower returns which probably result from these higher fees.[21] The credit market conditions affect the level of private equity transactions in LBOs probably even more than the desire by PE managers to load their balance sheets with debt (Kaplan and Stömberg 137). The leverage factor exerts pressure on targeted managers “not to waste cash flows on improvident projects”.[22]  These writers report that at the “company-level the evidence indicates leveraged buyouts create value after adjustments for industry and markets” (136).

Private equity investments as alternative investments have risen to a level of significance (5%-10%) for institutional investors seeking diversification of their portfolios. The limited partnership structure creates agency problems because limited partners cannot become active or they will pick up liabilities to third parties. The complexity of PE transactions causes LPs to seek out successful GPs with good reputations who do not game the system. The typical agreement subjects the limited partner to high fees that impose a hurdle that must be cleared before realizing gains on its long-term investment. These PE funds are not currently regulated by the Securities and Exchange Commission. However, big data generation places a lot of information on the internet. PE funds do provide, however, much needed capital to private companies. Being activist investors who seek majority control in a long-term position, they are likely to advance governance recommendations to boards of directors and senior managements. Kaplan and Stömberg say PE managers add “‘operational engineering’ which refers to industry and operating expertise that they apply to add value to their investments” (132). In sum, careful investors scrutinize high fees, complex agreements, and agency problems. All studies did not report gains, but overall, the weight was definitely on the side of gains exceeding the public market equivalents which were used in the researchers’ models.

Footnotes

1 Sensoy, Wang and Weisbach report that the PE industry increased from $6.7 billion in 1990 to $261.9 billion by 2008 (320). PE involves 13,000 funds and $3 trillion dollars in assets under management (Arcot et al.103). 

2 The Wall Street Journal (Grant C11). 

3 State pension funds claimed that the fees were difficult to ascertain in the PE reports to investors. On the other hand, the PE firms disagreed about the transparency of their fees. However, bottom line for the last decade the median returns for private equity was 12.0% compared with 7.9% for U.S. equity (Martin C1-C2). 

4 Calpers now have $28.7 billion dollars of its $295 billion portfolio invested in 700 private-equity deals. The huge fees are primarily generated by performance (incentive) fees of typically 20% of the gains (Martin C3). 

5 Barron’s (Max S-6). 

6 “However, we can infer from many studies, . . . that PE gains can be substantial for top performing funds” (Reus and Mulvey 344). 

7 Robinson and Sensoy 2794. 

8 Reus and Mulvey 343. This research investigates how much investors should allocate to PE and public equity. 

9 However, some of the largest PE firms are publicly-traded limited partnerships (“LPs”). 

10 Reus and Mulvey 342-343. 

11 The Financial Accounting Standards Board issued FASB 157 which requires general partners to value their investments at fair market value at the end of each quarter (Brown, Gredil, and Kaplan 8). 

12 Harris, Jenkinson, and Kaplan 1852. 

13 Korteweg and Sorensen 16. 

14 Phalippou and Gottschalg 1749. 

15 Large plans have learned about their strengths so these plans invest a higher percentage of their portfolio in private equity (Dyck and Pomorski 44). 

16 Metrick and Yasuda 2337. 

17 Robinson and Sensoy 2782. 

18 Sensoy, Wang, and Weisbach 342. 

19 Arcot et al. 129. 

20 Fang, Ivashina, and Lerner 176. 

21 Harris et al. 27. 22 Kaplan and Stömberg 131.

Works Cited

Arcot, Sridhar et al. “Fund managers under pressure: Rationale and determinants of secondary buyouts.” Journal of Financial Economics 115 (2015): 102-135. 

Brown, Gregory W., Oleg R. Gredil, and Steven N. Kaplan. “Do Private Equity Funds Game Returns?” (unpublished working paper). University of North Carolina at Chapel Hill. (2013): 1-35. 

Cumming, Douglas, Donald S. Siegel and Mike Wright. “Private equity, leveraged buyouts and governance.” Journal of Corporate Finance 13 (2007): 439-460. 

Dyck, I. J. Alexander and Lukasz Pomorski. “Investor Scale and Performance in Private Equity Investments.” Review of Finance, Forthcoming. Available at SSRN: http://ssrn.com/abstract=2192619 or http://dx.doi.org/10.2139/ssrn.2192619 (November 1, 2014): 1-67. 

Fang, Lily, Victoria Ivashina, and Josh Lerner. “The disintermediation of financial markets: Direct investing in private equity.” Journal of Financial Economics 116 (2015): 160-178. 

Gillan, Stuart L. and Laura T. Starks. “The Evolution of Shareholder Activism in the United States.” Journal of Applied Corporate Finance 19.1 (2007, Winter): 55-73. 

Grant, Peter. “Calpers-Blackstone Deal Revives Secondary Market.” The Wall Street Journal 18 November 2015: C11. 

Harris, Robert S., Tim Jenkinson, and Steven N. Kaplan. “Private Equity Performance: What Do We Know? The Journal of Finance LXIX.5 (2014, October): 1851-1882. 

Harris, Robert S., et al. “Financial Intermediation in Private Equity: How Well Do Funds of Funds Perform?” Darden Business School Working Paper No. 2620582. Available at SSRN: http://ssrn.com/abstract=2620582 or http://dx.doi.org/10.2139/ssrn.2620582 (August 1, 2015): 1-45. 

Kaplan, Steven N. and Antoinette Schoar. “Private Equity Performance: Returns, Persistence, and Capital Flows.” The Journal of Finance LX.4 (2005, August): 1791-1823. 

Kaplan, Steven N. and Per Strömberg. “Leveraged Buyouts and Private Equity.” Journal of Economic Perspectives 23.1 (2009): 121-146. 

Korteweg, Arthur G. and Morten Sorensen. “Skill and Luck in Private Equity Performance.” Rock Center for Corporate Governance at Stanford University Working Paper No. 179. Available at SSRN: http://ssrn.com/abstract=2419299 or http://dx.doi.org/10.2139/ssrn.2419299 (October 29, 2014): 1-41. 

Klein, April and Emanuel Zur. “Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors.” The Journal of Finance LXIV.1 (2009, February): 187-229. 

Lopez-de-Silanes, Florencio, Ludovic Phalippou, and Oliver Gottschalg. “Giants at the Gate: Investment Returns and Diseconomies of Scale in Private Equity.” Journal of Financial and Quantitative Analysis 50.3 (2015, June): 377-411. 

Martin, Timothy W. “Pension Funds Tackle Fee Mystery.” The Wall Street Journal 23 November 2015: C1-C2. 

Martin, Timothy W. “Calpers’ Private-Equity Fees: $3.4 Billion.” The Wall Street Journal 25 November 2015: C3. 

Max, Sarah. “Big Data Bring Hedge Funds Out of the Dark Ages.” Barron’s 30 November 2015: S6. 

Metrick, Andrew and Ayako Yasuda. “The Economics of Private Equity Funds.” The Review of Financial Studies 23.6 (2010): 2303-2341. 

Robinson, David T. and Berk A. Sensoy. “Do Private Equity Fund Managers Earn Their Fees? Compensation, Ownership, and Cash Flow Performance.” The Review of Financial Studies 26.11 (2013): 2760-2797. 

Phalippou, Ludovic and Oliver Gottschalg. “The Performance of Private Equity Funds.” The Review of Financial Studies 22.4 (2009): 1747-1776. 

Reus, Lorenzo and John M. Mulvey. “Multistage stochastic optimization for private equity investments.” Journal of Asset Management 16.5 (2015, May): 342-362. 

Sensoy, Berk A., Yingdi Wang, and Michael S. Weisbach. “Limited partner performance and the maturing of the private equity industry.” Journal of Financial Economics 112 (2014): 320-343.