Diligence Lessons from Private Equity - 3 of 3

The SEC have fined various PE managers for undisclosed fees. Will the focus of future enforcement actions be something far more serious.....fake performance?

Many subscribe to the view that private investments outperform public market investments, due, it is said, to both a liquidity premium and the benefit of an ownership structure which moves management from a focus on quarterly reporting to a longer time horizon, better suited to value creation. Both are plausible arguments, and extensive allocations to private markets makes the "Yale model" (and pretty much all "sophisticated" large pension funds in 2018) very different from the traditional world of 60/40 stocks and bonds.

However, the industry has - belatedly - honed in on a key issue: what actually is the performance of private equity?

In a July 2017 article, the Financial Times wrote about "Private Equity's Dirty Secret" - the subscription credit line. Per the article:

This little-discussed technique, known as subscription-line financing, helps private equity managers earn performance fees because one of their funds’ key assessment metrics, the internal rate of return, is based on the date an investor’s cash is put to work.

“This sleight of hand artificially raises the fund’s apparent performance but it does nothing to increase the actual returns earned by investors,” says Jennifer Choi, managing director of industry affairs at ILPA.

ILPA’s criticisms echo recent comments by Howard Marks, co-founder of Oaktree Capital, the $100bn US alternative investment manager.

“A fund that used a subscription line and came in with a high IRR [internal rate of return] may not have done as good a job, or made its investors as much money as one that didn’t use a line,” says Mr Marks. 

ILPA's credit line white paper is available here; the article by Mr. Marks of Oaktree is here.

Meanwhile, in response to the ILPA article, the Fund Finance Association - the industry group for the banks providing credit lines - said they disagreed (who would have thought it!) with the International Limited Partners Association - here. 

Moving the debate forward is an excellent research piece recently published by the consulting firm Cambridge Associates. As reported by Private Equity International, judicious use of subscription lines to defer capital calls and shorten the period of cash on cash returns can boost reported IRRs for PE vehicles by up to 300 basis points. Cambridge is quoted as saying: 

"The returns-boosting power of subscription lines of credit have the GPs "pursuing them in droves, like a Black Friday shopping mob".

Yikes.

Finally, we came across an excellent LinkedIn article - "Lying Most Effectively with IRR" which provides some simple examples to illustrate the math behind the IRR scam.

What does this mean for diligence?

1. A subscription line of credit has the same economic outcome as an investor taking out a loan to pay for their capital call and paying it back 180, 270, 360 days later (the only difference is actually that the manager essentially pays for 20% of the interest assuming we exceed the hurdle rate / preferred return). As such, the IRR generated is a levered IRR - and different funds using leverage in different amounts over different time periods makes advertised performance very likely misleading and certainly non-comparable between funds. This is the area where regulators could focus: any private equity manager which has used a subscription line and has not fully and completely disclosed the economic impact of that usage is potentially (and we say potentially, not definitely) exposed to SEC action in relation to misleading advertising.
2. Given that actual performance is a key input in asset allocation and funding studies, broader questions of fiduciary responsibility emerge for asset owner boards and their representatives - especially once factors such as ERISA and the Department of Labor become involved. Without reliable return assumptions, the accuracy of actuarial studies and statements of pension plan funding solvency come into question. Conflicts of interest within asset owners - especially if investment teams receive short term compensation based on IRR metrics - could become an issue for pension oversight bodies around the world.
3. How should we measure private equity performance? Accurate reporting, sufficient to meet fiduciary obligations, must meet two criteria - a consistent methodology, applied across funds at a point in time and over time; and independent validation. The CFA Institute's GIPS is likely the best framework.

So, if we were to have a private equity checklist, it would be:

• Report GIPS verified performance
• Appoint a fund administrator who generates the data which underlies GIPS reporting across composites
• Appoint compliance experts who can validate all performance numbers included in advertising materials
• Complete a SOC 1 (which should be completed by an "alternate" auditor, not the auditor of any of the PE manager's funds / tax advisor / portfolio company advisor). The SOC 1 should include a statement of control objectives around performance reporting, with testing completed by the service provider assurance auditor as to accuracy of performance calculations.

Quite a long ways to go, then.