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. 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.
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.