Thursday, October 31, 2013

Overstating the Case for Private Equity

Overstating the Case for Private Equity

For the past few days, I have been taking apart a report from the Private Equity Growth Capital Council.[1]  The council is the lobbying arm of big private equity firms. The report, entitled “Public Pension Fund Analysis,” is designed to send two messages.  First, that private equity returns have beaten the stock market over the last five and ten years.  Second, that some public pension plans have done exceptionally well investing in private equity.  While the basic conclusion that private equity beats publicly trade stocks is true, it darn well better be true if pension plans are going to take the risks associated with PE.  As I’ll discuss in a moment, the conclusion is overstated.  The second part of the report, touting the returns of certain states, is classic private equity marketing.  Just as a private equity firm will tout its winning investments, the PEGCC has done the same thing with the best returns among public pension plans.  The report’s conclusions are conveniently summarized in the one page chart show below.


Why should PE beat public equity hands down?  Investors are taking at least three risks with private equity that are greater than public equities.  First, PE uses much more leverage than public companies.  Second, private equity owned companies are smaller than the median public company held in a pension portfolio.  Third, the PE investment is far less liquid than a public one.  Investors should be compensated for each of these risks.
 
Fund Flows (1999)
Why are the PEGCC’s conclusions misleading and overstated?  In fairness to the PEGCC, the data for generating these results is messy.  The Council appears to have gathered its data from the annual reports generated by public pensions.  Unfortunately, pension plans are slow to produce these reports and inconsistent in how they present the data.  While the PEGCC alludes to these factors in their footnotes, the Council’s conclusion would lead to you believe that its approach was scientific and measured.  Go back and look at the bottom of the chart.  Good luck reading the footnotes; they are in tiny grey font on white paper. Here are few examples of the problems with the data. 

·      A few plans report their returns on a gross rather than net of fees basis.  Obviously, gross fees are going to be substantially higher.  I believe the Massachusetts Plan, which is ranked number one in the Council’s report, uses gross of fees data.
 
·      The private equity returns reported by public pensions overstate the results because they tend not to include the cash that has to be held in reserve to fund capital calls or the cash that is deposited when a PE firm realizes an investment.  While it is easy for pension plans to remain fully invested in publicly traded stocks, private equity creates a cash drag.  This cash drag isn’t factored into the results reported by public pensions or the Council’s report.

·      The annual reports issued by pension plans use compounded returns.  Admittedly, this is all the data that is publicly available on a consistent basis. However, compound returns can be extremely distorted if there have been a lot of cash flows in and out of an asset class.  In private equity and real estate this is very often the case. See “Another Quick Lesson in Private Equity: All Returns Aren’t Created Equal (November 16, 2012) for an explanation of IRRs use to calculate PE and RE returns versus compound returns.

·      When it comes to the state rankings, the Council report mixes end dates with some of data coming from June 30, 2012 and other data coming from December 30, 2012.  Admittedly, the PEGCC had to work with the available data, but their conclusions should be far more nuanced.

I understand that the PEGCC is an advocacy group.   They try to come off as researchers, but their aim is to promote the industry.  Much of the time, they issue reports to defend the tax preference for carried interest.  In this case, they are making a marketing push to protect private equity’s broad advances into the public pension market.

I laud the PEGCC for their marketing prowess.  Numerous news outlets have picked up the conclusions of their study without any further analysis.  However, they are grossly overselling the benefits of private equity to public pension plans.



[1] http://www.pegcc.org/wordpress/wp-content/uploads/2013-Pension-Fund-Analysis.pdf

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