Myth of Private Equity Performance: Episode IV

“Perhaps what is not fully understood cannot be completely destroyed.” – Anthony Burgess, Kingdom of the wicked

The three myths about the reliability, predictability and resilience of private equity (PE) performance play an important role in drawing investors towards the asset class.

To prove the outperformance, however, PE returns are assessed relative to other asset classes. From this practice, performance comparative myths emerge.

Myth IV: Private equity performance can be benchmarked

Our attraction to the league table carries some blame for the competition towards performance reporting. The results of asset managers are often the criteria against their peers. PE managers typically report quarters where the investment returns of their reserve funds fall.

But it makes the interests of PE firms mysterious about their actual performance. If potential investors are not fully aware of the relative results of a fund manager, they will be sensitive to marketing strategies and branding and will associate the fear of missing (FOMO), anchors, and homosexuals, or our tendencies with whom we share similarities. .

In addition to performance manipulation strategies, PE fund managers have developed a variety of strategic tools that make it difficult to analyze and evaluate their returns.

By building huge one-stop shops, for example, the Big Four PE firms অ্যাপ Apollo, Blackstone, Carlyle and KKR কন are configuring a unique business model. Potential investors are unable to set their standards against the rest of the pack. They, Bain Capital, CVC, Equity and TPG, are trying to name some important competitors but they are becoming innocent.

This is a risky venture. TPG’s field of expertise is supposedly mega buyouts, yet its track record doesn’t always inspire confidence. The significant failures of my former employer Carlyle in the hedge fund space are hardly consistent with the firm’s reputation. Meanwhile, EQT has recently pulled out of its credit activities business. All of which proves that there are many false beginnings in the path of incomparability.

Private fund managers are wary of hiding their money-making process. The leverage buyout (LBO) artists ’investment pyrotechnics subsequently leaves an air of mystery arising from their financial innovation as much as from the ambiguity of their reported performance. But there is another aspect of this comparative theory that has far-reaching implications.

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Benchmarking against the public market

Raising surplus capital from institutional investors is an almost infinite game. Blackstone reached UM 500 million in assets (AUM) in the first quarter of 2019. For this reason, the Big Four are not in too much competition with their PE brothers. Rather, they aim to capture market share from other asset management sectors and transform it into a fully diversified private capital group.

In order to attract a wider asset base and the opportunity to raise significant fees in the process, leading firms emphasize the generation of their economic value creation and growth. There is a fatal argument to this. In order to attract this capital, PE firms need to market themselves as the most visible and popular asset class: upperformers rather than public equities.

Sadly, PE has failed to outperform public markets in recent years. Extensive research supports this. In a study of more than 100,000 North American buyouts and venture capital fund cash flow data from approximately institutional investors, Robert S. Harris, Tim Jenkinson, and Steven N. Kaplan determined that the U.S. private EQ was more of a vintage after 2005 or more. Equivalent to the public market.

According to Bain & Company, PE investors have averaged 15.3% annualized earnings for the 10 years ending June 2019. During the same period, the S&P 500 averaged 15.5% annual revenue.

In an upcoming study of U.S. endowment fund performance, Richard M. Ennis, CFA, found that none of the 43 funds reviewed have surpassed public markets in the last 11 years, but one in four is substandard. “The problem,” Ennis writes, is “the combination of extreme diversity and high cost.”

Late last year, the consulting firm added its own research to the CEM benchmarking mix, showing that the net of fees, PE, has lowered the small-cap stock index over the past two decades. Researchers have concluded that an in-house, low-cost approach is the only effective investment strategy.

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Defective analytical tools

These results are quite clear. But they don’t tell the whole story. In my experience, the inherent inconsistencies in the analytical process make these comparison practices futile. The most surprising thing about the PE industry’s performance data is that anyone relies on it in the first place. Returns are so easy to manipulate and misreport that it is impossible to prove their relative superiority or inferiority without their authenticity.

Errors in the Internal Rate Return (IRR) method have been well documented. Austin Long to meet its deficit. Third, and Craig J. Nichols, CFA, has created a tailor-made index-the Public Market Equivalent (PME) or Index Comparison Method (ICM). PME private equity reproduces cash flow as if the same capital call and distribution had taken place in the public market. The yield is then compared with the actual IRR of the fund. If the IRR exceeds the PME, the fund performs better than the public index.

Don’t think that, since then, PME has become the new benchmark for measuring performance and reaching a certain conclusion to determine whether the innocent asset class has exceeded public equity.

Almost immediately after the introduction of PME, academics created new metrics to overcome it. Why? Because Warren Buffett once saw:

“There is information and educators have worked hard to learn the mathematical skills needed to manipulate them. Once these skills are acquired, it is a sin not to use them, even if there is no usefulness or negative use to them.”

Less than the next four versions of PME have not been launched. Christophe Rouvinez created PME + to better match the net asset value (NAV) of the investment with the NAV of the fund. After that, modified PME (or MPME) was envisaged. The researchers then directly proposed the alpha method. Subsequent incarnations of PME include built-in personal premium (IPP or PME alpha) and alternative ICM.

Lots of other metrics. There is cash on-cash multiple, paid-in capital (DPI) distribution, remaining value of paid-in capital (RVPI) and total value of paid-in capital (TVPI). The proliferation of analytical tools is a serious problem. Buffett has a point.

Perhaps the main flaw of the study in PE performance is that the decision is made from a subset of performance data and then compared to the S&P 500, or some other benchmark, which in itself reflects a sample of public stock. Unfortunately, no data provider has access to an extensive list of the more than 5,000 PE firms operated worldwide. Academic research suffers because datasets are not representative of the PE Fund universe.

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The process of complexity

No one can show for sure that PE performance is higher or behind than in the public market. Issues of representation, bias, misreporting, comparability, manipulation and perseverance make such a decision impossible.

Of course, fund managers are very interested in making their performance reporting and evaluation processes additional engineers. Inevitably, they improve their false track records with bizarre opacity enough to frustrate opponents in any attempt to prove their lies.

Using the financial equivalent of mysterious instincts, fund managers will promote the benefits of their products and quality features and the ability to control and nurture portfolio assets as a majority shareholder. Marketing experts also know that the complexity of a technical product helps to cover its shortcomings. The complexity leads to comprehension.

Perhaps the most enduring and misleading notion inspires research into PE performance that investors are rational. If researchers can prove – in itself a Quixotic initiative – that PE does not work better than the public market, they assume that institutional investors will stop allocating capital to the asset class.

But management guru Peter Drucker once wrote:

“Of all the inconsistencies, which may be the most common between perceived and actual reality. Producers and suppliers often misunderstand that this is actually what the customer buys.

In other words, PE firm clients – institutional investors – are not rational. They will continue to capitalize on PE even with unequivocal evidence that the asset class cannot consistently and consistently lose public equity. To understand this kind of behavior, one should remember the famous business policy of the 1980s: “No one was ever fired for buying IBM.”

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Takeways for investors

This series reveals several key insights into personal equity:

  1. PE performance is not reliable: Fund managers can manipulate and manipulate results.
  2. PE Performance Not Replicable: Fund managers do not demonstrate unique ability to consistently drive returns, which is thus not predictable or resilient.
  3. PE performance is not comparable: there is no shortage of measurement techniques and criteria for achieving return on investment.

Potential PE investors are still interested in playing the game so a disciplined approach must be followed. These include:

  • Diversification by allocating capital across a selected and thoroughly diligent subset of fund managers.
  • Capitalized on a contractual basis by a contract rather than a fund. It has two main advantages: for management fees, the watch starts only when the investment is made when the capital is first pledged; And investors maintain complete discretion on which to take part.
  • Invest directly to avoid full fees.
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Like ghosts, witches, and elves, urban legends persevere in excellence, resilience, and personal equity performance. Even if the myth is able to record a parabolic upheaval over the past decades, no evidence can be found: PE results cannot be reliably benchmarked or consistently supplied. Which makes the exorbitant fees of the industry so confusing. Most fund managers still charge a generous 2/20 fee structure, or 1/20 for megafunds.

How do they get it? That’s why we showed up. They work tirelessly to perpetuate a dense veil of opacity that makes their trade understandable.

The impression of asking for rent is safe. Unless change comes from within.

As he prepared to leave the industry in 2004, the legendary LBO Trailblazer Teddy Fortsman halved the annual fees of his firm Foreman Little Clients, reducing them from 1.5% to 0.75%. At the time, he announced:

“It simply came to our notice then. I don’t see the kind of return we can make in the past, and as long as the return is low, the fee should probably be lower. ”

Seventeen years later, is it time for another reality check?

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.

Photo Credit: © Getty Images / Anders Blomqvist

Sebastian Candarel

Sebastian Candarel is a private equity and venture capital advisor. He has worked as an investment executive for multiple fund managers. He is the author of several books including N trap And Good, bad and ugly personal equity. Candarel also lectures on alternative investments in business schools. He is a Fellow of the Institute of Chartered Accountants in England and Wales and holds an MBA from The Wharton School.

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