Private equity challenged over $400bn fee haul

Private equity’s winning run faces late-cycle challenge

US private equity managers have extracted $400bn in fees and expenses from investors since 2006 but on average they failed to beat the returns from an S&P 500 tracker fund, according to a new analysis.

The findings are an analysis by Oxford Saïd Business School based on the Burgiss database.

Pension funds and other institutional investors hunting better returns after the 2007-08 financial crisis ramped up allocations to illiquid private equity strategies.

This created a gold rush for managers such as Blackstone, KKR, Apollo, Carlyle and CVC Capital.

Investors, however, have difficulty in assessing value for money because of complex and opaque agreements that allow private equity managers to charge multiple layers of hidden fees.

About $2tn in new cash was raised from investors by US private equity managers between 2006 and the end of 2015.

Ludovic Phalippou, a Saïd finance professor, said the funds launched in those 10 years have, on average, performed in line with the S&P 500, the main US equity benchmark. This delivered annualised returns, including dividends, of 8.6 per cent between January 2006 and the end of March 2018.

Nine out of 10 of these private equity funds also beat the 8 per cent annual return “hurdle” that allows their managers to claim performance fees, which amounted to an estimated $200bn.

A further $200bn was paid in management and other expenses, but there was less certainty over this data. The estimate could be conservative, said Mr Phalippou, an expert who has been hired by BlackRock as an adviser on private markets.

These cost estimates are significantly higher than other published data. “We do not know the exact total of fees and expenses paid by investors because a lot of effort is spent by private equity managers to ensure this information remains as secret as the recipe for Coca-Cola,” said Mr Phalippou.

He said investors had paid a lot for results that were “mild at best”.

The American Investment Council, a lobby group for the private equity industry, disputed the data.

8.6 per cent

Median annualised return over the past 10 years from private equity (net of fees), according to the AIC

“The industry consensus based on multiple analyses confirms that private equity outperforms public markets,” said Bronwyn Bailey, vice-president of research at the AIC.

The AIC’s analysis found the median annualised return over the past 10 years from private equity was 8.6 per cent (net of fees), based on data from 163 US public pensions schemes. This was higher than the median 6.1 per cent return earned from public equity by the same pension schemes.

Rows have erupted in Pennsylvania, Maryland and California over failures by pension officials to disclose multimillion-dollar payments made to private equity managers over decades.

Joseph Torsella, Pennsylvania’s Treasurer, has accused the Quaker state’s two largest public pension funds of wasting $5.5bn paid as fees to Wall Street investment managers whose funds performed poorly.

Maryland’s $49bn state pension scheme was forced to admit in May that it had paid $87m in previously undisclosed performance fees to its private equity managers for the year to December 2016.

The largest of these US schemes, Calpers (the California Public Employees’ Retirement System) revealed in 2015 that it had paid $3.4bn in previously undisclosed performance fees to private equity managers over 25 years.

Pressure for improvements in cost transparency have increased alongside worries about the outlook for private equity returns with managers sitting on a $1.7tn mountain of unallocated capital or “dry powder”, according to the data provider Preqin.

This has fuelled concerns that competition for deals will drive up prices and reduce future returns.

Andrew Brown, senior consultant at Willis Towers Watson, the world’s largest adviser to pension schemes, said investors needed to “take their foot off the accelerator” in making allocations to private equity.

“Deal prices paid by private equity managers and leverage multiples have gone up considerably,” said Mr Brown.

Private equity managers are paying between 11 times and 12 times earnings before interest, taxes, depreciation and amortisation to secure deals, a higher multiple than at the previous peak of the market in 2007, as well as using leverage multiples of around six times ebitda.

US regulators were unwilling to grant approval to deals with leverage multiples of more than six times, but those restrictions have been relaxed since the election of Donald Trump.

“Managers that have priced buyout deals to perfection could find themselves exposed if there is an economic downturn. It is still possible to find better value in some areas but investors need to tip-toe around carefully and be very selective,” said Mr Brown.

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