Private Equity's Moment of Truth?

David Wighton of Financial News reports after the Covid crisis, private equity faces a moment of truth:
If private equity firms cannot clearly show outperformance of the stock market soon, surely even their stoutest defenders among investors will start questioning the hefty fees they pay.

Private equity firms insist they have learned their lesson. After the global financial crisis they were too slow to take advantage of all the cheap assets up for grabs. They are determined not to make the same mistake again. Some observers say they cannot afford to.

It may seem crazy to suggest that the private equity industry is under pressure. After all, firms have been deluged with money in recent years as investors have desperately searched for returns in a world of rock-bottom interest rates.

Yet the industry has signally failed to produce those returns, at least relative to booming stock markets. At some stage that will have to change, or investors will start to look elsewhere. Now may be the industry’s best chance.

For several decades the top private equity firms produced remarkable returns that comfortably justified their remarkable fees. Yet following a series of reports by academics and investors that have examined their performance there is now little argument that, at least since the financial crisis, US funds have failed to beat US public equities. In absolute terms the returns have been healthy. But matching public equities is hardly what investors pay fees of up to 6% for.

A recent report by Harvard economist Josh Lerner and consultants Bain & Co found that US private equity returns have lagged the S&P 500 index over the decade to June 2019, the first time that has happened over any ten-year period.

Now work by Ludovic Phalippou, a professor at Oxford University’s Saïd Business School, suggests that the lacklustre performance dates back further.

For 15 years, Phalippou has been dissecting what he sees as the highly misleading way that the industry presents its returns. One trick is to adopt the most flattering index for comparing relative performance. The standard benchmark for US funds used to be the S&P 500 index but it has increasingly been replaced by the MSCI World Index, which has performed much less well in recent years.

Phalippou points out that most companies in which private equity firms invest fall below the size range of the S&P 500, the MSCI World Index or the FTSE 100. So it would be fairer to compare funds with indices that exclude the largest companies. On that basis he found that US private equity fund returns were similar to US public equities not only in the most recent period, but also between 1996 and 2005 (when big companies underperformed).

The picture in Europe is less clear. The Bain study found that European funds continued to outperform over the last decade. That was relative to the FTSE 100 index, however, which has done less well than smaller company benchmarks. An earlier study by another Oxford professor, Tim Jenkinson, found that just like US firms European funds had lost their edge since 2006, though this was based on a small sample.

Even if the average returns have been disappointing the leading private equity firms have been able to produce figures showing that they have turned in consistently strong returns for decades. Yet Phalippou claims this is based on the use of internal rates of return, an “absurd” measure that is easily gamed and flatters the industry leaders which all had spectacular returns in the early years. His analysis suggests that their recent returns have been close to the average and to the returns from US public equities.

Whatever the truth of this the industry as a whole clearly needs to raise its game. And the crisis presents just the sort of opportunity firms say they have been waiting for. Even though the industry did not make the most of the bargains on offer after the global financial crisis, funds from the 2009 vintage produced bumper returns.

But firms also face daunting challenges. Much of the immediate focus has naturally been on shoring up existing portfolio companies, many of which have seen business evaporate. Some firms have taken advantage of government-backed loan schemes, but others are wary of the strings attached and there is continued wrangling about whether some companies with very weak balance sheets should be disqualified by EU rules.

Some in the industry are rightly nervous about a possible backlash against high corporate debt, which is seen as making businesses less resilient in the crisis and more dependent on taxpayer bailouts. This could result in restrictions on leverage and further limits to the tax deductibility of interest which could hit future returns.

Although there will be plenty of distressed assets, finance will be less generous and some executives fear competition will drive prices too high given the uncertainties about the pace of recovery and changing consumer behaviour.

All of which means the crisis will be a huge test of the real value private equity firms add. If they can’t begin outperforming public equities again soon even their doziest investors will start questioning the model — and those remarkable fees.
I spent a good part of my day looking at the ongoing liquidity orgy in public markets and arguing with someone on LinkedIn about private equity's long-term performance.

You can read our exchange here but to be honest, it's my mistake engaging with people who think they're experts in private equity and pensions.

And let me be clear, my beef isn't against professor Phalippou or other academics who are asking tough questions on PE, but I would like to clarify a few issues.

Let me sum up my thoughts for you below:
  • Private equity is all about active management and I hate comparisons with public indexes. There are many terrible PE funds out there and a handful of great ones. Even the big brand name funds have terrible vintage years they'd like to forget about but my point is this: median returns don't cut it in private equity. If you look at the broad universe, no doubt you're better off investing in the S&P 500 over the long run.
  • On top of this, there's too much money and competition in private equity and now the industry successfully lobbied Congress to gain access to 401(k)s, which might turn out well or it might be an unmitigated disaster.
  • Fund returns have been steadily declining over the years as a wall of money chases scarcer deals and valuations are being bid up to nosebleed levels. Couple that with the fact that long-term rates are at zero and risk going to negative, you see there's tremendous pressure of PE funds to deliver the double-digit returns of the past.
  • Still, top funds are posting solid returns and some of them are ramping up new funds to take advantage of distressed opportunities as they arise. IMCO just took a $250 million stake in Apollo's new $1.75 billion fund. KKR has raised close to $4 billion from investors to snap up corporate debt at significant discounts, as the coronavirus outbreak weighs on big swathes of the corporate world. It doesn't want to repeat mistakes it made in 2008. There are plenty of other examples.
  • Vintage year 2020 should turn out to be a great one for top PE funds as they are able to raise money fast and put it to work, taking advantage of opportunities in distressed debt. It also helps that the Fed has committed to shoring up credit markets, effectively aiding and abating these funds.
  • Canada's large pensions have solid partnerships with top PE funds which allows them to gain access to large co-investment opportunities. To do this properly, Canada's large pensions have the right governance which allows them to attract talent, pay them properly, and analyze co-investments quickly and maintain their allocation to private equity.
  • For example, CPPIB has almost 25% of its $400 billion in total assets in private equity. If they did this solely through funds, they'd never achieve this scale, they need to invest with top funds and gain access to co-investments to maintain scale and reduce fee drag
  • As Mark Machin notes in the Fiscal 2020 Annual Report:" Our dollar value-added (DVA) compared with our Reference Portfolios for the fiscal year was $23.5 billion as a result of the continued resilience of many of our investment programs. DVA is a volatile measure, and so again we look at our results over a longer horizon. Since inception of our active management strategy, we have now delivered $52.6 billion in compounded DVA. "  That should put at ease all of you who think private equity can't add value over the long run if the partners and approach are right.
  • US pension funds are hampered because they can't attract and retain the requisite talent to do co-investments (a form of direct investing where you pay no fees) so they mostly do fund investments and are significantly under-allocated to private equity.
  • Lastly, it is true that pandemic and lockdowns have brought about private equity's Minsky moment and that may over-leveraged PE portfolio companies are n big trouble, but the critics of private equity are too critical and generalize way too much.
As I said, there's a liquidity orgy going on in public markets. The Fed's massive and swift QE is creating another bubble in public stocks:

It's amazing to watch the nonsense parabolic moves in some stocks that are posting extraordinary gains for no real reason other than manic speculative frenzy.

PE funds are looking at this and thinking two things:
  1. Let me get out (exit their investments) now that the going is good
  2. Let me replenish my cash pile to take advantage of opportunities when the market collapses
I know, a lot of you think this is it, stocks will keep grinding higher now that the Fed is backstopping risk assets, but you're in for a shock when the bottom falls out of this liquidity-induced insanity.

Of course, some bears are throwing in the towel now that markets are melting up:

I would remain more cautious than ever for a few reasons:
  1. Speculative trading is reaching extreme levels and stock market melt-ups never end well
  2. If rates keep inching higher, it will put pressure on stocks
  3. Global pensions and large sovereign wealth funds will rebalance at the end of this month which is end of quarter.
Admittedly, the bulls are in control and the bears are nowhere to be found but when the market frenzy pops, the bears will be back and they will extract a pound of flesh.

For PE funds, they are playing credit markets which are backstopped by the Fed but also keeping an eye out for the real distressed opportunities as they arise.

What else? They're providing their portfolio companies the liquidity and operational value add they need to weather this storm. 

I think there's a lot of nonsense on "Private Equity's Moment of Truth" because global pensions and sovereign wealth funds aren't trading these markets, they're diversifying across public and private markets and maintaining their long investment horizon.

Over the long run, this is the right approach, especially if you can co-invest with your partners on larger deals, maintaining scale and reducing fee drag, which is exactly what Canada's large pensions are doing.

Below, back in mid March, Bloomberg's Lisa Abramowicz talked with Andres Saenz, EY Global Industry Market Leader for Private Equity. Listen carefully to his comments.

More recently, Blacktone's Stephen Schwarzman spoke with China's Yicai Global and Carlyle's David Rubenstein joined "Closing Bell" to discuss private equity in the age of coronavirus. Listen to their insights, they're the titans of this industry.

Fourth, Jonathan Korngold, head of growth equity investing at Blackstone Group, discusses the performance of the firm's recent investments, the growth in electronic payments due to the coronavirus pandemic, and tech investment competition. He speaks with Bloomberg's Sonali Basak on "Bloomberg Markets: The Close."

Fifth, Jake Heller, co-head of next generation technology growth at KKR, discusses the firm’s investment in the Slice app, an ordering and marketing technology platform for local pizzerias. He speaks on "Bloomberg Markets: European Close."

Lastly, earlier today, CNBC's Scott Wapner talked with Chris Gardner, author of “The Pursuit of Happyness,” about diversity and inclusion as well as empowering students across the United States. Fantastic interview, listen to his insights on leadership, diversity and inclusion.