Private Equity: Effective and Misleading Marketing
The election, which mercifully comes to a conclusion tomorrow, has put the practices and performance of private equity under a spotlight. The lobbying organization for the industry’s largest firms has decided it needs to protect its biggest source of sustenance, public funds. It has issued a “report,” which “demonstrates” the superiority of private equity versus public equities. In fact, it isn’t a report, just a six page power point. Once again, the industry has demonstrated that marketing is its true skill.
|The End of a Job (2000)|
The organization is called the Private Equity Capital Growth Council. About a year ago, it was still known as the Private Equity Council. I guess they changed the name because they wanted to emphasize the expansionary component of the business and bury the idea that they also layoff people and downsize companies. The industry, which initially called itself “leveraged buyouts,” has always tried to stay one step ahead of the more negative part of its image.
The slide included at the end of this post is the key take away of the industry’s pitch. It shows that $1.00 invested in private equity ten years ago is now worth $2.60, while the same investment in public equity would only be worth $1.40. The conclusion: private equity is good for public pension plans.
If a target company ever presented this chart and accompanying data to a private equity firm, the analysis would be eviscerated. It’s not that the math is wrong. It’s just that the assumptions are either wrong or inappropriate, and the conclusion is misleading. In order to begin to begin to tear apart the analysis, you need to read the footnote. It is conveniently produced in microscopic print using a light grey font. I took out my magnifying glass to read the footnote, and I studied the six-page “report.”
Your first reaction ought to be, so what? Of course, private equity earns a higher return than public equity. Investors ought to earn a premium for locking up their money for 10 years (known as a liquidity premium), and taking the risk of making leveraged investments. Risk should be rewarded.
Your second reaction should be, there’s something a bit strange about the data. Bonds outpaced stocks over the 10-year period used in the study. Does anyone really believe that bonds earn a higher return than stocks in the long run? If this were true, no one would ever invest in stocks. The end date of June 30, 2011 makes stocks look bad against almost every investment. To have any meaning, you’d want to run this “study” over various ten-year periods.
The shoddiness of PEGC’s methodology is breathtaking. While the tiny print tells you that the study is based on examining 151 public pension plans, the $2.60 estimate is actually based on the returns for only 26 pension plans and the $1.40 is derived from 55 plans. The returns used to derive the two figures are also a mix of gross and net returns. In other words, in some cases the “study” subtracted out any fees from the returns, but in others it hadn’t. To be a meaningful comparison, all fees and carry should be netted out. Next, we have the problem that the return calculation for private equity and public equity involves different methodologies, which make comparisons tricky. Even if all the underlying assumptions were true, the nice smooth methodology that PEGC used to grow a dollar of private equity isn’t how private equity investments increase in value. The road is much rougher, and it’s impossible to keep your cash invested in the way the calculation implies.
Does private equity beat stocks net of fees? Yes, over the long run. However, pension plans are taking a lot more risk, and the excess performance doesn’t fully compensate for the risk, because the fees are too high.
Having contributed heavily to a wide range of political campaigns, this chart will come in handy when private equity firms visit politicians and pension trustees. In one simple picture, they’ll be able to demonstrate that private equity is the solution to their pension problems. There’s no need to cut plan assumptions or reform benefit calculations and every reason to increase allocations to private equity. In the short run, the chart and accompanying report will probably help private equity raise one or two more generations of funds and earn a bunch more in fees. When it turns out that private equity didn’t solve the problems of public pension plans, it will be lights out for the plans. Don’t worry about the partners of private equity firms; their lights will stay on.