The Shrinking Private Equity World?
The notoriously private private equity industry can't escape the glare of the spotlight these days, but the more immediate issue facing the industry is a lack of funding.So what is going on? Is private equity fundraising really drying up? Not according to Michael Corkery of the WSJ who reports, Public Pensions Increase Private-Equity Investments:
In 2011, U.S. firms invested just $32.1 billion in private equity, down nearly 79% from the industry's peak year in 2007.
And 2012 is expected to be even worse.
"It's taking a lot longer to raise funds," said Jeffrey Bunder, head of Ernst & Young's global private equity practice. "The process isn't like it used to be. They're having to demonstrate why they deserve the money."
Pensions and endowments, which make up the bulk of private equity investors, have been casting a wary eye on the industry because of the combination of high fees, lackluster returns and generally erratic returns.
Keith Garrison, the director of alternative assets for Texas Christian University's $1.1 billion endowment, said he's been more cautious about investing in buyout funds since the financial crisis.
"The returns have been more drawn out than you would have originally anticipated," said Garrison. "We need to manage liquidity. I'm not the only endowment closely watching its allocation to private equity."Unlike hedge funds or other assets that offer quarterly returns, private equity funds return cash to investors only when the companies they're invested in are sold, go public or add new debt.
Part of the problem for the industry is that since the financial crisis, private equity firms have had a hard time selling their acquired companies, as mergers and acquisitions and initial public offering activity slowed down.
In fact, current returns are at their worst level since at least 1990, when the California Public Employees' Retirement System first started tracking the data.
Private equity funds raised in 2006 have returned just 4.2% to investors, according to the pension fund's website. Funds raised in prior years generated double digit returns. Similar to hedge funds, managers of private equity firms generally earn 2% fees on all funds they manage and 20% of all profits.
Meanwhile, the same firms are struggling to find companies to take private that could generate returns. The industry is sitting on roughly $400 billion of cash globally. Private equity managers haven't found the right companies to put this so-called dry powder in.
All but the best performing firms are expected to shrink, as investors put a smaller amount of their portfolio into private equity firms.
Firms that have raised between $1 billion and $5 billion with so-so performance will have the most trouble raising new funds.
Most of the largest funds that already have a spot in a public pension such as CALPERs, which manages $219 billion of California employees' retirement funds, will keep some money from these funds. CALPERs and its larger pension peers spend a lot time and a lot of money vetting new investments, so earning that initial spot in a pension portfolio helps keep a private equity firm alive in all but situations of extremely poor performance.
As U.S. investors scale back their private equity investments, the industry is increasingly looking to sovereign wealth funds and wealthy families in Asia and Latin America for new money.
"Funds are spending a lot of time overseas telling their story and thinking there's an appetite there," said Ernst & Young's Bunder. "That money doesn't come in overnight though."For many private equity funds, that extended fundraising cycle could strike a fatal blow.
Large public pension plans are pouring more money into private-equity funds, deepening ties between government workers and an industry currently under the harsh glare of U.S. presidential politics.
Big public-employee pensions had about $220 billion invested in private equity in September, or 11% of their assets, according to Wilshire Trust Universe Comparison Service, which tracks the holdings of pensions, foundations and endowments.
That is up about $50 billion from a year earlier, when such investments accounted for 8.6% of large pension funds' assets. A decade ago, pensions with at least $1 billion under management had just 3% of their money with private equity.
Private-equity funds buy companies, restructure them and try to profit by reselling them at a higher price. That approach, particularly with respect to the fate of workers at companies they buy, has become an issue in the Republican campaign because Mitt Romney formerly led private-equity firm Bain Capital.
In Monday's debate in Florida, which holds its primary on Jan. 31, Mr. Romney defended his business track record, which he said involved creating thousands of jobs.
Some of Mr. Romney's critics are labor unions, including those who count public employees as members and have representatives on pension boards that determine how much to invest in private equity. The retirement benefits of thousands of police officers, firefighters and teachers depend in part on the profits of investments in private-equity firms such as Bain.
Earlier this month, the Service Employees International Union, a major public-sector labor group, blasted Bain for what it described as "a long and troubling track record of putting profits above workers." The union said, for example, that Bain had acquired a plant in Indiana where workers were fired and then rehired at a lower wage.
SEIU members have pension money invested in numerous state and county pension plans around the U.S., many of which are invested in private-equity funds. And SEIU members serve on the pension boards that make decisions about where funds are invested.
An SEIU member, for example, serves as a trustee of the Ohio Public Employees Retirement System, which holds billions of dollars in private-equity investments and, in recent years, increased its target private-equity holdings to 7% of assets, from 5%.
Investment officials at the Ohio fund and other public pension plans say their primary duty is to secure the highest returns possible for public workers.
"Our board members are fiduciaries who act in the best interest of the fund, regardless of whatever political leanings they have personally'' or their unions have, said Julie Graham-Price, a spokeswoman for the Ohio pension fund.
An SEIU spokesman declined to comment.
The American Federation of State, County and Municipal Employees, or Afscme, which represents 1.6 million active and retired public employees, is taking a swipe at Mr. Romney for one of Bain's many investments.
"What kind of businessman is Mitt Romney?'' asked a new Afscme-funded television advertisement. The ad said Mr. Romney collected a "fortune" from a company, formerly held by Bain, that was accused of Medicare fraud.
A spokesman for Bain declined to comment.
Afscme's members have billions of dollars of pension money invested in about 150 public pension plans around the nation, many of which are invested in private-equity funds. Afscme's members also serve on pension-fund boards in about a dozen states and cities.
An Afscme member, for example, is one of the trustees overseeing the New York City Employees' Retirement System, which recently increased its targeted allocation for private equity to 7%, from 5%.
The Afscme member on the New York City pension board, Lillian Roberts, said in a statement: "I have a fiduciary duty to protect the investments Afscme members and others have made to the pension fund.''
Ms. Roberts added that she has pushed pension officials to address high fees and other drawbacks of private-equity investments.
A national spokesman for Afscme said it was "ridiculous" to question whether there was a conflict for the union to criticize Mr. Romney's private-equity track record while union members' pensions were invested in private equity generally. "The purpose of the ad was to shine light on Mitt Romney's dubious record in the private sector. …Afscme members have savings in banks that engaged in questionable behavior, too," the spokesman said. "They still know that this kind of behavior needs to be reined in."
Asked about the SEIU and Afscme criticisms, a spokeswoman for the Romney campaign said in a statement: "The last thing President Obama and his cronies want is Mitt Romney as an opponent because they know he is the only candidate that can beat President Obama and put an end to the big labor's power."
Pension-fund officials say they increasingly are turning to private equity in an effort to hit annual return targets of 8%. Over both the past five years and the past 10 years, private-equity returns were more than double those of the S&P 500 stock index and the Dow Jones Industrial Average, according to Cambridge Associates LLC, which tracks over 4,500 private-equity firms.
As of September 2011, median private-equity returns for large public pension funds over the past five years was 6.6%, according to Wilshire Associates. Median stock-market returns for those funds were a negative 0.9% over that same five-year period.
During the private-equity buyout boom of the 1980s, many pension funds steered clear of the sector, fearing the unknown.
Today, pension-fund managers "would say you may be breaching your fiduciary duty if you avoid this asset class," said Bill Kelly, a lawyer at Nixon Peabody who has worked with pensions and private-equity firms for 30 years.
Wilshire said private-equity investments surged last year as a percentage of pension-fund holdings partly because pension funds' existing investments in private equity increased in value while other holdings, such as stocks, were mostly flat.
Pension funds are experimenting with new ways to team up with private-equity firms, such as publishing joint research and investing directly in companies alongside private-equity partners.
In November, the $100 billion Teacher Retirement System of Texas made one of the largest single private-equity investment ever—a $6 billion commitment to new partnerships with Apollo Global Management and KKR & Co. The pension fund and the two New York firms will swap strategies and share resources.
The Texas fund has private-equity portfolio with investments in about 1,500 companies. It doesn't disclose the names of those companies publicly.
"I am confident that our private-equity investments have created more jobs than they have lost,'' said Steve LeBlanc, head of private markets at the Texas fund. "The way you make money is through growth."
Some pension funds enter into side agreements with private-equity firms barring certain investments, such as in tobacco or firearms companies. Since 2004, the largest U.S. public pension plan, California Public Employees Retirement System, or Calpers, restricts private-equity investments in companies that are likely to outsource government jobs to the private sector, such as prison guards and garbage collectors.
In 2010, the Ohio Public Employees Retirement System sent a letter to private equity firm Permira protesting plans by one of its portfolio companies, clothing retailer Hugo Boss, to close a local factory. Permira declined to comment. A spokesman for Hugo Boss said the plan ultimately remained open.
Calpers investment officials had no comment on the criticisms being leveled at private equity in the presidential campaign.
CalPERS' delivered paltry returns in 2011 but their private equity portfolio is up 12% for the first three quarters of 2011.
Increasingly, large public plans are looking to private equity to bolster their returns. Top funds have no problem raising assets. Bloomberg reports that Blackstone secured more than $6 billion of pledged capital for a new real estate fund that will buy mainly distressed-property assets:
The New York-based buyout firm plans to raise at least $10 billion for the fund, known as Blackstone Real Estate Partners VII, said the people, who asked not to be identified because the capital-raising is private. Blackstone expects the vehicle to be fully funded this year, they said.
The company has remained one of the most active investors in commercial real estate at a time when such Wall Street competitors as Goldman Sachs Group Inc. (GS)’s Whitehall funds and Morgan Stanley’s real estate funds retreated after incurring losses in the crash.
“Blackstone is in a bit of a unique position because so many mega-funds have been eliminated or are struggling with ongoing legacy issues,” said James Corl, a managing director at Siguler Guff & Co., a New York-based private-equity firm that raised $630 million for distressed-property investments.
But while the top firms thrive, others lag behind, and private equity is being scrutinized by politicians and investors alike. Some are complaining about private equity's public subsidy while others are calling private equity profits into question:
Private equity has proved better at enriching its own managers than producing investment profits for US pension funds over the past decade, according to a study prepared for the Financial Times by academics at Yale and Maastricht University.
The industry faces mounting political scrutiny as the presidential candidacy of Mitt Romney, a former private equity executive, has drawn attention to its business model and favourable tax treatment. Mr Romney will release his tax returns today after pressure from Republican challengers.From 2001 to 2010, US pension plans on average made 4.5 per cent a year, after fees, from their investments in private equity. In that period, the pension funds paid an average 4 per cent of invested capital each year in management fees. On top of those, private equity often collects a variety of other fees and a fifth of investment profits.
“Assuming a normal 20 per cent performance fee, this would amount to about 70 per cent of gross investment performance being paid in fees over the past 10 years,” said Professor Martijn Cremers of Yale.
Private equity describes its fees as “two and twenty”, a 2 per cent management fee and 20 per cent share of profits. However, the management fee is usually calculated as a proportion of total capital committed by the investor, which takes time to invest.
So in the early years, the management fee can be a much higher proportion of actual cash invested. For instance, if a $1bn fund invests $100m in its first year, the $20m management fee would be 2 per cent of committed capital, but 20 per cent of invested capital for that year.
From 1991 to 2000, US pension funds paid an average 2 per cent of invested capital each year in management fees, and received 21 per cent returns, after fees, annually from their private equity investments, according to data from the CEM Benchmarking database used for the study. The database covers about a third of US pension fund assets.
The rise in management fees since 2000 may reflect greater fundraising, meaning that more funds are in the early investment phase when fees are high. The increased use of third-party fund of funds to invest in private equity could also have added an extra layer of fees.
The Private Equity Growth Capital Council, a trade body, said that calculating fees on the basis of committed capital was the industry standard, and it was inappropriate to compare fees on the basis of invested capital.
Indeed, Steve Judge, Interim President and Chief Executive, The Private Equity Growth Capital Council, responded to the FT claiming that private equity data isn't rocket science:
Sir, Dan McCrum’s article “Private equity fees called into question” (January 24) describes statistics about private equity performance and fees that we at the Private Equity Growth Capital Council do not recognise. His main finding is that in recent years the pension plans have paid higher fees to private equity funds than in previous decades. In contrast to this assertion, most industry observers believe that management fees have declined in recent years. Preqin, a leading provider of data on alternative assets, finds that management fees for private equity funds are at or below 2 per cent and fees for funds over $1bn in assets have declined to an average of 1.71 per cent.
The reason the nominal amount of fees went up is simple: pension funds and other sophisticated investors have invested substantially more money in private equity over the past 10 years. Since management fees are typically based on the amount of money committed by the investor, it logically follows that the nominal amount of fees to private equity funds will go up as more capital is committed to these funds. This finding is simple mathematics, not news.
Pension plans have found private equity investments to be a superior performing asset class. Just this week Calpers, the pension plan for California’s public employees and the US’s largest public pension, reported that private equity investments returned more than 12.3 per cent during the year while the rest of the portfolio returned only 1.1 per cent.
Mr McCrum’s assertions rely on a study conducted specifically for the Financial Times. Your newspaper should release the study publicly so that the data, methodology and conclusions can be reviewed. Until then, the findings of any unpublished study are inconclusive.
Mr. Judge is talking up his industry. That's his job. The truth is that the bulk of private equity funds are mediocre and if you factor in illiquidity and leverage, they've underperformed the S&P 500 over the last 20 years.
And the fees are high, especially for pensions and endowments investing in private equity funds of funds (totally insane!!!). This is why large Canadian and U.S. public pension funds are increasingly co-investing alongside private equity funds so they can reduce fees.
Of course to do this properly, you need deep pockets and you need to hire talented professionals and pay them properly. For example, Financial News reports that the Ontario Teachers’ Pension Plan has appointed Jo Taylor, a former 3i executive, to be its head of its London office, a new role for the key private equity investor:
Other large Canadian public pension plans are doing the exact same thing. Will it all pan out? We shall see. None of the Canadian or U.S. funds publish the performance of their direct investments separately from that of their fund investments.
The role will involve finding and executing investments, which typically range from between around C$100m (US$98m) and $300m. The London office was set up in 2007 but had until now been run from Toronto by vice-president Andrew Claerhout.
Taylor had spent over 20 years with 3i Group holding a number of senior investment roles before departing in 2008. His last role was as head of venture at 3i, before he then launched an unsuccessful bid to acquire 3i’s venture portfolio in 2009, creating the now-defunct firm Ethean Capital for the bid.
In the end, pensions looking to private equity, real estate and infrastructure to 'save' them might be better off focusing a lot more on public markets. Keep in mind, private equity's landscape is changing and its fortunes are inextricably tied to what's going to happen in public equities.
Below, Jim Bianco thinks the stock market is living on borrowed time. Giving his outlook for the rest of 2012, the president of Bianco research says stocks "might have another 5 to 6% to go and that's on the topside." He has two main reasons for his relative gloom: The end of stimulus and rapidly shrinking earnings.
As much as I respect him, I happen to disagree with Jim. With the Fed committed to keeping rates low until 2014, and other central banks pumping up the jam, I see a massive rally in risks assets once we get over all the Euro gloom and doom. Germany should listen to Soros, he understands what's at risk.