When it comes to private equity investing, some recent reports tell an upbeat story. According to research firm Preqin, 178 funds reached a final close in the period from July through September, securing an aggregate $137 billion in capital raised, which was “the best third quarter for buyout fundraising since the financial crisis.” The New York Times reported that Warburg Pincus, which has more than $40 billion in PE assets under management, “closed a $12 billion private equity fund, the largest the firm has conducted since before the financial crisis.” Separately, Preqin found that 74% of PE managers surveyed made firm-wide increases in base salary from 2014 to 2015, with 7% being the average increase, while almost half boosted performance-related payouts in 2014.
But it is not just these recent developments that are positive. Other research by Preqin details a heady rise in assets under management over the past decade-and-a-half. From December 2000 to June 2014, private equity AUM grew more than sixfold to $2.6 trillion, which is not far removed from what hedge funds in aggregate have under management. Over a 10-year horizon through midyear 2014, according to data from Cambridge Associates cited by Bain & Company, the return for global buyout funds has been 14.4%, ranking private equity among the best asset classes in terms of long-term performance.
A Lack of Transparency
Despite all the good news, there is no shortage of dark clouds looming over the sector. First and foremost have been widespread and growing complaints about a lack of transparency, including reports that managers have not been especially forthcoming about the way they are compensated. In fact, the SEC has been investigating private equity fee practices, including whether managers are misallocating or unfairly charging fees and expenses to investors. According to Financial News, “when examining fees and expenses last year, the SEC found that in more than 50% of cases there were violations of law or material weaknesses in controls.” The regulatory agency has in recent months settled fee-related charges with three firms: Fenway Partners, Blackstone Group and KKR.
As with the hedge fund sector, the industry generally operates with a management fee and profit-share structure, with 2% and 20%, respectively, being the traditional terms. But some argue that such arrangements, where PE managers appear to have significant “skin in the game,” suggest an alignment of investor-manager interests that is at odds with reality. According to Naked Capitalism, citing a landmark study detailed in Private Equity at Work: When Wall Street Manages Main Street, “the overwhelming majority of private equity income came from fees not at risk, as in the management fees and the other fees and expenses that they extract from the portfolio companies that they own.”
How firms calculate the management fee has also been called into question, with many private equity funds reportedly basing the value on “committed,” rather than invested capital. Generally speaking, when investors become limited partners, the size of their commitment represents the amount that will be invested over some period of time, rather than at the outset, as is typical with hedge funds, mutual funds and other investment management arrangements. Consequently, the effective management fee is higher relative to the amount of money being put to work than the stated rate.
That said, the issue of how much managers charge for their services needs to be looked at in the context of overall performance, as I noted in “The Misguided Focus on Hedge Fund Fees.” In other words, it is the net return after fees are deducted that matters. For example, while the California Public Employees Retirement System recently disclosed that it paid $3.4 billion to private equity firms since 1990, “Calpers also said it had made $24.2 billion in profits from [these] firms over the same period,” The New York Times reported. The article noted, however, that a breakout of other fees that managers charge, including those related to transactions, costs for monitoring investments and legal fees, was missing from the report.
Regardless, questions about fees have naturally raised concerns about how transparent PE firms are in other areas. It’s one thing to assess the strategy and holdings of a hedge fund or mutual fund that invests, say, in publicly-traded shares. It’s another to evaluate a fund that holds assets whose values are more subjective. As financial blog A Wealth of Common Sense noted in “Are The Private Markets Getting Too Crowded?” there are significant “operational headaches” associated with investing in private equity.
The majority of investors don’t have the resources, expertise or due diligence process in place to be able to thoroughly vet these types of investments. Not only that but they can be a nightmare from an operational perspective if you don’t have the back office in place to deal with auditors, handle the cash flows, figure out the marks on the investments and understand how to track and measure the performance. There aren’t many rules of thumb or industry standards in this space.
Efforts by regulators to rein in or curtail certain practices also represent potential threats. These include a crackdown on leveraged lending, which is aimed at reducing systemic credit risk by limiting the use of borrowed money in corporate buyout transactions. According to Institutional Investor, citing remarks by Morningstar’s Stephen Ellis, “leveraged lending to private equity managers has dropped about 50% in the 18 months leading to October.” The preferential tax treatment of profit-sharing allocations that managers have long enjoyed is also under intense scrutiny. The IRS is reportedly seeking to end the loophole that allows PE firms’ partners to artificially lower personal income tax bills. Instead of being taxed as ordinary income, this “carried interest” has historically been taxed at the correspondingly lower capital gains rate. In some cases, firms have arranged to have management fees converted into capital contributions, a practice the IRS is also seeking to rein in.
A changing monetary landscape
The biggest risk to the industry, perhaps, is a prospective change in market conditions, especially given what appears to be an imminent shift in the monetary landscape. Private equity has been a major beneficiary of “easy money” accommodation and the seemingly insatiable demand for risky assets that have been the hallmarks of Federal Reserve policymaking since the global financial crisis unfolded. Amid growing signs that the Fed is set to begin the process of interest-rate “normalization,” former tailwinds could soon become headwinds. Other developments, including diminished liquidity in equity and fixed-income markets as a result of the Volker Rule, which limits the market-making activities of banks, will likely make it harder for firms to sell their investments when they look to cash out.
The fact that private equity is facing various challenges after years of success doesn’t necessarily mean that it’s the beginning of the end for the sector. For one thing, its long-term performance record will likely continue to appeal to pension funds and other institutions that operate with a multi-decade perspective in mind. But if financial history teaches us one thing, it’s that the good times can’t last forever. In the case of PE investing, there are more than a few signs that this Wall Street maxim is becoming increasingly relevant.