Friday, December 11, 2015

Doing the Work of the Private Equity Industry: The Times Deal Professor

Doing the Work of the Private Equity Industry:  The Times Deal Professor

Yet again, there’s a financial item that requires me to put down my pens and brushes.  Steven Davidoff Solomon, “the Deal Professor” in The New York Times, published a column entitled, “Private Equity Fees Are Sky-High, Yes, but Look at Those Returns.”[1]  Mr. Solomon makes the case that private equity is a worthwhile investment despite the high fees.  He cites the entirely obvious and expected fact that the returns of private equity beat the returns for publicly traded stocks over lengthy periods of time.  Although he concedes that the fees are indeed large and partially obscured, he concludes that the fees are a secondary matter because the overall returns are all that really matter in the end.  While a small investment in private equity can certainly add to an investor’s overall return, the average investor would be best served by ignoring Mr. Solomon’s column.

Unlike public stock or bond funds, private equity funds are not normally distributed.  This means that the average fund doesn’t produce the average return for the asset class.  It turns out that top quartile PE managers pull up the overall average.  Thus investors face two big problems.  As Mr. Solomon points out, they have to gain access (be allowed to invest), and they have to hope that the fund will perform.  Mr. Solomon doesn’t discuss this latter point.  It’s easy to identify top performing funds with the benefit of hindsight.  It’s very difficult to identify top quartile funds before they’ve invested any money.

As evidence for the attractiveness of PE, Mr. Solomon cites Yale’s endowment and CalPERS.  This is like citing Warren Buffet as the reason for investing in common stocks or a big winner at a casino as a reason to gamble.   The average investor isn’t going to achieve Mr. Buffet’s success and is best off following Mr. Buffet’s advice to index his equity investments.  Yale and CalPERS have sound long-term PE records.  However, they began investing in a period when the industry was neither large nor institutionalized, and they enjoyed spectacular returns decades ago.  The average endowment and public fund has not had this degree of success.

Mr. Solomon also cites the long-term record of KKR and Apollo.  Again, he’s correct that both firms have strong long-term track records. However, he fails to point out that these records are based on some huge early successes and very variable results thereafter.  For example, if you invested in Apollo V in 2001, you enjoyed a 44% return, but if you selected Apollo VI in 2006, your return was only 10%.  KKR has a similarly variable record.  Most importantly, the average firm hasn’t come close to these results.  Nonetheless, Mr. Solomon characterizes, PE returns as having “steady return potential.”  Any investor who makes a commitment to PE based on steady returns doesn’t understand the risk and shouldn’t have any exposure whatsoever.

While Mr. Solomon acknowledges that the fees are high and that investors need to pay some attention to them.  However, he doesn’t give the question of fees nearly the attention that it deserves.  Unlike mutual funds, PE fees calculations are complicated and hidden.  Moreover, the GP has control and discretion over the calculation.  Although an accounting firm audits the fund, there’s still plenty of room for the manager to enhance his return at the expense of the investor.  Even with the recent addition of SEC oversight (which mainly concerns proper legal disclosure), there’s still a need for investors to closely monitor fees.

Mr. Solomon surmises that CalPERs has done a pretty good job of negotiating fees because their carried interest is only 12% rather than the customary 20% of profits.  Mr. Solomon forgets that many funds do not pay out carried interest because they fail to earn a sufficiently high return, while some funds charge less than 15%.  Thus, the fact that CalPERS has paid out 12% of profits doesn’t tell us much about their negotiating prowess.

As a whole, private equity can and should beat public stocks, much as emerging market or small cap stocks should return more than large cap stocks in the long run.  Thus, PE can play some role in a diversified investment portfolio.  However when PE or any asset class is seen as a panacea for what ails investors, it tends to be overused and then winds up being a disappointment.  Unfortunately, Mr. Solomon’s column does nothing to enlighten investors and does much to broadcast the talking points of the private equity industry.



  1. Andy,
    A very valuable commentary, but you actually haven't been as skeptical of private equity as you should.
    Remember that PE investments are generally heavily leveraged. While most private equity deals are complicated, in practice their returns can be replicated fairly closely by a levered investment in a public equity index such as the S&P 500, the Russell 2000, or the R2000 Value. Yet any idiot can make a levered investment in public equity without paying the sky-high fees of PE managers, and without suffering the illiquidity of PE. In other words, PE returns should not be compared to unlevered public equity returns, but to returns on levered public equity.
    Several academic teams have done a more careful comparison of PE with public equity, and come away unimpressed. Demaria [2015] found that "more than 20 years of U.S. PE do not deliver any significant out- or under-performance." Ang, Chen, Goetzmann & Phalippou [2014] found that "private equity has had an alpha of zero." Buchner & Stucke [2014] found that, "for buyout funds, annual alphas are slightly negative but statistically insignificantly different from zero." Phalippou [2014] found that "the average buyout fund underperforms by -3.1% per annum." Sorensen, Wang & Yang [2014] found that "LPs in these (buyout) funds may just break even, on average." Da Rin, Hellmann & Puri [2013] noted that "there is an emerging consensus that average returns of VC funds do not exceed market returns."
    Thanks for critiquing "the Deal Shill," but you didn't go far enough.

    1. Brad
      I agree with your argument and I've said the same thing many times in blogging about CalPERS's and North Carolina's public pension plans. In fact, it would be much cheaper for public pension to create the leverage since they can borrow money at tax-exempt rates and avoid PE fees.