The Economist (2022-02-26) Riva

8 Special report Private markets TheEconomistFebruary26th 2022

equityfunds,”saysJoTaylor,theotpp’s

chiefexecutive.AndreaAuerbachofCam-

bridge Associates,aninvestmentfirm,

reckons co-investment alone now ac-

countsforaquarterofbiginvestors’com-

mitments,upfrom10% 15 yearsago.

Aswellasgivinginvestorsmorecon-

trol,directandco-investmentcanboost

returns.Overthepast 25 yearstheotpp’s

directinvestmentshavedeliveredatop-

quartilereturnofaround20%,abovethat

ofitsinvestmentsthroughfunds.Between

2009 and2016,around80%ofallco-in-

vestmentsoutperformedfundslaunched

inthoseyears,saysMichaelCembalestof

JPMorganChase.

Higherreturnsarenomystery.Direct

andco-investorsavoidfeespaidbyfund

investors:typicallya1.5-2%management

feeand20%performancefee(themanager’s“carriedinterest”).

Institutionsthatdoalotoffreelanceinvestingcanbring“blend-

ed”managementfeesdownto1-1.5%.TheUniversitiesSuperan-

nuationScheme,an£82bn($110bn)pensionschemeinBritain,

hassaveditsmembers“hundredsofmillions”byinvestingdirect-

ly,saysGeoffreyGeiger,itsheadofpefunds.Theextrastaffcost

palesbesidethefeessaved,saysMattPortnerofMcKinsey.

Agooddeal?

gps are ambivalent about this. It means forgone fees, but it can

still be useful. Some funds would find it hard to make large invest-

ments without co-investors, because of risk limits on single hold-

ings as a share of the total. Blackstone and its partners would have

struggled to complete the $34bn purchase last June of Medline, a

medical-supply giant, without co-investors, including gic.

Most investors pay close to the infamous “2 and 20”. Gary Gen-

sler, chair of the sec, said last year that average pemanagement

and performance fees in 2018-19 were 1.76% and 20.3%, respective-

ly, “not that different from when I was on Wall Street” in the 1980s.

Other expenses can push overall fees, including carried interest,

up to 5% or more per year over the life of a fund. These include

charges for “monitoring” portfolio companies, for administrative

expenses, or even for use of private jets. StepStone, a private-mar-

kets advisory firm, memorably described pefees as “like snow-

flakes: abundant, unique and lacking in transparency”.

lps don’t kick up much fuss about fees partly because they fear

being excluded from gps’ future funds or co-investment opportu-

nities. Some keep quiet because they get rebates under side agree-

ments. Still, many complain that fees are too high and that the fee

structure is rigid even though funds’ performance varies. Others

grumble that fees are charged on all committed capital, not just

that actually deployed.

Some gps seek to assuage such concerns. A few have switched

to charging based on funds deployed. One large investor predicts

that pewill eventually follow hedge funds: when relative returns

sagged after the financial crisis, some hedge funds closed, others

turned into family offices, and many of the rest cut fees.

Yet 2 and 20 is likely to stay as pe’s reference point. “The way

the buy-out and venture-capital markets are rationed is that man-

agers of underperforming funds struggle to raise more money and

fade away rather than staying in business by slashing fees,” says

Steven Kaplan of Chicago University’s Booth business school. The

head of one American endowment’s peportfolio says that, if any-

thing, there is greater pressure on lps to pay more than 20% car-

ried interest for good results than to pay less than 20% for below-

average results. Some investors will pay 25% or more if the manag-

erdeliverssomethingspecial,suchasfour

timestheoriginalinvestment.

Thebiggestfactorlimitingpressure

fromlpsforlowerfeesistheirfaiththat

unlistedinvestmentswillcontinuetoout-

performpublicmarkets.pefirmstoutdiz-

zyingreturnsoverthepast 20 years.Aca-

demics whocrunchthedataaresplit,

thoughnotdownthemiddle.Asmall,vo-

calminority,ledbyLudovicPhalippouof

Oxford’sSaidBusinessSchool,arguesthat

pe’soutperformanceisanillusioncreated

byanindustrythathasmasteredwaysto

massagethenumbers.Overthepastdec-

ade,MrPhalippoucalculates,returnshave

merelymatchedthose ofstockmarkets.

Forgpstoinsistotherwiseamountsto“a

mis-sellingscandal”.

Mostotherboffinsdisagree.Theyac-

knowledge that the “internal rate of return” (irr) measure fa-

voured by the industry is flawed: it can be gamed by playing

around with cashflows or by taking out “subscription lines”, loans

that managers get from banks to delay calling capital from lps.

However, the academics have developed their own, more solid

metrics. The best of these is “direct alpha”, a less manipulable,

market-adjusted version of irr.

A paper in January from the Institute for Private Capital at the

uncKenan-Flagler Business School calculated direct alpha since

the mid-1990s for funds in the 1986-2016 vintages. It found that pe,

including buy-outs and vc, outperformed shares over all time pe-

riods (three, five, ten, 15 and 25 years) by 2-6 percentage points. It

beat them regardless of the benchmark used; the authors tested

among others the msci’s global-equities index, the Russell 3000

index of usstocks and a small-cap value index.

The less good news is that the performance gap has narrowed.

As private markets get more crowded, competition for stand-out

investments intensifies. And as the industry gets bigger, it learns

the truth of Warren Buffett’s dictum that “no one in the world can

earn 20% with big money.” The real question, says Gregory Brown,

the study’s lead author, is whether private assets are worth it once

returns are adjusted for risk. pe’s “beta” (risk relative to markets) is

20-30% higher than that of equities. Investors also demand a pre-

mium for illiquidity (the consensus is around three percentage

points a year, says the bis). Against this, investors must weigh the

diversification benefits of holding private assets.

Even if institutional investors conclude that pepays, average

returns are just an average. Pick a below-average fund and you can

be soaked in red ink. The gap in performance between top- and

bottom-quartile pefunds is wider than in public markets: for

some vintages 15 points or more. One-fifth of peinvestments re-

turn less than was put in, reckons one private-markets adviser.

Picking winners is made harder by a weakening of the link be-

tween past and future performance. The odds that a pe manager’s

next fund will be in the top quartile if its

previous one was have fallen over time, to

“not much better than 25%”, as the indus-

try has grown, says Mr Jenkinson. And in-

formation about past performance is often

incomplete: investors must decide wheth-

er to back a manager’s next fund three or

four years after the previous one started in-

vesting, long before its final returns are

clear. Even in the highest reachesofprivate

markets, investing is as much aboutkeep-

ing the faith as studying the form.

The gap narrows

Global buy-out funds, direct alpha by vintage, %

Source:InstituteforPrivateCapital,

UNCKenan-FlaglerBusinessSchool

15

10

5

0

-5

1995 2000 05 10 16

Fund vintage

↑ Outperforms stocks

↓ Underperforms stocks

pe, including

buy-outs and vc,

outperformed

stocks over all

time periods