Private equity outperforms public markets, because "patient capital" collects a liquidity premium. Or does it?
We were very interested to read an article from Top1000funds.com - an excellent resource - entitled "PE Performance Doesn't Add Up."
The article refers to a recent study by academics at the Said Business School at Oxford. Using data sourced from Burgiss, the well-know PE data aggregator, the Oxford team reviewed information on a large sample of funds raised between 2006 and 2015.
First, the researchers chose a suitable performance benchmark to evaluate private equity performance.
"We opt for the Public Market Equivalent (PME), currently the best tool for comparing the performance of private equity and public equity. This measure compares an investment in private equity to an equivalently timed investment in the public market."
Under this model, private market performance is compared to a public market benchmark. A number higher than 1 indicates outperformance, where a number under 1 shows underperformance. Notably, the researchers do NOT consider IRR to be a suitable return measure - likely due to the numerous performance pumping techniques which PE managers can apply when using credit lines / leverage (see our earlier blog on issues related to IRR).
The team concludes:
"Our sample includes 2424 funds with a total size of $2.2 trillion. We find that PME (public market equivalent) as of March 2018 is 0.97 on average (median is 0.98) and total value to paid in multiple (TVPI) or total value distributed, compared to invested is 1.46. Verdict: performance of these funds is slightly below that of the S&P 500 Index."
To rub salt into the wounds, the Oxford academics analyze fees. Considering management fees and incentive allocation / carried interest (assuming all funds have a conservative 8% hurdle) of their $2.5 trillion sample of 2006-2015 vintage funds, they identify "a fee bill of $400 billion for net-of-fees returns slightly below those of the S&P 500 Index."
This number is, of course, an understatement - it excludes consulting fees, (accelerated!) monitoring fees, advisory fees etc. etc. which all add revenue to the PE manager community.
What are some potential implications for investors?
First, the performance of private equity portfolios appears unclear and open to multiple presentations. As a starting point, it is time for institutional investors to require objective, standardized performance measures across all third party asset managers. Alternative investment firms (PE, hedge, infra, venture etc.) should be required to generate GIPS compliant performance information, with full external validation of each composite.
This leads to a broader consideration: governance, risk and compliance oversight over an asset owners' allocations to external managers should include not only ODD, but also the separate discipline of performance measurement. Investment performance should be an objective process, standardized across an institutional investors' external manager relationships. Performance measurement activities should be specifically segregated from investment teams to ensure objectivity, accuracy and avoid conflicts (investment teams are, of course, compensated based on that performance.)
This all sounds very similar to ODD. Both ODD and performance measurement work to ensure that the asset owners' supply chain - their roster of external managers - are objectively and robustly evaluated both at the point of initial allocation and then on an ongoing basis thereafter.
Second, investors should be prepared for ever more attention and "publicity" around the fees paid to third party managers, particularly as ESG analysis gains more traction. (As an aside, try reading the Institutional Investor article "Your Fees are Bull%$&*" if you're of the view that 1 or 30 gives the 2 and 20 crowd a 50% pay increase on their incentive fee).
Castle Hall's ESG team reviewed the Top1000 funds article and asked a direct question - how can institutional investors justify such an enormous wealth transfer from many millions of plan beneficiaries (most of whom will never earn anything like a six figure salary) to 2,500 investment management companies?
It is early to think of more "social" concepts when analyzing the investment industry - from portfolio composition, to manager selection, to investment outcomes. Indeed, as of today, many professionals engaged in the investment industry will find it puzzling - or just downright wrong - to think about "soft" issues such as fairness, equality and equity when designing an investment program.
However, the "S" in ESG means "social", and to some in the ESG world, the "S" certainly includes concepts of "Social Justice". As such, institutional investors will face increasing exposure to awkward questions. To be provocative, here are three examples of questions constituents could ask of an institutional pension plan:
It is clear that new questions will be asked, from unexpected sources with new agendas, over the next 3-5 years. All of us in the investment industry can usefully start thinking about the many changing perspectives which will arrive with this "new normal".