Experts Split Over Private Equity?
Pension funds allocating their assets to private equity have reaped little or no rewards on average, according to a Yale study.
Martijn Cremers, associate professor of finance at the Yale School of Management, concluded in a recent paper that returns on private equity over the last 10 years were no better than the stock market. Investments in public equity were on average unlikely to yield more profit than investments in stocks or bonds, because of their high management fees. However, some experts disagreed with the findings, saying that private equity is still a good option for asset allocation.
According to the paper, private equity funds had a spectacular run in the 1990s where it returned an average net return of 21.5 percent to its investors. Impressed by this performance, institutional investors increased their investment in private equity, bringing the total funds in private equity from $200 million to $2 billion in the last 10 years. But the Midas touch of private equity disappeared at the turn of the century and the returns fell to an average of 4.5 percent in the last 10 years, the paper said.
“If I had to summarize it in a nutshell, pension funds got similar returns to what they would have gotten had they invested in passive equities,” Cremers said.
Since private equity is more volatile than stocks or bonds, a portfolio with a large asset allocation in it would have a high amount of risk. For example, the paper said, the net returns from private equity fell from a profit of 36 percent in 2000 to a loss of 21 percent the next year.
Even as the profits in private equity took a hit in the aftermath of the dot-com bubble, private equity fees continued to climb. Cremers explained that in addition to taking a cut from the share of returns, known as the performance fee, private equity managers also charge an overall management fee on the invested capital. He said the average management fee has increased from 2.4 percent in 2000 to 4.2 percent in 2010. Private equity fund managers have taken 70 percent of the gross profits made in the last decade as fees, Cremers said.
Steven Kaplan, professor of entrepreneurship and finance at the University of Chicago, disagreed with the findings. According to his research, every dollar a pension fund put into private equity earned 20 percent more than it would have in Standard & Poor’s 500 index. Accounting for management and performance fees, he said, private equity funds have outperformed public markets by an average of three percentage points over the past 20 years.
Kaplan pinned the drastic difference in results on unreliable data.
“Cremers does not have particularly good performance data [but] we do,” Kaplan said.
In the past several studies have relied on commercial data sets provided by Thomson Venture Economics, which is problematic for analysis, Kaplan said.
Ayako Yasuda, associate professor of management at the University of California, Davis, shed light on the problems of gathering definitive data. Unlike pension funds, private equity funds are not legally required to disclose their activities, so all data available is based on voluntary disclosure, which is subject to bias.
“What’s missing is not just random noise,” Yasuda said. “Even a very small percentage of the missing data could mean that it is being systematically obstructed, which could create hidden bias.”
The difficulty in collecting data about private equity makes the field’s performance uncertain, if not controversial, Kaplan said.
Yasuda contended that the 4.5 percent average return, which Cremers calculated, is no worse than the turbulent performance of the stock markets in the last decade.
“It’s a period in which the benchmark also performed poorly,” Yasuda said.
She agreed private equity funds tend to have higher fees than other investment asset classes, but said the performance fees are typically structured to avoid consuming all the net returns for investors in low-performance funds.
In an underperforming market, private equity fees may seem exorbitant, but they are within reason during economic booms, such as the 1990s, Deputy SOM Dean Andrew Metrick said. Compared to a hedge fund, private equity charges a lot less, he said.
Metrick said that private equity funds also allow its institutional investors to invest in buyouts and ventures as partners, which means that pension funds may bypass a large portion of the overall fee. Such transactions are not included in Cremers’ data because they are not available to the researchers, Metrick said.
The key for pension fund managers is to find the right private equity investments, which requires enormous skill and long-term dedication, Metrick said.
For the unsophisticated investor, making investments in private equity funds is “like throwing darts at a newspaper,” he said.
The paper was co-authored by Aleksandar Andonov and Rob Bauer of Maastricht University in the Netherlands.
Go back to read my comment on Bain or blessing. Just like hedge funds, most private equity funds are mediocre but top funds tend to consistently outperform. There are also smaller funds that are true gems in private equity but the large pension funds that write big tickets focus on the larger PE funds, investing or co-investing with them.
BC Partners Ltd., the British private-equity owner of gym operator Fitness First Ltd., raised 6.5 billion euros ($8.6 billion) for leveraged buyouts, surpassing its target.
BC European Capital IX, which will target controlling stakes in “defensive growth” companies, was oversubscribed and is 14 percent bigger than the previous one, the London-based firm said today in a statement.
“I am delighted with the enthusiastic response from existing and new investors from around the world, particularly in the context of a challenging fundraising environment,” Charlie Bott, head of investor relations and a managing partner, said in the statement.
BC Partners was one of the first private-equity firms in Europe to come back to investors in 2010 for a new fund after the financial crisis stymied dealmaking. Initially targeting 6 billion euros, it offered a 5 percent discount on fees for investors who committed money before its first close in early 2011, people with knowledge of the matter said then. It also agreed to end transaction fees, billed each time the firm or one of its companies make an acquisition, to lure investors at a time when lack of distributions made them reluctant to commit to new pools.
The firm said it secured “a substantial amount” of commitments from the majority of existing investors. About 40 percent was raised from backers in North America, 30 percent in Europe and 30 percent in Asia and the Middle East, it said. About 37 percent of backers are pension funds, while sovereign wealth funds make up 25 percent and fund of funds 12 percent.
Some of the largest European firms, including Apax Partners LLP, Cinven Ltd. and Permira Advisers LLP, are raising buyout funds. Private-equity firms, which are seeking $711 billion globally, raised 46 percent less in the third quarter than in the previous quarter as the European debt crisis deepened, according to London-based research firm Preqin Ltd. Meanwhile, the value of LBOs announced by private-equity firms in the second half of last year dropped 32 percent to $71.5 billion from a year earlier, according to data compiled by Bloomberg.
Indeed, top European private equity funds are not having any trouble raising funds. Mark Scott of NYT's DealBook reports, Permira Sifts for Bargains, Even in Europe’s Periphery:
Kurt Björklund does not seem worried about Europe’s sovereign debt crisis.
As competitors pull back from the troubled market, his private equity firm has doubled down on the region, picking through distressed companies from Dublin to Dubrovnik.
Since the start of 2010, Permira, one of the largest buyout specialists in Europe, has spent almost $6 billion, including acquisitions in debt-ridden countries like Spain and Ireland. The firm bought the call center operator Genesys from the Franco-American telecommunications company Alcatel-Lucent for $1.5 billion in early February.
“This is the right time to be staying in — not getting out of — the market,” said Mr. Björklund, a co-managing partner at Permira, which has assets of 20 billion euros. “Europe is a complicated place to do business, but the outlook for investing is good.”
Now, the private equity firm is playing up its Continental roots, as it looks to expand in the United States and elsewhere. To differentiate itself from rivals, Permira, in part, highlights it regional network of offices. The firm operates in eight European countries, compared to three for Blackstone and two for Kohlberg Kravis Roberts.
“You can’t do private equity in Europe if you are just based in London,” said Mr. Björklund, 42, who joined the firm in 1996 after working for the Boston Consulting Group in Sweden. In each country, private equity firms require on-the-ground knowledge, says Mr. Björklund, who is from Finland.
Permira will need to draw on that experience as the European economy slides toward recession. The gross domestic product of the euro zone is expected to contract 0.5 percent this year, according to the International Monetary Fund. Southern European countries — where Permira currently has six holdings — will be the worst hit. Spain’s economy is forecast to shrink 1.7 percent this year, while Italian G.D.P. is predicted to fall 2.2 percent.
The private equity industry has felt the ripple effects of the economic turmoil. As banks have pulled back on lending, buyout firms have been reaching deeper into their pockets to finance deals. Last year, debt — or leverage — represented 55 percent of European buyout deals, compared to 66 percent in 2007, according to data provider Standard & Poor’s LCD.
“It has become more difficult to finance buyout deals,” said Peter Roosenboom, a private equity professor at Erasmus University in Rotterdam, the Netherlands. “Leverage isn’t as cheap as it was before the crisis.”
Permira has ridden out previous periods of uncertainty. The private equity firm was founded in 1985, after the buyout divisions of the European asset manager Schroder were spun off as a separate business. Since then, it has weathered the reunification of Germany, the creation of the euro as well as the slow growth and high unemployment that have characterized Europe’s economy over the last two decades.
Last year, valuations across the firm’s three active funds increased by a combined 16 percent, compared with a more than 30 percent rise recorded in 2010. Its portfolio of 25 companies, including the German high-end fashion retailer Hugo Boss, the Asian casino operator Galaxy Entertainment and the Spanish fast-food chain Telepizza, currently has a combined market value of around $80 billion.
Amid the upheaval, Permira is trying capitalize on Europe’s fragmented markets. The private equity firm focuses on leading local companies in a small number of sectors, like financial services and consumer products. Then it consolidates those businesses to create larger regional players.
With growing demand for low-cost travel, Permira joined forces with rival Axa Private Equity last year, merging three online travel Web sites across the Continent. Each company — eDreams of Spain, Opodo of Britain and GO Voyages of France — had a strong market share in specific areas in Europe, but now cover all 27 countries in the region.
Permira also emphasizes global brands with a significant portion of revenues overseas. Last December, it bought a controlling stake in Netafim, a leading water irrigation company majority owned by three kibbutzim in Israel. Despite its Israeli heritage, Netafim holds a dominant market share in more than 100 countries worldwide.
The Permira team spent over a year — and more than 60 separate trips to Israel — convincing the owners to sell. In the end, the firm beat out other leading private equity firms, after owners interviewed an executive from another Israeli company in Permira’s portfolio.
“We had to convince them that we would be able to take the company forward,” said Jörg Rockenhäuser, 45, the head of Permira’s Frankfurt office.
With less debt financing available, Permira’s network of offices across Europe could give it at a competitive advantage, according to Stefano Caselli, a finance professor at Bocconi University in Milan. Private equity players can no longer offer high valuations, financed by debt, to takeover targets, so local contacts able to woo companies are increasingly important.
“Investors are looking for private equity firms with strong roots and high levels of expertise,” Mr. Caselli said. “Today, leverage isn’t enough. You have to fundamentally know the company you’re investing in.”
Still, convincing investors to part with cash just as Europe’s economy is going from bad to worse remains a tough sell. Permira has been raising a new 6.5 billion euro fund — one third smaller than its previous fund raised in 2006. Tom Lister, 47, Permira’s other co-managing partner who is based in New York, said he had spent a lot of time with potential United States investors explaining the implications of the Continent’s debt crisis. Much of the discussions have focused on short-term problems facing the euro zone, like the bailout of Greece.
Despite the challenges, Mr. Lister said Permira’s long-term American backers have experience investing in Europe and understand the Continent will most likely bounce back from its current difficulties.
“There’s more uncertainty for U.S. investors because of the lack of information coming out of Europe,” said Mr. Lister, who joined Permira in 2005 after more than a decade with New York buyout firm Forstmann Little. “But North American investors continue to commit funds to Europe.”
Permira’s returns will depend on its finding buyers for its assets. In November, the firm sold the Dutch animal feed company Provimi to Cargill for $2.1 billion, more than doubling its initial investment. Permira also sold one-third of its stake in Galaxy Entertainment last September for $616 million.
Future deals may be more difficult. The market for initial public offerings is still shaky. Nonfinancial companies also are wary of spending their cash reserves on acquisitions, given continued weakness in the broader European economy. In 2010, Permira shelved its plans to take the British fashion retailer New Look public because of volatility.
But the private equity firm is willing to wait out the tumult. The amount of distressed assets in Europe is likely to rise, and Permira is currently focused on expanding, not reducing, its portfolio of companies, according to Mr. Björklund.
“We never want to be held hostage to an I.P.O. as the only possibility,” Mr. Björklund said. “If you have a market-leading business, you will always have different exit opportunities.”
True, the top funds will always have different exit opportunities but it's a lot easier to exit when general conditions are favorable in stock markets.
And while European private equity is picking up, Reuters reports that Asian PE is stalling, allowing secondary firms to march in:
As hundreds thronged a financial conference in Hong Kong last year to hear an executive of U.S. private equity firm Bain Capital, Doug Coulter took a seat in a nearly empty room next door at a separate session on the secondary part of the buyout industry in Asia.
Coulter, Asia head of private equity for LGT Capital Partners, was encouraged by what he saw.
"I just thought, 'Wow, nobody is covering this. This is a great opportunity ,'" Coulter recalled, reminiscing about the 2011 Asia Venture Capital Journal event.
Five years after global buyout giants first flocked to the region to tap its growth, Asia's private equity market has reached a tipping point. Maturing funds, a crop of inexperienced managers and global market instability are all opening the door for so called secondary players to come in.
Lexington Partners, Pantheon and Green Capital have launched in Hong Kong in the last year alone, joining LGT and others already here.
NewQuest, which spun off from Bank of America's private equity arm, recently opened in Hong Kong as well. Most of the major secondary firms are now set up in Asia, taking a crack at what is a relatively small field compared to the traditional buyout industry.
These firms face a budding opportunity and a major challenge, as they too are susceptible to the region's volatility and will be playing in a smaller market than in other parts of the world.
Secondary investors operate in several ways. They can buy stakes in private equity funds from investors seeking an exit, take over managing a company or a portfolio of companies held by a private equity firm, or they can team up with a private equity firm doing a leveraged buyout by offering cash to support a bid.
Secondary players in Asia have performed all three of these functions in the last year. While the market here is just getting started, around the world, industry analysts expect there to be $30 billion in secondary transactions this year, more than triple the amount two years ago.
Tucked away behind the bustling central business district of Hong Kong is a new building with no name, the number "8" being the only identifying sign.
On the 26th floor, in a freshly painted office, NewQuest Capital Partners looks and feels like a startup, even though it is made up of a team of veteran industry professionals.
"Not many people know about this building," said Darren Massara, an American of Italian heritage and the former Asia head of private equity at Merrill Lynch, now the managing partner of NewQuest.
Not many people know the private equity market Massara plays in, either. Secondary market activity tends to grow when the primary private equity sector stalls, and requires new investors and managers to support the industry.
NewQuest, with backing from HarbourVest, Paul Capital, LGT and Axiom Asia, was formed when Bank of America dumped Merrill Lynch's private equity arm after rescuing the brokerage in 2008. NewQuest now manages Merrill's former private equity portfolio.
Newquest estimates that $200 billion of private equity capital invested in Asia since 2005 has yet to exit. With IPO markets shut and many Asia private equity funds fully invested and seeking new funds, the pressure is on both buyout firms and their committed investors -- known as limited partners (LPs) -- to show investment returns.
That is where the secondary firms come in. The firms specialise in buying these commitments from LPs that want to cash out of a private equity fund. Secondary firms assume that commitment and the ups and downs that can come with it, such as eventual profits from the sale of various holdings.
A strong run in the first half of last year saw private equity-backed Asia Pacific M&A hit its best figures since 2006 on volume of $33.2 billion, according to Thomson Reuters data.
But fourth-quarter volume plunged 67 percent to $3.9 billion, the data shows, as equity and debt availability dried up in the second half amid global economic turbulence fed by Europe's debt crisis.
In that economic turmoil, the struggles of private equity managers in the region grew, with sources pointing to India's private equity sector as a brewing trouble spot, where a lot of money was raised, with very little coming out.
And even though LPs are still pouring money into Asia, that money is going mainly to top-performing funds. Many of Asia's first-time funds are expected to go out of business.
That is another area opening up for secondary firms in Asia. Primary private equity funds avoid the practice of taking over the struggling portfolio of a peer, but certain secondary firms are happy to do so.
Another secondary area opening up in Asia is investing alongside leveraged buyouts.
When Bain Capital acquired Japan's Skylark restaurant chain from Nomura last year, the equity cheque needed for the deal was a massive $1.3 billion. Bain signed for $1 billion and its limited partners, including HarbourVest, came in to provide the other $300 million.
The challenges secondary players face can be daunting. These include investing in a poorly run private equity fund, co-investing in a buyout deal that fails, and failing to revive a struggling portfolio of companies.
Asia's secondary market role has been small until now, largely because the region's private equity boom only kicked off in 2005. Fund and deal sizes tend to still be smaller than in the United States and Europe.
That is changing, as the early wave of investments are coming due for exits now.
"Asia will be a bigger part of the deals universe," said Tim Flower, Principal at HarbourVest Partners, Asia . "You've got to be here if you want to have complete global coverage."
The same drivers that influence the secondary market in the rest of the world are at play in Asia.
Australian banks and Japan's megabanks, like their counterparts in Europe and the United States, are selling private equity stakes, in part because of the 'Volcker rule' and Basel III capital rules, which offers a massive opportunity for secondary firms to fill.
In addition, sovereign wealth funds and pension funds are pruning their exposure to alterative assets such as private equity amid the economic downturn, cutting underperforming managers from their rosters - another window for secondaries.
GIC, the Singapore sovereign wealth fund, is selling $750 million of private equity and other funds it no longer wants to invest in, and will redeploy the money to other better-performing managers, according to sources familiar with the matter.
India is a current focus for secondary specialists, where overcrowding in the private equity space, coupled with high valuations and now shuttered IPO markets mean secondary activity is rising.
Tens of billions of dollars have been raised for India private equity activity. But getting that money out has been a challenge. Exits through the Indian IPO market dropped 66 percent in 2011 to $85 million in 15 deals, according to data from VCCircle.
China is also on the radar, as the country's roughly 3,500 funds, many of them start-up firms suffering from last year's market selloff, face an industry shakeout.
Besides the $200 billion in unexited positions in Asia, NewQuest estimates an additional $110 billion is sitting on the sidelines, waiting for investment.
As private equity veterans like to point out, it's easy to put money into a company. Asia's first-time funds are finding out how difficult it can be to get the money out.
All this to tell you that while academics argue over private equity, the industry's top funds are thriving. Private equity is here to stay and investors have a lot more liquidity in this asset class than in the past because of the secondaries market.
Finally, some large investors are speaking up on private equity's public subsidy. Bloomberg reports, Calpers’s Dear Calls Private Equity Tax Break ‘Indefensible’:
Private equity managers’ preferential tax treatment, less than half the rate paid by ordinary wage earners, is “indefensible,” the investment chief of the California Public Employees’ Retirement System said.
Calpers, as the pension fund is known, is one of the largest investors in private equity with about $50 billion as of June 30. The fund, the largest public pension in the U.S., has $234 billion of assets under management.
“General partners should recognize that tax treatment of their income has become indefensible,” said Joe Dear, the fund’s chief investment officer, at a meeting of the Calpers board yesterday in Sacramento.
Private equity managers get a portion of their clients’ earnings as investment income if the underlying earnings are treated that way. So-called carried interest is taxed at the 15 percent rate for capital gains, rather than the 35 percent top rate that applies to regular income.
“The tax treatment is incomprehensible to ordinary taxpayers and citizens,” Dear said in an interview. “If people come to believe that private equity general partners are reaping giant returns, while paying less in taxes than wage earners do, their support for those policies that enable private equity to work will be withdrawn.”
U.S. public and private pensions provide 42 percent of the capital for all private equity investments, according to the Private Equity Growth Capital Council in Washington.
Mitt Romney’s campaign for the Republican presidential nomination has put a spotlight on the industry, including Romney’s former firm, Boston-based Bain Capital LLC. President Barack Obama’s budget proposal yesterday reiterated his proposal to tax carried-interest income earned by hedge fund managers and private equity partners at ordinary income rates, raising $13 billion over a decade.
Private equity firms typically charge about 1.5 percent of assets to cover their expenses, and 20 percent of the profits from investments as compensation, or carried interest.
Under pressure from rivals, Romney, whose wealth is estimated at between $190 million and $250 million by his campaign, last month disclosed tax returns showing he paid a 13.9 percent tax rate in 2010 on income of $21.6 million.
“The private equity industry can use logical argument all day long,” Dear said. “It does not diminish the gross unfairness that people perceive. That some of the wealthiest and most prosperous people in this county pay a lower tax rate on their income than wage earners.”
U.S. Representative Sander Levin of Michigan, the top Democrat on the House Ways and Means Committee, said on Jan. 18 that he plans to reintroduce legislation that would tax carried interest at ordinary income rates.
Joe Dear is absolutely right. Funny how outspoken New Jersey Gov. Chris Christie had some rather harsh words for billionaire investor Warren Buffett on Tuesday, saying "he should just write a check and shut up". Meanwhile he's being wined and dined by Steve Cohen, the billionaire hedge founder of SAC Capital who has now switched sides after heavily backing President Barack Obama four years ago.
Even John Bogle, the Vanguard Group Inc. founder who popularized index investing, said lower tax rates for certain types of gains earned by private equity firms are “ridiculous", calling carried interest "a bit of a technical fraud”. Below, Bogle talks about financial markets, investment strategy and U.S. tax policy with Bloomberg's Betty Liu at the Bloomberg Link Portfolio Manager Mash-Up conference in New York.
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