It is unclear what repercussions a Trump presidency will have on private equity. Its proposed repeal or dilution of the Dodd-Frank Act should encourage lending from banks, although that could negatively affect non-bank lending activities. Trump has also proposed to tackle the generous tax treatment of carried interest, the traditional freebies for PE dealmakers. Regardless, if fund managers have a choice in the matter, the sector has a great future.
Since 2008, private equity, hedge funds and private debt have continued to gain market share in their respective arenas of M&A, capital markets, and corporate lending. And because the largest PE groups, such as Blackstone, KKR and TPG, are today active in real estate, hedge funds, venture capital and private credit, the shadow world of finance is inexorably merging into one.
Limited oversight and seemingly unbounded access to capital
If self-regulation is an appealing draw for any manager eager to stay clear of accountability, this shadow world has also been adept at exploiting new sources of funding.
Importantly, most of these sources originate from the savings of the entire population. When PE firms raise capital, the vast sums they gather come from fund providers overseeing endowments, retirement contributions and life savings of hard-working citizens. More than half of capital deployed in PE originates from pension funds, banks and insurers.
That would be bad enough if that was all. However, as the financial crisis demonstrated when things go horribly wrong and capitalism is on the brink of collapse, governments step in by bailing the economy out with, what else, but the taxpayers’ money. Because that is how all-time-low central bank rates and rescue plans of the financial industry, such as TARP, should be interpreted. Among other things, they helped keep overindebted buyouts afloat.
Earning fees for managing or mismanaging assets
Modern-day finance has become hostage to an elite circle granted quasi-exclusive access to the rest of the population’s nest egg, all without much supervision. What they do with that money is up to them.
But what is astonishing is that alternative fund managers have convinced investors that they should be paid a commission for the privilege.
In a market economy, you typically get paid if you let someone else use your assets. When you put your money into a savings account, you earn interest. If you rent out your apartment, you get compensated by the tenant. When you invest in a company, you commonly receive a dividend as a reward for getting your money tied up.
PE fund managers do not pay investors – the fund providers – to use their capital. Instead, they charge them an annual commission that can be as high as 2.5%.
If claims that investment returns at most LBO firms fail to exceed the hurdle rate necessary to deliver carried interest are true, then why do so many financiers want to join the sector? Because of the potential to earn generous commissions. An even greater lure than self-regulation is the promise of sizeable guaranteed income irrespective of performance.
PE managers are not risk-takers – except when investing other people’s money – but very much rentiers. Their co-investments are nominal (typically 3% to 5% of committed capital) compared to the huge emoluments they derive annually from management, transaction and directors’ fees. In summary, the fees earned by LBO managers are simply a “tax” (or rent) on the rest of the population’s savings.
What is strange is that investors have come to find this natural. But it only appears so because fund managers have done a great job at claiming that it is. When he set up his investment partnerships in the 1950s, Warren Buffett reportedly did not charge a management fee to his investors. He only earned an income by taking 25% of the upside if, and only if, he delivered capital gains. That seems like a fair revenue model. Which other industry pays huge remunerations irrespective of performance?
Maximising the fee-earning potential
Recently, as managers felt under pressure to significantly reduce their princely management fees – in part due to several over-charging scandals exposed by the S.E.C. – they came up with a new business model by setting up investment vehicles with a longer duration. Instead of sticking to the all-too-restrictive 10-year investment model, how about making it 15 or 20 years?
As Carlyle’s recent close of a $3.6 billion long-dated fund and CVC’s announcement earlier this year of a 15-year $5 billion vehicle suggest, some investors might fall for it, especially if they see it as a way to lower annual commissions. However, they should resist the temptation. All this longer-duration model will do is create a list of corporate zombies as portfolio companies will be refinanced time and again in order to pay out dividends to their PE owners throughout the holding period.
We know what happens to assets exploited repeatedly until they become barren. The lengthy list of struggling secondary buyouts shows that this model is not the way forward for postmodern capitalism; even if we can all understand why 15 or 20 years’ worth of fees would automatically grant fund managers a more predictable business model, not to mention the equivalent of half a professional career with guaranteed, lavish annual bonuses.
No proper performance yardstick
If self-regulation and prodigious management fees are enticing, another factor explains why PE has proved even more popular than hedge funds: the lack of appropriate performance benchmark. Hedge fund managers cannot pretend to be decade-long investors – most of them are day traders. Hence, their performance is publicly benchmarked monthly or quarterly. That is why it is common knowledge that most hedge funds underperform public markets, sometimes significantly so. The information is available for all to see.
PE returns are disclosed by vintage, meaning that the real internal rate of return (IRR) of a fund will not be known for at least 8 to 10 years. In the meantime, PE firms disclose interim IRRs. The latter can be manipulated and prone to change in line with economic cycles. Until the economy turns, however, PE managers can optimise fundraising plans in order to max out fee-earning potential.
Academic research on PE performance is conveniently contradictory. Some scholars have attempted to demonstrate that LBO returns exceed those of public markets, even after accounting for the inordinate use of debt, but the reality is not so clear-cut. Information made available by fund managers is often unaudited and includes “unrealised returns”. When a large proportion of a vintage is still held in portfolio, managers use their own comparables analysis to determine the IRR of the unrealised assets. This kind of manipulation and the lack of short-term performance visibility allows PE managers to earn fees over a long period without facing the risk of capital withdrawals from dissatisfied investors, as happens so frequently with hedge funds.
While the dire economic consequences of the financial crisis continue to affect investment returns, as long as self-regulation, high fee income visibility and inadequate performance benchmarking stay in place, private equity will remain popular with fund managers. Even Donald Trump is unlikely to change that.
Article by Sebastien Canderle
Sebastien Canderle is the author of The Debt Trap: How leverage impacts private-equity performance
