By Anthony Harrington
Private equity (PE) has long been considered to have a vital role in the economy across a wide range of corporate deal making, from mergers and acquisition, to "take-privates" and, of course, buy-outs and buy-ins. However, for investors to keep on coming up with the cash to enable new PE funds to be launched, the returns for this relatively high risk asset class have to be worthwhile. At the very least, they need to be better, on average, than can be had from lower risk asset classes. Going up the risk curve for no additional reward is not something that any reasonably intelligent or competent investor would do twice, and most would be annoyed to discover that they had been talked into doing so at all.
Yet, under-performing lower risk asset classes is exactly what PE, on the whole, has done over the last few years, according to a working paper from the Massachusetts-based National Bureau of Economic Research (NBER), entitled Valuing Private Equity. The authors, Morten Sorensen, Neng Wang and Jinqiang Yang, specifically set out to look at whether PE delivers a sufficient return to compensate investors for the disadvantages of investing in PE. Those disadvantages are the heightened risk and long-term illiquidity of PE, which typically ties up investors' funds for anything from three to seven years, plus the steep management and incentive fees charged by the PE house (the General Partner or GP, in PE terms). Investors, known as Limited Partners (LPs), expect a level of compensation that can only be generated by very significant out-performance, or alpha generation, by the GP. So, is PE delivering?
Prior to the 2008 crash, when debt was really cheap and banks were prepared to compete to provide senior debt to PE houses at very low rates, leveraging the debt was a very good formula for generating alpha. The smaller the amount that a PE house had to put into a deal, which is to say, the higher the percentage of senior debt in the deal, the higher the percentage return made by the fund. Those days are gone. The paper's stark conclusion, after examining a wide range of deals, is as follows:
"Conventional interpretations of PE performance measures appear optimistic. On average, LPs may just break even, net of management fees, carry, risk, and costs of illiquidity."
In other words, had the majority of investments in PE over the last five years or so gone into equities instead, investors would have done vastly better. This may still be a well-kept secret, but the NBER working paper is certainly not going to be the last study of this topic and eventually the message will get through to investors in general. This is not good news for the future of PE. It would be interesting for some theoretical studies to look at what the absence of PE would mean to advanced and emerging economies; of course, there is little likelihood that we will see PE folding up its tents and going away anytime soon.
That said, it will have to generate a lot more "good news" to gee up potential investors, or fundraising exercises could become seriously difficult in the near future.