More inconvenient truths on the private equity industry

I have blogged earlier on several occasions about the distortionary influence of private equity practices on financial markets and their physical investments. In terms of performance, Oxford Professor Ludovic Phalippou has shown that private equity funds have done no better than public market indices since at least 2006, but have enormously enriched their fund managers.

One such practice is that of subscription-line financing, which artificially boosts the fund manager's returns. 

New money pledged by investors is widely used by private equity managers as security for bank loans that are then used to pay for buyout deals in advance of receiving the clients’ capital. This technique, known as subscription-line financing, helps private equity managers earn lucrative performance fees because a key assessment metric, the internal rate of return (IRR), is based on the date when an investor’s cash is put to work. Delaying the date when client money enters the fund boosts the IRR but it also reduces the ultimate cash flow to investors because they pay the fees and interest on the bank loans... Subscription lines historically had a maturity of one year or less but they have now evolved beyond such short-term financing. Ultra-low interest rates have encouraged many private equity managers to extend subscription lines over several years and even to use this borrowed money to make repayments to investors in advance of realising profits on any of their deals. Since it is possible for distribution of profits to begin before clients have paid a penny, the IRR can, in theory, be infinite. However this financial engineering does not raise the actual amounts earned by investors...

ILPA (a body representing investors in buyout funds) said managers should report net IRRs both with and without the use of subscription lines and also provide a clear explanation of their calculation methodology. No universally accepted method exists for calculating IRRs, which has encouraged managers to extend their use of subscription lines in an effort to flatter performance comparisons with their competitors... Private equity managers routinely use “since-inception IRRs”, which measure their lifetime performance as part of their marketing to investors. Early PE funds performed well and this ensures since-inception IRRs remain at an artificially high level, provided private equity managers avoid major disasters.

An example of how since inception IRRs distort the picture is below, 

Apollo reports its since-inception IRR as 39 per cent gross (excluding fees). This would transform an investment of $100m made in 1990 when Apollo launched into $2.3tn. Apollo’s assets under management stood at $316bn at the end of March. “In 50 years, assuming no major disasters, Apollo’s gross since-inception IRR will still be 39 per cent. Since-inception IRRs are an absurd measure of performance,” says Mr Phalippou.

Recently the US regulators allowed 401(k) plans to invest in private equity. This opens up $6.2 trillion in assets to the PE industry. A recent study of pension plans by Richard Ennis found that diversification into alternative investments have not only not helped but has also been a drag on performance,

The diversification of public pension funds and educational endowments is explained by a few stock and bond indexes alone. Alternative investments ceased to be diversifiers in the 2000s and have become a significant drag on institutional fund performance... The cost of institutional investing is 1.0% to 1.7% of asset value annually. Public pension funds underperformed passive investment by approximately 1.0% a year for the 10 years ended June 30, 2018; the shortfall of educational endowments was 1.6% a year... Given the extent of institutional diversification, the diminished effect of alternatives, and the funds’ prevailing cost structure, institutional investors face the prospect of continuing significant underperformance in the years ahead.

The author advocates "much greater use of passive investment management as a way to bring cost into line with the characteristic diversification of institutional investors".

All this assumes significance in light of the rapid growth of the PE industry in recent times. PE firms have amassed $3 trillion in dry powder, make up nearly 40% of the M&A deals in the US, and the five biggest listed PE firms are collectively worth more than $250 bn.