The long-standing myth of super-duper private equity returns is meeting the cold ugly reality of unfinessable lousy returns. That’s what happens when an industry dependent on long term falling interest rates and then protracted near zero policy rates regime meets up with central banks increasing interest rates and inclined to normalize them well above their former “almost free money” levels.
And a very bad and very consequential hangover has started. David Sirota gives a fine overview. I strongly urge you to read his piece in full. Here is the money section:
As public officials across America prepare to funnel even more of government workers’ savings to private equity moguls, an alarm just sounded for anyone bothering to listen. It is a warning that Wall Street executives want you to ignore as they skim fees off retirement nest-eggs – but the longer the warning goes unheeded, the bigger the financial time bomb may be for workers, retirees, and the governments that pay them.
Earlier this month, Pitchbook — the premiere news outlet for the private equity industry — declared that “private equity returns are a major threat to pension plans’ ability to pay retirees in 2023.”…
Signs of a doomsday scenario are already evident: Some of the world’s largest private equity firms have been reporting big declines in earnings, and federal regulators are reportedly intensifying their scrutiny of the industry’s writedowns of asset valuations. Meanwhile, one investment bank reported that in its 2021 transactions, private equity assets sold for just 86 percent of their stated value last year.
Let’s stop there. That is a stunning development given that private equity, on average, accounts for 11% of public pension fund investments. But it is even worse since public pension funds and the hired guns that are supposed to steer them to make prudent decisions have been all in for private equity when it has long been known that it’s not what it’s cracked to be.
Your humble blogger, relying on the work of independent academics and experts like Eileen Appelbaum, Rosemary Batt, Ludovic Phalippou, and Richard Ennis, has been reporting for nearly a decade that private equity wasn’t generating enough in returns to justify its extra risks. In more recent years, the data showed private equity wasn’t even outperforming the stock market. That is because, to the extent private equity did outperform on a gross basis, the fund managers hoovered that out via fees and expenses that add up to a staggering 7% or so per year.
Private equity barons were warning, starting in 2016, that returns in the future would be lower than in past. They were accordingly trying to find new chumps, as in retail investors. Yet the money kept pouring in from big investors desperate for high returns. The most frantic have also been the most clueless, namely public pension funds. They have long believed that private equity would rescue them from the underfunding resulting from not being willing to put enough aside to cover retirement obligations on a current basis.
So why has the private equity fandom persisted? First is it takes a long time, often over a decade, to know how much a fund delivered, but by then, bizarrely, no one is much interested. The focus is on the early returns. Second, private equity bribes public pension and other investor staff by holding lavish annual meetings at tony destinations with great food and wine and routinely, top drawer entertainment. Oh, except those expenses are paid by the fund, not the fund manager….meaning the public pensioners.
Third, private equity funds generate a lot of analytical busywork which is highly profitable for various consultants. How much could advisers charge for telling public pension funds like CalPERS to invest in five Vanguard funds (or CalPERS in-house analogues) and be done? Yet a five-fund approach outperforms 90% of all public pension funds.
So back to the looming train wreck. Sirota focuses on one element, discussed in Pitchbook, of losses from 2022, which are reported on a lagged basis, showing up in 20231, as well as a second that we have discussed for many years: valuation chicanery. Private equity funds get to do their own valuations, with the justification being it would be too costly to have independent parties do it. Ahem, so if it’s too expensive to give investors proper accounting for returns, why is it considered to be prudent for fiduciaries to invest in private equity?
In fact, it’s widely acknowledged that private equity firms engage in various forms of valuation chicanery, yet it’s somehow waved away by private equity investors and their enablers in academia because private equity supposedly can’t get away with all that much, since the companies in the portfolio do get sold.
But this is hogwash. No where else in investment land is admitted falsification of valuations seen as acceptable. For instance, a 2014 study found that private equity firms inflate their valuations right before launching new funds, typically 4 years after they had their last major fundraising. The rationalization is that this fudging is harmless because the fund managers back out the air in their “marks” later.
But this practice is harmful. Goosed up returns early in a fund’s life have a disproportionate impact on then reported returns. This impact is magnified by the widespread use of a misleading return metric, internal rate of return. So investors think they are doing better than they are, which leads them among other thing to allocate more to private equity than is warranted.
It also leads them to allocate money to not necessarily deserving funds. One former private equity manager said that one of his firm’s flagship funds reported a 77% return at year 4 because they sold one deal for a monster profit. That fund’s final return was 11%. Even more disconcerting, this executive said no investor noticed.
But a third reason for public pension fund woes, not mentioned in the Sirota article, is the actual cash flows. As has been discussed at CalPERS and presumably other public pension funds, private equity had been producing more “cash out” (sales and special dividends) than “cash in” (capital calls). That reversed at CalPERS, if I recall correctly, in 2020 or 2021. CalPERS is so large that it is effectively a private equity indexer, so it’s likely that the same pattern is developing at many other private equity stalwarts.
In general, the lack of liquidity is a huge wart for private equity that is seldom acknowledged. As we wrote in 2014:
Readers might wonder why private equity relies so heavily upon the deep pockets of state entities for its funding. The reason is basic: governments are among the very few investors that can accept the uncertainty about both when a fund may demand capital contributions or when they will give back the money.
Private equity funds are highly distinctive in their design. First, they are almost always “blind pools”, which means that at the time when you commit as an investor, you have no idea what the fund will end up owning.
Second, when a given round of fund raising has been completed (in industry parlance, at the “closing”), you generally do not hand over the full amount of money that was agreed upon. Instead, you make a contractual “commitment” to send in portions of that amount whenever the PE fund “calls” for it.
Third, the investment manager will give your money back (together with your share of the profits, if any) when it suits him – there is no specified schedule. While the PE investors typically start to receive meaningful “distributions” of capital starting around year four or five, and most of the money will typically be given back within eight or nine years after the investor commitment was made, it’s not at all uncommon for some distributions to be made a dozen years or more after the closing…
In addition, the PE funds need to be sure that investors will be good for the money when they call for it. That restricts which investors the funds will welcome. For the fund, the best possible investors are extremely credit-worthy, supremely liquid institutions – and so governments often fit the bill.
Public pension funds have long been the biggest single source of private equity funds, at about 30% of the total. That meant they were playing a mugs’ game, paraphrasing Lenin, of buying the rope that would be used to hang them. Private equity firms engage in large scale cost cutting and headcount reduction, to the degree that they often bankrupt companies. Those wage reductions lower state and local government tax receipts, putting pressure of budgets and making government pensions seem like a costly, unjustifiable luxury, particularly when public pensions are the last bastion of “defined benefit” pensions, as in ones that pay a fixed dollar amount to retirees every year.
So the actions of private equity firms are damaging the communities that fund public employees salaries and their pensions. The worsening of job security and employment terms is increasing resentment towards government workers, whose bet on what looked like lower upside but lower risk positions paid off. Private equity firms often engage in union busting and oppose pro-union laws. So if and when public pensions funds get in trouble, don’t expect a lot of sympathy from voters who will be asked to bail them out.
Yet Sirota also describes how the considerable majority of government investors in private equity remain enthusiastic, and are on the whole increasing their investments. However, in a possible harbinger of things to come, a few are breaking ranks. For instance:
And following a pension corruption scandal in Pennsylvania — whose state government oversees nearly $100 billion in pension money — there’s a potential financial earthquake: During his first week in office, Gov. Josh Shapiro (D) promised to reprise his move as a county executive and push to shift pensioners’ money out of the hands of Wall Street firms, which raked in more than $1.7 billion in fees in a single year from one of the state’s pension funds.
In perhaps the harshest language ever uttered on the topic by any governor, Shapiro told his state’s largest newspaper: “We need to get rid of these risky investments. We need to move away from relying on Wall Street money managers.”
Shapiro could face opposition not only from private equity moguls and their lobbyists — but also from the pension boards’ union-affiliated trustees. As the Philadelphia Inquirer reported: “Union members [on the boards] have mostly favored the old strategy of private investments, even when challenged by governors’ reps and the last couple of state treasurers.”
When investment returns were somewhat better, that unholy alliance between some unions and Wall Street firms flew under the radar, even as pension funds were ravaged by fees. Same thing for pension funds’ overall investment strategy that has been sending more and more retiree’ savings to private equity firms.
At CalPERS, we’ve chronicled how unions went into overdrive, first with JJ Jelincic, later with Margaret Brown, to prevent their re-elections to the CalPERS board. They spent what is a staggering amount of money for these private elections, over $400,000, to prevent one board member out of thirteen asking basic questions about private equity. The desperation to preserve a united front is telling. One prominent CalPERS retiree, based on the huge differential in fees paid by CalPERS compared to its nearly as large California sister CalSTRS, that some of the private equity money is a laundromat for political donations. While no one has produced a smoking gun, this idea would explain a lot of otherwise destructive behavior.
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1 This lagged reporting is one of many practices that no finance professional should tolerate, yet is pervasive in public pension land. To illustrate: public pension returns as of June 30, 2022 will show marked to market values of liquid assets….but March 31, 2022 private equity valuations. Rather than use an estimate and update in when the final results are ready, false precision is prized over substance. This bogus approach has produced another unwarranted bennie for private equity, namely the appearance that private equity helped provide diversification because its returns allegedly did not correlate strongly with public equity. But when you correct for the lag, the correlation is actually tight.
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I am thinking that third CalPERS is meant to be something else, perhaps CalSTRS. But I don’t follow this closely enough to substitute with any certainty.
Aargh, yes, CalSTRS. Fixing…..
Thank you for clearly reading to the end.
As a retired teacher, I can personally tell you that for 2022, my retirement $$ in CalPers, lost over $500.00. And just like CalPers, I lost another $250.00 from my Washington State Retirement System for 2022.
Having moved up to Washington State and during the Financial Crash, in 08-09, a large segment of my WA State Retirement, lost 40% via Black Rock/Vanguard. Under a special proviso, I was able to pull out that part of my retirement, I put that $$ in T-bills.
That was my “wake-up call.” Since then, I’ve followed the course of massive assets by Black Rock: about $ 22 Billion, or is that “trillion” and have been very wary of both these pension funds.
I was a junior actuary for 2 years in former life…. Back then I had feelings that “this doesn’t add up”. When friends ask me about my current pensions my response is along the lines of “don’t care…. It’ll be non-viable before we retire”.
Some don’t like that. Yeah I’m a glass half empty type but based on current economic trends I simply don’t see “pay their pensions and maintain society” as viable. True friends try to understand why there are problems. My main response of you’re in defined benefit scheme is caveated….. Still need major systemic upheaval to pay you.
It seems like most pensions are DB so I can’t imagine they would face the same difficulties.
Here is the link to the Sirota piece:https://www.levernews.com/a-wall-street-time-bomb/
Makes me think this is all an extension of runway foam – the decades-long process of disinflation. Because otherwise the erstwhile US government should have protected pensions. Private equity is like private bankruptcy resolution, buying up sick overextended corporations, shaking them down, forcing them to take on debt like the IMF and dumping them on investors. Eventually they fail and the investors absorb their own losses but in the long process the greater economy is prevented from a big 1929-style crash and the Fed is complicit doing everything it can to keep asset values high. And now playing hardball with a new policy of bringing wages down (per Powell in links @ Stephanie Kelton).
I do not speak finance with any degree of fluency so I must ask. Is there any reason for Private Equity to exist at all? Seems to me that the greatest beneficiaries in the medium and long run are the firms and their partners taking their skim and leaving all the costs to the client. Great business if you are on the right end of it, but does it serve any economic function that is not served more efficiently by other means?
I think the sector exists for the reasons that I believe Yves suggests. My own background is accountancy and being a public company brings many disclosure and governance requirements that a private company typically does not need to follow. It is argued that these things create a deadweight cost that PE avoids.
However, these requirements are potentially most pertinent if you choose to leverage a business up with debt. Doing so increases the risk to equity shareholders and tends to spook public stock markets. But at the same time this also creates the opportunity for outsized returns on the equity component if things go to plan. A bit like if I buy a house with a 99% mortgage and the market value goes up to 110% then I make an eleven fold return on my initial stake. But if the value falls then I am bankrupted. In some jurisdictions the tax shield on debt finance then also plays a role here to magnify this. The great book “Barbarians at the Gate” remains for me the best exposition of what this is really all about. I do not think the drivers have altered since the 80s when that was written. PE portfolio businesses tend to include a lot of debt which might work when interest rates are low.
These drivers are purely extractive, of course. From a societal perspective, I am not sure there is an obvious rationale. Claims are sometimes made that a higher level of debt incentivises greater efficiency. I’ll leave you to decide if you buy that!
https://prospect.org/economy/cut-off-private-equitys-money-spigot/
Cut Off Private Equity’s Money Spigot
A variety of legislative and regulatory actions would make it hard for private equity to stay in business. That should be the goal.
by David Dayen
July 28, 2022
“PRIVATE EQUITY FIRMS RAISE funds from several different sources. But after the industry temporarily collapsed amid Michael Milken’s prosecution in the late 1980s, institutional investors like public pension funds and university endowments drove the return to prominence. That support can be traced to one law signed by President Bill Clinton. It’s called the National Securities Markets Improvement Act of 1996 (NSMIA), and its impact has been almost totally forgotten to history.”
” But Section 209 of NSMIA allowed exceptions for funds with over 100 investors, as long as they were “qualified purchasers,” defined as either individuals with $5 million or more in investments or institutional investors with over $25 million in assets. This opened a new funding base, which happily rushed in, seduced by the prospect of outsized returns. A decade later, in 2006, there was $375 billion in private equity acquisitions, 18 times the amount of just three years earlier. “
@John, 2:12 pm
My experience is in Canada but I’m pretty sure it applies to the US. Due to the partial collapse of many private pension schemes caused by the 2008 financial collapse the Canadian labour movement, many of the provinces, and some others, asked for a major expansion of the Canada Pension Plan (CPP). The CPP is an excellent plan but is limited – at the time it capped out at an income of $50,000 and paid out a max of 25% (numbers are approximate as it’s from memory 15 years later). The labour movement wanted to double it and one prominent labour-supported research centre employed the former chief actuary of the CPP who worked out a way to increase it by 4 to 5 times. Under this latter plan workers earning up to $105,000 would max out at 70% of income after between 35 and 40 years of work (don’t remember exactly). The plan would have been entirely portable from one employer to the next. This plan would have eliminated virtually all private pension plans, including the self-managed ones, except those for the top 2% or so.
Big Finance went bonkers! In the end the CPP was increased by about 10%, a number Big Finance could live with.(Tells you who really runs Canada.)
I believe the US equivalent would be a large increase in Social Security but someone more familiar with it than me would need to confirm that. The result would be the disappearance overnight of most pension-related private equity funds.
For those who dive more deeply into these things, pensions are a matter of distribution and no funds at all are required, only a public commitment to distribute income to retired people. Social Security funding is a way to get political support for income distribution to retired people.
Hi Yves, another magnificent take down of PE. I wish you could do the same for VC but I know it’s not in your wheelhouse. Too bad, it’s a target rich environment. I think that the two have much in common, beyond the “2 and 20″ looting.
For starters, I think the big players do the equivalent of wash trading on multi-round fundings, so that these things get kicked up in value beyond what can be supported by any realistic business case. I think the SBC/FTX funding from Sequoia was a fascinating window into this process: it’s clear that SBF and FTX didn’t need the money they were raising, particularly in that last round that put a $32 billion valuation on FTX. I’ve been a pitcher to major VCs, and trust me, you don’t do it while playing video games. And SBF turned around and took the $400 million that round raised and re-invested it in another Sequoia investment fund. I mean, WTF? Most real founders try to avoid raising more money than they actually need. I submit that in both PE and in VC there are valuations that are untethered to reality.
BTW, I think you may have gotten the wording off in this line:
” That meant they were playing the mugs’ game described by Lenin, of buying the rope that would be used to hang them. ”
I’m pretty sure Lenin said the capitalist would *sell* the rope that would be used to hang him. Not to say that you can’t get dumb people to buy the rope that will be so used. Sex cults and multi-level marketing schemes come to mind ;-)
Cheers,
P
Thanks for the kind words.
Yes, I repurposed Lenin’s statement and should have clearly said that.
Agree with your wash sales point. There is so much wrong with PE practices that it would exhaust reader patience to put it all in one article.
Re VC, on the fundraising/pension fund side, I do know enough to write some decent piece. I’ve steered clear because the biggest pension funds like CalPERS and CalSTRS don’t invest in VC because they can’t put enough money to work in VC. I’ve also written about their dodgy valuation conventions. But there is more there to say about bad behaviors that are not the same as those of PE.
Yep, I think this is right. I have been expecting the bubble to burst for a long time but perhaps now it actually will. I have tended to see specific PE portfolio businesses at close hand rather than obtaining an overview of the funds themselves.
However, my own anecdotal data points include a neighbour, who happens to work for a small(ish) PE fund asking me recently for career advice and at least two portfolio companies that I have worked with having still not been sold or IPO’ed even though the expected investment horizon long since passed.
I have also noticed in the past five years that PEs flipping portfolio companies to other PEs or even merging portfolio companies that they own has been a “thing”. As have examples of multiple CEOs / executives being fired in relatively quick succession at a couple of portfolio businesses that I also know. I am also friends with one other set of executives who used to run a specific PE owned business and whose ambitions of personal wealth heavily bit the dust not so long ago too. Those amongst them who could then left to run yet another PE owned business! We’ll see how that goes for them. These trends that are also several years old suggest that something has been not right for a long time.
You are very right to point out the professional services element. In London my sense is that over the past several years pretty much office for every London based consulting firm (and in most other places, I just know the market in London best) has built a Private Equity Practice to carry out serial due diligence studies on prospective acquisitions and then to coordinate “value creation” when the businesses are acquired. A lot of careers depend on this work. My own has in the past too, to be fair. And might do again: only I suspect it will be to help “rescue” businesses that are struggling to make enough EBITDA to fund interest payments.
The interesting thing though is that every consulting firm with a PE practice seems to be super busy right now and has been for the past few years, with just a small dip when Covid first hit. The growth in the number of professionals in the sector has been considerable I believe. A bust will for sure get interesting.
Stephen, I agree with your observations on the UK PE market. All the advisers have been exceptionally busy since about the second half of 2020, and lots of hubris about how clever they are in winning revenue (not noticing the rising tide). This has been driven over the last decade by QE pushing interest rates down, which has had the twin effects of making leverage cheap, and causing investors to chase yields.
At present there is a bit of a slowdown in transactional activity, given economic uncertainty and rising interest rates. But the common refrain is there is lots of dry powder, and it needs to be spent. No one seems to be aware of a bifurcating world and the implications for currency devaluation, input prices and growth prospects.
Not sure how long the bubble can continue, but I wouldn’t bet against it; there could well be another bout of QE and interest rate reductions to come. And no accounting for the foolishness of pension funds.
Exactly. I am not betting that the can will not be kicked further down the road either. So many insider vested interests have an incentive to do that.
Not resolving structural problems is an increasing feature in our societies. It applies here and then also to topics such as the Ukraine War where the politicians will not address reality either.
I can’t recall where I read the following, but I found it an interesting take on this topic.
The suggestion was that public fund managers gravitating more and more towards PE has little to do with the prospective returns, since as noted by Yves in the post, the evidence suggests the returns are on par or even lagging traditional instruments that are traded publically.
The main appeal is that private assets are trickier to value and are thus easier to manipulate with accounting tricks. When a trade in public equities goes south, everyone knows the state of play in relatively short order. Consider, however, the degree of obfuscation that can be employed with private enterprises where the numbers are not publically available.
This suggests that the growth of PE investments in public funds is not merely owing to the hubris of the principals involved who think they’re going to land a sweetheart deal. It’s because the principals can fudge the numbers of their PE investments and avoid accountability for their professional failures.
Briefly stated, the appeal of PE to public fund managers is that it provides a form of professional ass-covering not available with alternative types of investments.
The article is a good overview of the issues but there is one omission which may give a false impression. Most PE funds are fixed term (10 years + 2 years extension is the fund’s investors agree). The timing of cash distributions within these years is not guaranteed but the fund needs to realise as many as possible of its investments as cash by year 10 or 12 and distributed the residue in specie because its investors can force its winding up.
Also, there is a “hurdle” on the money of 6-8% which the manager has to earn and pay to the investors before the profit share kicks in. The hurdle drives PE managers to try to win big early in at least some portfolio companies because if you can pay off the investors’ initial commitments quickly, you can really improve the profit share.
As an example, a £100m fund run on 2% annual fee and 20% profit share with 8% hurdle will have only £80m of investable capital after managers’ fees (and there will more fund costs on top!). Over 10 years, 8% is a doubling but this is calculated on committed capital. So £80m has to generate £200m before the profit share kicks in, I.e. 2.5x. So each deal has to generate 2.5x its initial cost simply for the manager to break-even (ignoring fees – fees on multi billion funds make managers rich without profits… This is why from a fund investor perspective, the best relative returns come from £100m finds, even if £bn funds have greater absolute returns). If half your deals die with zero recovery value, the other half have to generate 5x….
These swing-for-the-fences economics are propagated to the portfolio company managers, who will have a big chunk, say 20%, of the equity at nominal price and the business will be funded with debt. The debt guarantees a 1x return to the fund (assuming no default) plus interest, at least to match the hurdle. If the business can grow faster than the cash bring extracted, the equity will accrue value and everyone’s a winner.
Thanks for that informative post. I can imagine a company that has been taken private by a PE firm must be a rather hellish place to work (constant high pressure all around). Some top managers may get some profit share as compensation for the stress and risks they take but the lower level workers, my guess, get a lot of the downside without much upside– poor working conditions, low wages and benefits, “efficiencies” from cutting safety, training, etc.
The plight of the worker is that they’ve come to believe they’re lucky to just have a job.
I have seen several.
There is always pressure on the leadership and, shall we say, an interesting relationship with the representatives of the fund who typically sit on the board.
A Business Plan is typically created that is the prime control document. In line with the earlier comment it is based on EBITDA growth to pay the interest and generate the valuation multiple that enables exit within the fund’s own horizon. Usually on a five year cycle from what I have seen, which is consistent with needing early returns if a fund has a ten year life.
Clearly, achieving the business plan requires cost cutting. Which is hard for everyone involved.
If the plan is not looking likely to be achieved or there are surprises then management changes happen quickly!
Of course, public companies fixate on quarterly earnings and todays stock price. Which creates pressures of its own. One argument used to justify PE is that you can at least plan a five year horizon. Public companies are often challenged to do this meaningfully. I guess that neither model is perfect.
Senior executives also can stand to get very opulent in both models too. Or get removed quickly if things are not working out.
Good overview Revenant. But doesn’t leverage enter into the calculations? It’s not 80 million that is being deployed to achieve the 2.5x. It’s a multiple of that amount using leverage that is deployed to achieve the returns. This makes it much less daunting to surpass the hurdle rate.
Please show me where in private equity documents that investors can force a liquidation. We have the limited partnership agreements from most of the major players, Blackstone, KKR, TPG, and there is no such provision in any of them.
Moreover, as we wrote. CalPERS has many deals as recently as a year ago, which were 1990s vintage years, meaning over 20 years old and had still not been wound up. I think a few of the very oldest got tidied up in their recent secondary market sale.
If you look at CalPERS’ site, they still have stakes in 73 fund of 2006 vintage year or earlier: https://www.calpers.ca.gov/page/investments/about-investment-office/investment-organization/pep-fund-performance
I worked for a few years for a prominent and heavily-laureled economist whose business was built around justifying private equity as a force for good in the world.
The most important lesson I learned there was that private equity–with a vanishingly small number of exceptions–should have been outlawed a long time ago.
Krugman?
https://www.marketwatch.com/story/bill-clintons-legacy-is-our-financial-disaster
NEW YORK (MarketWatch) — On Wall and Main streets they call William Jefferson Clinton the “comeback kid,” but it’s not because of some election-day surprise.
It’s because most everything he did regarding financial services regulation has come back to haunt us…
The Legacy of the Clinton Bubble
Timothy A. Canova ▪ Summer 2008
“During the Clinton years, command-and-control regulation was largely replaced by a risk-based approach that was based on inherently flawed estimates of value and risk.”
“Banks were suddenly free to load up on riskier investments as long as they did so through affiliated entities such as their own hedge funds and special investment vehicles. Those riskier investments included exotic financial innovations, such as the complex derivatives that were increasingly difficult for even experts to understand or value.
In 1998, the sudden meltdown and bailout of the Long-Term Capital Management hedge fund showed the dangers of large derivative bets staked on borrowed money. “
Can you name some academics who are cheerleaders for pe?
All of this concern, yet somehow CalPERS manages to not have any Investment Committee meetings between December 2022 and May 2023. Six months of no public conversation and the only communication is the posting of a monthly fund summary and a quarterly report that is usually two months late. And despite those that speak up and ask for more transparency, they continue to bury as much as possible from public conversation.