The Economist - USA (2022-02-26)

8 Special report Private markets TheEconomistFebruary26th 2022

equityfunds,”says JoTaylor,theotpp’s

chiefexecutive.AndreaAuerbachofCam­

bridge Associates, an investment firm,

reckons co­investment alone now ac­

countsfora quarterofbiginvestors’com­

mitments,upfrom10% 15 yearsago.

Aswellasgivinginvestorsmorecon­

trol,directandco­investmentcanboost

returns.Overthepast 25 yearstheotpp’s

directinvestmentshavedeliveredatop­

quartilereturnofaround20%,abovethat

ofitsinvestmentsthroughfunds.Between

2009 and2016,around80%ofallco­in­

vestmentsoutperformedfundslaunched

inthoseyears,saysMichaelCembalestof

JPMorganChase.

Higherreturnsarenomystery.Direct

andco­investorsavoidfeespaidbyfund

investors:typicallya 1.5­2%management

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

Institutionsthatdoa lotoffreelanceinvestingcanbring“blend­

ed”managementfeesdownto1­1.5%.TheUniversitiesSuperan­

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

hassaveditsmembers“hundredsofmillions”byinvestingdirect­

ly,saysGeoffreyGeiger,itsheadofpefunds.Theextrastaffcost

palesbesidethefeessaved,saysMattPortnerofMcKinsey.

Agooddeal?

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

still be useful. Some funds would find it hard to make large invest­

ments without co­investors, 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

medical­supply giant, without co­investors, 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 2018­19 were 1.76% and 20.3%, respective­

ly, “not that different 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 private­mar­

kets  advisory  firm,  memorably  described  pefees  as  “like  snow­

flakes: 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 co­investment 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 financial crisis, some hedge funds closed, others

turned into family offices, and many of the rest cut fees.

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

the buy­out and venture­capital 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.

The biggest factor limiting pressure

fromlps forlowerfeesistheirfaiththat

unlistedinvestmentswillcontinuetoout­

performpublicmarkets.pefirmstoutdiz­

zyingreturnsoverthepast 20 years.Aca­

demics who crunch the data are split,

thoughnotdownthemiddle.Asmall,vo­

calminority,ledbyLudovicPhalippouof

Oxford’sSaidBusinessSchool,arguesthat

pe’s outperformanceisanillusioncreated

byanindustrythathasmasteredwaysto

massagethenumbers.Overthepastdec­

ade,MrPhalippoucalculates,returnshave

merely matched those of stockmarkets.

Forgps toinsistotherwiseamountsto“a

mis­sellingscandal”.

Mostotherboffinsdisagree.They ac­

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

voured  by  the  industry  is  flawed:  it  can  be  gamed  by  playing

around with cashflows 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,

market­adjusted version of irr.

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

uncKenan­Flagler Business School calculated direct alpha since

the mid­1990s for funds in the 1986­2016 vintages. It found that pe,

including buy­outs and vc, outperformed shares over all time pe­

riods (three, five, ten, 15 and 25 years) by 2­6 percentage points. It

beat  them  regardless  of  the  benchmark  used;  the  authors  tested

among  others  the  msci’s  global­equities  index,  the  Russell  3000

index of usstocks and a small­cap value index.

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

As private markets get more crowded, competition for stand­out

investments intensifies. And as the industry gets bigger, it learns

the truth of Warren Buffett’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

20­30% 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

diversification benefits of holding private assets. 

Even  if  institutional  investors  conclude  that  pepays,  average

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

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

bottom­quartile  pefunds  is  wider  than  in  public  markets:  for

some vintages 15 points or more. One­fifth of peinvestments re­

turn less than was put in, reckons one private­markets 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  final  returns  are

clear. Even in the highest reachesofprivate

markets, investing is as much aboutkeep­

ing the faith as studying the form.n

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