Tuesday, November 25, 2014

The More Things Change, The More They Stay the Same: Private Equity

The More Things Change, The More They Stay the Same: Private Equity

The Wall Street Journal has had a lot of coverage of private equity in the last few days.  Last week they reported that many firms are amending their SEC disclosures (known as ADV Part 2) to acknowledge their practices of charging monitoring or other fees and deploying and paying employees and consultants through fund expenses.[1]  Then last week in Paris at the Super Return Conference, a number of large European investors complained about the exorbitant fees charged by private equity.  Some of those investors indicated their interest in making direct private equity investments.  At the same conference, David Rubenstein of Carlyle predictably reminded them that they’d never be able to hire and retain the talent necessary to run their own private equity shops.[2]
Despite all the news, nothing is really changing. 

Let’s start with the disclosures at the SEC.  The industry appears to be responding to the SEC’s examinations.  However, all the industry offers is more disclosure.   There’s no evidence that they’re prepared to actually change any of their abusive practices.  Moreover, the new disclosures on ADV Part 2 don’t change the fact that many PE firms weren’t honest with their investors when they first raised their respective funds.  In other words, all too many firms did not spell out their fees and practices clearly in their partnership agreements.  Amending their ADVs only serves as an admission that the firms misled investors in the first place.   A sample of the new disclosures is shown below. In the end, I don’t expect anything to change.

Investor complaints about fees have been around for over a decade.  At the Super Return Conference, the Dutch pension plan PFZW revealed that it has 6% of its assets invested in private equity, which accounts for 51% of their fees (see chart below).  Other than complaining, I don’t see any real signs that institutional investors are either banding together against or standing up to private equity.  Instead they seem to be kowtowing to the PE industry in order to gain an allocation to the next big fund.  Only a handful of investors such as the Canadian Pension Plan have had the courage to set up their own shops and disintermediate PE firms.  Other than complaining, nothing is changing.

The lack of change leads me to Mr. Rubenstein and his warning that institutional investors would never be able to offer the kind of compensation necessary to directly manage a private equity program.   Mr. Rubenstein added, “If you live by the sword, you die by the sword,” If institutions invest directly in companies, Mr. Rubenstein said, “you can’t blame somebody else if something goes wrong.”   Mr. Rubenstein was inadvertently revealing a central truth about externally managed private equity.   Institutional investors are paying hundreds of millions of dollars in unnecessary fees because of politics.   There’s no substantive reason large institutions couldn’t build their own private equity teams.  However, politics makes it difficult to put together the necessary compensation packages.  Moreover, it’s the finger-pointing directed at large institutions that encourages trustees to hire private equity managers instead of making those decisions themselves.  In a sense, Mr. Rubenstein is right.  However, Mr. Rubenstein and other private equity executives are the ones who support and finance the political system that maintains the status quo and keeps hundreds of millions of dollars flowing into Carlyle, Apollo, KKR, Blackstone and the other big private equity shops.

[1] http://online.wsj.com/articles/buyout-firms-disclose-more-fees-1416510945
[2] http://online.wsj.com/articles/pension-funds-lambast-private-equity-firms-for-large-fees-1416562426

Friday, November 21, 2014

Culture and Dishonesty in Banking: A Research Study Provides a Bit of Confirmation

Culture and Dishonesty in Banking:  A Research Study Provides a Bit of Confirmation

The following headlines caught my attention yesterday, especially after I’d devoted a good part of my Sunday New & Observer Column to the problem of culture in banking:

Bankers Cheat In Experiment But Only After Being Reminded They Are Bankers[1]
Bankers are more likely to cheat, at least according to one worrying experiment[2]
Banking breeds cheating for financial gain - Swiss researchers[3]
Banking industry culture fosters cheating[4]

A letter published in Nature entitled, “Business culture and dishonesty in the banking industry”[5] drove the press coverage.  As you’ll see, some of the headlines cited above misrepresented the study while others captured the researchers’ conclusions.  In the study, various groups, including a group of bank employees, were invited to play a simple game.  The subjects had to record the results of flipping a coin ten times after being told whether a heads or tails would result in the subject winning $20 per toss.  The subjects were not monitored.

In other words, the participants could make $200 in the unlikely event the coin came up with the winning face (heads or tails) ten times in a row, or if they cheated.  Otherwise, across a sample of 128 bankers, you’d expect them to report an average of five winning occurrences.  The participants were also asked a bunch of questions before playing the game.  One group was reminded via the questions that they were bankers.  The other group was not.  The researchers found that those bankers reminded of their profession reported much higher occurrences of tails than bankers who were not reminded of their profession.

The control group reported 51.6% winning tosses and the bankers who had been reminded of their profession reported 58.2%.  About 10% of the prompted bankers reporting winning all ten tosses.  The odds of ten winning coin tosses is 0.0098%.  In short, a significant proportion of the prompted bankers had to be cheating.  When other professions were reminded of their professions, the amount of cheating did not increase significantly.

The study is receiving so much publicity that the American Bankers Association felt compelled to release the following comment: “While this study looks at one bank, America's 6,000 banks set a very high bar when it comes to the honesty and integrity of their employees. Banks take the fiduciary responsibility they have for their customers very seriously.”    Clearly, this research has hit a nerve.

The ABA has a point.  It’s probably a huge stretch to condemn the honesty of an entire industry based on one study.  However, the ABA fails to mention that the researchers applied their experiment to people working at other banks (not just the 128 in the main part of the study) and got similar results.  I also think it’s a bit cheeky of the ABA to invoke the loft standard of  “fiduciary responsibility” when so many financial institutions deny that they had such a responsibility when they deal with claims filed by their customers.

I don’t see this study as proof that the banking industry has an honesty or culture problem.  Rather, I see it as a small bit of confirmation.  Whether it’s mortgages, credit cards, consumer loans, commercial transactions, setting LIBOR, or trading currencies, just about every major financial institution has committed serious transgressions.  If you need further evidence, download “Wall Street Bank Involvement with Physical Commodities” issued by the Senate Permanent Subcommittee on Investigations.”[6]  Over the course of 386 pages the committee’s staff report provides detailed studies of the corrosive impact of banks as they’ve come to control the markets for commodities like aluminum and gasoline.

[1] http://www.forbes.com/sites/fayeflam/2014/11/19/bankers-cheat-in-experiment-but-only-after-being-reminded-they-are-bankers/
[2] http://www.independent.co.uk/news/science/bankers-are-more-likely-to-cheat-at-least-according-to-one-worrying-experiment-9871166.html
[3] http://rt.com/business/207175-banking-cheating-financial-gain/
[4] http://www.cbsnews.com/news/banking-industry-culture-fosters-cheating/
[5] http://www.nature.com/nature/journal/vaop/ncurrent/full/nature13977.html
[6] http://www.hsgac.senate.gov/subcommittees/investigations

Thursday, November 20, 2014

Blackstone Proposes a Product that Benefits Blackstone

Blackstone Proposes a Product that Benefits Blackstone

Blackstone Group is looking for five or six investors willing to invest about $2 billion apiece into “core” private equity.  It’s not clear what “core” actually means, and I am sure the legal documents will eventually give Blackstone a great deal of latitude over the definition.  I think the concept is being borrowed from private real estate funds, where “core” means investing in properties that are usually close to fully leased with little development risk.  In the case of private equity, Blackstone is trying to distinguish between conventional PE and the new concept.

Blackstone’s latest product idea is designed to attract and lock up more permanent capital, which might afford Blackstone a higher valuation in the public markets.  At present Blackstone must continuously market new funds, because a conventional 10-year fund is usually fully invested within about 3-4 years, and the bulk of investments are usually sold within 6-8 years.

According to press reports, the fund would invest in less risky companies than a conventional buy-out fund and use less leverage.  The idea might have the following kinds of terms (conventional terms in parentheses):

            Life of the fund: 20 years  (10 years)
            Management fee: 1.5%  (2%)
            Carried interest: 15% (20%)
            Capital Invested: 100%  (65%)
            Hurdle Rate: (< standard 8%)
            Target Return: 12%  (20%)

To be sure there are aspects of Blackstone’s pitch that might be attractive to large institutional investors.  A fund with a longer life and less turnover would enable an investor’s capital to compound more efficiently because their capital would remain invested.  In addition, since companies would be held for longer periods of time, investors would incur fewer transactions costs.  I’m sure there are plenty of investors who will be wooed by the promise of lower fees.

However, Blackstone’s pitch requires investors to tie up their money in an illiquid vehicle for the better part of two decades.  Should a pension plan or sovereign wealth fund make that kind of long-term bet with a PE firm that is likely to undergo massive changes over two decades?  Does 12% offer investors a big enough liquidity premium for such a long-lived private investment?  Will the monitoring and board fees imposed on the portfolio companies more than offset any discount in the management fees?  Will a lower hurdle rate more than compensate Blackstone for reduced carry?  Obviously, we’d need the details of Blackstone’s proposal to definitively answer these questions.  Based on back of the envelope calculations, I’m pretty sure, that Blackstone comes out ahead of its investors on this type of product offering.

 find two aspects of Blackstone’s pitch rather revealing.  First, it is quite an indictment of the conventional PE product.   Blackstone is basically saying to some of its largest investors that the conventional PE fund doesn’t do a very good job of putting capital to work.  Moreover, they are as much as admitting that the 20% return of a successful PE fund is overstated.  Return is calculated using the internal rate of return method (IRR), which is the best approximation we have when an investment has irregular cash flows.  Nonetheless, IRR is deeply flawed and very often overstates the returns achieved by a PE fund (see, “Another Quick Lesson in Private Equity: All Returns Aren’t Created Equal [November 16, 2012] for a detailed discussion of the flaws)”.  I also think it takes a bit of nerve to ask investors to accept a lower hurdle rate.  For those that don’t dabble in PE funds, the hurdle rate is the amount a fund must first earn before the manager begins to share in carried interest.  For example, if a fund has an 8% hurdle rate, investors get this “preferred return” before carried interest (profit sharing kicks in).

Second, if large institutional investors are looking for and willing to take the risk of a 12% return, there’s a much less expensive solution.  A pension can borrow at considerably lower cost than private equity, so it could replicate Blackstone’s proposal by issuing its own debt and then investing its capital in a low cost ETF or perhaps Warren Buffet’s company.  Over 20-years, the simple formula would at least match Blackstone’s core PE strategy without tying up the pension’s capital.

Blackstone has $284 billion in assets under management.  In order to keeps its shareholders and senior executives (who are also major shareholders) happy, they are going to need to find major new markets. Core private equity is just another marketing strategy.

Tuesday, November 18, 2014

Misstated Profits at the US Department of Energy

Misstated Profits at the US Department of Energy

The US Department of Energy issued a brief press release about a week ago concerning the strong performance of its loan portfolio.[1]  It’s the same portfolio that contained a large loan to Solyndra, the alternative energy company whose demise led to Congressional hearings.  Two years ago, the media amplified Republican and Tea Party conclusions that the loan program was a disaster because a couple of credits had failed.  Today, the media is making the same mistake, except that they are touting the opposite conclusion.  None other than Paul Krugman in his column, “When Government Succeeds,”[2]  accepted DoE’s claim of success at face value.

The DoE is flaunting several “facts” about its $34 billion portfolio.  Even if every one of the “facts” is true, they hardly prove that the program is a success any more than Solyndra’s demise proves that the program was a failure.  For starters, DoE says that it’s already earned a profit because the interest earned on loans ($810 million) exceeds the amount of loans written off ($780 million).  That’s a very odd way to calculate a profit, because it doesn’t take into consideration the borrowing costs incurred by taxpayers to make those loans (and issue guarantees) or any of the expenses for administering the program.  If we had all the figures, the loan program would be running a loss, which is okay for a portfolio that is in its early stages.  The typical loan has a term of 18-years.

Second, DoE says that its losses are only 2.28% of total loans and commitments.  While this is certainly a small loss ratio, it too is meaningless at this point.  DoE’s loan portfolio is not nearly seasoned enough to know what the loan loss ratio will be over the next decade and a half.  Moreover, since DoE is investing in emerging technologies, it’s hard to believe that they’ll achieve loan loss ratios consistent with more conventional credits.

Third, DoE estimates that it will earn $5 billion in interest over the life of the program.   This is the point that Mr. Krugman cites for the proposition that “the program that included Solyndra is, in fact, on track to return profits of $5 billion or more.  As I noted before, gross interest isn’t any kind of measure of profit.  In addition, the figure can only be a rough estimate, since much of the interest will only be paid in the distant future.  Finally and perhaps most importantly, $5 billion on a $34 billion loan portfolio doesn’t seem like much compensation for the risk entailed in investing in alternative energy technologies.

Just to be clear, I am not critical of DoE’s loan program.  In a world where Wall Street has turned all too much of private investment into short-term speculation, I believe the US government has to play a role.  We need to increase our funding into basic research, whether that research is conducted under the auspices of the National Institutes of Health or the Department of Energy.  However, it’s misleading to tell the public that the DoE’s loan program is profitable when there’s no solid evidence for that proposition.

[1] http://www.energy.gov/articles/energy-department-s-loan-portfolio-continues-strong-performance-while-deploying-innovation
[2] http://www.nytimes.com/2014/11/17/opinion/paul-krugman-when-government-succeeds.html?ref=opinion