Behind Private Equity's Veneer

Amy Whyte of Institutional Investors reports on why co-investment funds are outperforming in private equity:

Co-investing is becoming more popular — and with good reason, according to new research from private markets firm Capital Dynamics.

Citing a recent academic study and its own analysis of Preqin data, the multi-manager firm found that co-investment funds have outperformed single-sponsor private equity funds on a net basis over the last two decades.

For funds launched between 1998 and 2016, 60 percent of co-investment funds delivered a higher net internal rate of return compared to single-sponsor funds. During the later vintages of 2009 to 2016, a still greater proportion of co-investment funds outperformed — and the results were similar when Capital Dynamics evaluated performance using multiples instead of IRR.

This outperformance does not appear to stem from better deal-making. According to a recent academic study from researchers at the Technische Universität München and University of Oxford, co-investment deals are as likely to be good or bad as any other private equity deal.

As Capital Dynamics senior managing director Andrew Beaton explains, co-investment opportunities typically occur when general partners identify deals that they can’t afford on their own. These deals are not necessarily better investment opportunities than other deals those general partners have made — but the co-investment deals are not likely to be worse either.

“They don’t want to take a transaction to a limited partner that they would feel uncomfortable about,” he said in a phone interview. “Limited partners pay the bills. It would not make any sense to deliberately damage that relationship.”

Given that co-investments “perform pretty much the same,” the primary source of outperformance for a co-investment fund, according to Beaton, is fees.

“The standard fee structure for a multi-manager co-invest fund is about 1 and 10,” said Beaton, who oversees co-investment funds at Capital Dynamics. “The famous 2-and-20 model for private equity means the fee structure for co-investment is about half. All other things being equal, net returns would most likely be higher.”

These lower fees have proven to be a strong draw for limited partners seeking to invest in co-investment funds or make their own co-investments. For example, a 2019 survey by Cerulli Associates found that 75 percent of hospitals and health-care systems were targeting more co-investments within alternatives.

“There is certainly more demand for co-investments,” Beaton said. “LPs are seeking to get a fee break, and recognize that co-investments are an attractive opportunity.”

Still, while co-investment deals might work well in private equity strategies such as buyouts, Beaton warned that they could be less effective in situations where the general partner and co-investor are on less even footing. For example, in venture capital.

“If you think about the way in which venture capital works, the sponsor will put up a small amount in the B round, and the need for co-investment won’t arise until the C or D round,” he says. “Effectively what you’re doing is investing at a different price than the lead sponsor.”

Co-investments are more effective when the general partner and limited partner go “toe-to-toe,” Beaton explained. “We want to invest on the same terms, at the same price, and at the same time as the sponsor.”

Interesting article and here's my take, if you cannot develop a strong fund investment and co-investment platform internally, then it makes sense to invest in private equity co-investment funds to pay lower fees (1 and 10 instead of 2 and 20).

In Canada, our large pensions operate at arm’s-length from the government, they hire and pay top talent in public and private markets to invest assets internally and in private equity, they invest in top funds and co-invest alongside them to reduce the fee drag.

But they don't need to invest in co-investment funds and pay them 1 and 10, they simply co-invest with their GPs on large transactions and pay zero fees on these co-investments. This is how they maintain or increase their allocation to private equity and outperform over the long run.

Some US pensions like CalSTRS and CalPERS, are trying to emulate the Canadian fund investment/ co-investment model but unless they get the governance and compensation right, it won't be easy.

What the article above does confirm, however, is that co-investing is a critical part of outperforming in private equity over the long run and the primary reason is because it lowers fees.

I recently discussed how private equity is falling short of expectations and stated the performance on brand name funds is deteriorating and high fees compound this deteriorating performance.

One of my blog readers, Dominic Blais, Senior Risk Manager at the Canadian Medical Protective Association (CMPA), wrote me this after reading that comment:

I am curious why you think there is no way large cap US will match PE returns going forward? Assuming you are referring to net returns. I think PE offers a premium but it is, on average, eaten by fees, at least going forward. Fees are high at about 5% as investors mostly pay on committed capital through the investment period. To me, this is similar to traditional active management or HFs and it follows a natural progression to more efficiency and less excess return as capital floods a market. These used to offer net excess return on average many years ago but since then, offer at best no net excess return on average. This leaves many of us with relying on picking outperforming managers, aside for plans that do it directly and/or have large allocations to co-investments.

I replied:

Thanks for reaching out. I should have qualified my comments to state top quartile managers but as I explained, even they are finding it tough to outperform in this environment.

My thinking is that PE still has intrinsic properties investors love, focus on long-term, better alignment of interests than hedge funds, better returns over long run as there are inefficiencies to exploit in private markets.

Yes, fees are high but focus on fees is all wrong in PE as it’s all about active management. The good managers will outperform but you’re right, it’s tough finding them. Still, there is evidence of performance persistence in PE although I’m not sure it still holds.

Public equities are very expensive here. I guess you can argue the same for private markets. I just don’t buy AQR’s forecasts for PE. Everyone I talk to sees at least a 300 basis point excess net return over long run, down from 500 basis points but still respectable. PE remains the most important asset class for institutional investors looking to meet their target rate.

By the way, even Vanguard is getting into PE and we will see if this compresses fees in the industry. I doubt top funds will lower them.

Fund investing isn’t what it used to be, there I agree with you.

Dominic came back at me:

On a related note, I’m not sure investors measure their PE performance appropriately. And I am not 100% sure yet what that would be given the complexities but we should at least use net “modified IRR” more than net IRR. Measured properly, 300 – 500 bps of outperformance might shrink pretty quickly. I’m just not convinced most PE investors can state with confidence that they are outperforming a fully invested public market exposure.

https://www.evidenceinvestor.com/lies-damned-lies-private-equity-performance/

https://www.oaktreecapital.com/docs/default-source/memos/2006-07-12-you-cant-eat-irr.pdf

He's not the only skeptic. In a recent article, Jonathan Ford of the Financial Times looked into the "puzzling romance" between pensions and private equity, noting the following:

Academics have long questioned whether the internal rate of return (IRR) calculations favoured by buyout firms overstate their performance against quoted stocks.

Consequently, most recent studies favour the so-called “Public Market Equivalent” measure, which takes all the cash flows between the investors and a buyout fund, net of fees, and discounts them at the rate of return on the relevant benchmark (for example the stock market). On this basis, the outperformance vanishes.

A large study conducted in 2015 by three academics looked at nearly 800 US buyout funds between 1984 and 2014. They found that before 2006, these funds delivered an excess return of about 3 per cent per annum, net of fees, relative to the S&P 500 index. In subsequent years though, returns have been about the same as on the stock markets. A study of European markets produced similar results.

So why are pension fund investors continuing to pump huge allocations at private equity? Last year $301bn was poured into US buyout funds, a quarter more than the previous record set in 2017.

One intriguing explanation is that offered by the well-known hedge fund manager, Cliff Asness, in a recent article. He argues that pricing opacity and illiquidity are not actually bugs in the private equity model, but features that investors willingly pay for.

The reasoning runs as follows. Most pension funds know that they need to boost returns if they are to redeem the costly promises they have made to investors. The only way they can do this is to take more risk — a.k.a more leverage.

In theory they could do this without private equity. A pension scheme could assemble a leveraged portfolio of quoted stocks. True, it would sacrifice both control and the superior management skills private equity allegedly brings. But there’s a silver lining to this modest sized cloud: the fund would save private equity fees, presently running at 6 per cent a year.

One reason pension funds don’t do this, Mr Asness suggests, is not that it is beyond them. Rather it is the unwelcome freedom that transparently-priced liquid equity brings. A bad downturn, or a spell of fierce volatility, might persuade them, or their trustees, to crack and sell out at a disadvantageous moment.

“Liquid, accurately priced investments let you know how volatile they are and smack your face with it,” he says.

Opaquely-priced and illiquid private equity, by contrast, obliterates the temptation. Just as Odysseus stuffed beeswax in his crew’s ears and had them lash him to a mast to resist the call of the sirens, pension funds use the manacles of a private equity contract to resist liquidity’s lure.

Of course, there are ways they could avoid paying up for the privilege, such as trimming that average 6 per cent fee charged by private equity.

But that presumes it is a conscious decision, not something they have slipped into almost out of habit.

Odysseus may have understood what he was doing when he had himself trussed up. But how many of the pension funds accepting private equity’s “illiquidity discount” are doing so knowingly?

Illiquidity is not costless. That is why it is supposed to be compensated. Those costs have been suppressed in recent years, when bear markets have tended to be short and sharp. But consider the impact of a prolonged 1970s style downturn. Then investors might rue the shackles they paid to don.

Illiquidity isn't costless and one way to significantly reduce private equity fee drag is to adopt the Canadian fund investment/ co-investment model but that presumes pensions get the governance and compensation right.

There's another reason why pension fund clients love private equity, it's not as volatile as public market assets which are marked-to-market so their liability matching won't be impacted and thus their contribution rate stays more stable.

Sebastien Canderle, a well-known critic of private equity who once wrote a guest comment on PE's misalignment of interests and an expert who has written several books on the subject, had this to share with me on Ford's article:

I am afraid I have never quite believed in the existence of such a spread (between PE and public markets), other than the one generated by leverage, which mathematically increases returns on equity.

The problem I have with the article by Jonathan Ford is that it attempts to show that, on average, PE firms charge 6% p.a. Given that the majority of funds never reach the hurdle rate (and therefore never charge a performance fee), there is no such thing as average annual performance fee. The annual management commission exists. The average performance fee (carried interest) doesn't.

It takes more than ten years for a PE fund to completely return the capital they invested. In the meantime, they have raised at least two other vintages, which themselves take ten years+ to return their money.

Unlike in the hedge fund community, there is no redemption possible every year or even every quarter.

And on performance persistence, Sebastien was even more critical:

Actually I don't think there is persistence in PE (not even in the larger funds) but there is in VC.

In PE, you might have a top performing vintage fund, but it doesn't mean that the next vintage will be top quartile.

Sebastien posted his thoughts on performance persistence in private equity in a CFA comment which you can all read here.

Another reader sent me this cynical comment:

Some well-known firms have consistently been out of the top quartile, and yet they continue to raise ever bigger funds. It has nothing to do with performance. They bribe government officials, entice LP investments to invest by inviting them to parties and golf weekends. Wall Street is a different world. Don't assume that these guys have any superior skill set. They are good at raising money, not necessarily at investing them. It is simply too easy to hoodwink investors by reporting fabricated IRRs.

All it takes for a fund manager to attract new investors is to report fabricated interim (unrealised) IRRs on its previous funds and prospective investors will lap it up.

Here are several examples of PE groups that have bribed government officials in pay-to-play scandals:

https://abcnews.go.com/Blotter/WallStreet/story?id=7586756&page=1

https://www.sec.gov/news/pressrelease/2017-15.html

https://dealbook.nytimes.com/2014/01/13/stung-by-scandal-giant-pension-fund-tries-to-make-it-right/

https://www.jackolg.com/blog/another-private-equity-sec-pay-to-play-enforcement

https://www.wsj.com/articles/SB125553138534384951

As you can see, this is old news and extremely common.

Now, as you can read, not everyone is enthralled with private equity but I remain very confident that if the approach is right -- Canadian model of fund investments and co-investments where they pay no fees -- then private equity absolutely makes sense over the long run and it will help pensions meet their long-term return target.

Of course, there is a lot of hot air in private equity too, I realize this and think it's best to temper your enthusiasm on the asseet class as competition heats up and fund returns deteriorate.

Importantly, if you're not co-investing in private equity, you're paying a lot of fees for subpar long-term performance. Period.

Below, Steve Pagliuca, co-chair of private equity powerhouse Bain Capital, recently defended the industry, arguing that it has received an undeserved bad reputation.

Also, Vanguard Group is moving into private equity, the latest index-fund provider to try its hand at alternative investments. Bloomberg's Annie Massa speaks with Scarlet Fu and Romaine Bostick on "Bloomberg Markets: The Close."

Third, Mark Machin, chief executive officer of the Canada Pension Plan Investment Board, discusses portfolio diversification and the outlook for private equity and venture capital markets. He also comments on ESG investing in an interview with Sonali Basak on "Bloomberg Markets" at the World Economic Forum's annual meeting in Davos, Switzerland. Listen to Mark Machin, he knows what he's talking about.

Lastly, from last year's SuperReturn conference, Andrew Sheiner, Founder & Managing Partner at Altas Partners, explores the current state of the private equity industry, the mix of economic factors that could trigger a downturn, and the precautions managers need to take as we get closer to the end of the cycle to keep their ships afloat. Great insights, take the time to listen to him.

Update:New research from Harvard University and Stanford University shows that pension funds have given up billions of dollars in private equity gains because of their fee structures. According to this study, the “large variation in net-of-fee performance” suggests that pension funds could have earned $45 billion more in gains.

“Some pensions systematically pay more fees than others when investing in the same fund,” Stanford professor Juliane Begenau and Harvard professor Emil Siriwardane said in a recent research paper. The “large variation in net-of-fee performance” suggests that pension funds could have earned $45 billion more in gains.

More research that detractors of PE will use to criticize the asset class.

What else? With fewer attractively priced buyout targets, private equity firms are raising new funds to buy assets from their old funds. Private equity's incestuous new strategy is raising quite a few eyebrows:

To retain ownership of portfolio companies past fund expiration dates, general partners have gotten creative. Restructurings known as GP-led secondary transactions mean that a private equity firm “rolls one or more portfolio companies out of the original buyout fund and into a special purpose vehicle,” according to PitchBook. The same eggs, but a new basket.

Then there’s the “nascent and novel strategy” of private equity firms gathering new money to buy aging investments.

“These stakes can be majority stakes or minority interests retained after selling companies to other GPs,” the analyst note stated. “For example, if a flagship fund has two promising companies to sell, rather than selling to another GP or pursuing a GP-led restructuring, the GP could instead sell it to a fund it managers specifically raised for this purpose.”

We shall see where this all goes but it begs the question, if you're keeping your winners longer by raising new funds to buy old assets, why not raise a super long-term fund to better align your interests with those of your investors?