Don’t Throw the (Private Equity) Baby Out with the Bathwater

Criticism over private equity opacity and high fees make strong, catchy headlines. With reason.

I am a long-time supporter of increased (business-friendly, i.e. terms that do not compromise the proper execution of deals that require absolute confidentiality) transparency in the industry and not by chance the name of my 2009 firm is Xtal Strategies… Clear? Xmas may give a clue. But back to the baby.

Highlighting incorrect or unbalanced practices and vigorously requesting adequate corrections should not implicitly suggest that the industry is not worth consideration.

Two points are, I believe, of general validity.

  1. Any asset should be given consideration in relation to the expected return adjusted for risk it provides.
  2. Then, conditions of access can / should be negotiated with the manager.

With respect to the first one, as an industry, private equity has been a source of steady duration adjusted returns, solidly above the relevant public indices.

These are the USD duration adjusted, since inception annualised (5 to 10-year) rolling unlevered returns for the universe of US Buyout funds that we analysed from 1995 to 2015.

At duration (i.e.in the 7 to 10-year period since fund closing), the risk premium has hovered around 3%.

By the way this is approximately 100% of the listed equity’s rolling performance over the same period – that has gone through roller-coaster cycles.

Yes, I know, these numbers do not look as shiny as the IRR figures that are usually reported for private equity. Right, but this is real money, i.e. the cash moms-and-pops can use to pay the, say, 3% mortgage rate. For more about this, interested readers can skim through the thedarcroom.org blog.

To give a sense of how good these numbers are and how powerful the compounding mechanism that works behind time weighted returns is: for an S&P that had an average, rolling 9-year cumulated performance of  31,37%, an indexed equal weight allocation to the US buyout funds of the considered universe would have yielded 77,51% over the same horizon.

With respect to the second point, there is a provocative consideration that I want to put forward that is against a consolidated industry credo.

  • If investors can’t negotiate fees down with the “best” fund, they should commit to the three similar “good” ones that offer a reduction. There is a decent probability that the net performance of the chosen three will be close to that of the fund that declined the reduction – in particular on a rolling basis. In one of my previous post I write about the Malkiel’s monkey paradox applied to PE.

This should rebalance pricing and conditions’ negotiations in the market. Clearly, if benchmarking is made more objective, simple and accessible, this helps. And this is what we’ve been working on for the last few years.

Today, in a low real returns environment the private markets are a critical resource of risk premium. And conditions are intact.

The fact that there is a lot of dry powder is a good sign of investment discipline, perhaps an expensive one – but it can be negotiated.

Investors should not want to throw the baby out with the bathwater. They should put investment performance in the correct relative value perspective and negotiate conditions.

Otherwise the risk is that, given current market volatility, the decision to cut hedge funds positions because expensive and underperforming a long bull market with a deflationary, low interest rate, low volatility environment may be regretted.

I would welcome comments and invite interested readers to reach out, also to have access to our QY Analytics community.

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