Private Equity under Pressure

Greater transparency and lost perquisites may be unavoidable

Thanks to Mitt Romney and the Carlyle 3, the multi-trillion dollar private equity fund industry is now in the regulatory cross-hairs, and increased public scrutiny, coupled with the current drumbeat of adverse publicity, could easily result in PE fund managers having to provide greater transparency about their portfolio investments and, possibly, give up some of their prized perquisites.

Despite PE funds’ stated aims, we really do not know whether they actually create value for the companies they acquire because fund managers haven’t been required to publish the results of their leveraged buy-outs (LBOs) and no one else has the data to track the deals.

From a recent multi-university study, however, we now suspect the inefficiently-operated companies targeted by PE funds have fared no better in the marketplace than a control group of similarly indebted companies. Between 1997 and 2010, for example, LBOs reportedly defaulted on their bank debt at approximately the same rate as the companies in the control group.

PE fund returns don’t appear to be much better. A Yale University study found that, from 2001 to 2010, PE funds generated an average annual return of only 4.5% after fees, less than the 6.7% annualized return of the S&P 400 index of medium-sized companies during the same period.

An even more surprising finding is that PE fund managers have actually benefitted more from their PE investments than their investors. The Yale study found that PE fund managers actually captured a staggering 70% of total PE fund returns between 2001 and 2010. According to another Yale study, two-thirds of those earnings were attributable to their 2% annual management fees rather than their 20% carried interests.

The reason for these eye-opening results is the advantageous fee structure of the typical PE fund. Throughout a fund’s investment period (usually five years following its launch), its management fees are applied to the entire amount of capital committed by its investors and not to the amount actually invested by its managers (after the investment period, fees apply only to invested capital). PE fund managers adopted this fee structure in the early 1990s when pension funds and endowments revolted against a straight 2% fee applied to the total value of invested capital, fearing exorbitant fees on deals that performed brilliantly.

PE fund managers defend their current fee structure on the ground that they are sourcing LBO prospects for the full committed amount of their portfolios throughout the entire investment period. That may be so, but, as a result of this fee structure, Yale researchers found that fund investors have over the past decade been paying an average of 4% of invested capital in management fees. The largest PE investors — public and private pension funds, insurance companies, university endowments and now sovereign wealth funds – are coming to disbelieve the argument that huge and immensely successful PE shops can’t take advantage of economies of scale and are beginning to insist upon reduced management fees.

For PE fund managers, the final straw is the increasingly strident populist attack on the long-term capital gains treatment of their precious ‘carried interests.’ Stirring this now-questionable practice into the recently-aroused suspicions about the commercial efficacy of LBOs should alert PE fund managers to probable public calls for more information about their successes and failures, and the PE industry should likewise waste no time gathering the evidence necessary to vindicate its business model and fee structure.