This week, Warren Buffett answered questions with respect to PE during the annual Berkshire Hathaway AGM. Thanks to the "Hobbyist Investor" we can provide a full transcript of his remarks on alternative investments.
His main points?
- PE charges management fees on 100% of committed capital, but only reports performance - IRR - on called capital (and, as we all know, IRR can also be juiced through use of credit lines, which delay the date at which capital is called from investors). As we have said before - perhaps the biggest issue in PE is the lack of GIPS compliant performance reporting.
- Per Buffett: "I've told the story of asking the guy one time, in the past, 'How in the world can you....how in the world can you ask for 2-and-20 when you really haven't got any kind of evidence that you can do better with the money than you do in an index fund?' And he said, 'well, that's because I can't get 3-and-30' you know."
- Per Charlie Munger: "What I don't like about pension fund investments is I think they like it [i.e. pension funds / sovereign wealth funds like investment in PE funds] because they don't have to mark it down as much as they should in the middle of the panics. I think that's a silly reason to buy something. Because you're given leniency in marking it down".
And to finish things off, Munger says - "Warren, all they're doing is lying a little bit to make the money come in".
To which Buffett replies "Yeah. Yeah, well that sums it up."
Indeed.
Castle Hall agrees that private markets can add considerable value to pension portfolios, particularly when pension plans deal with underfunded portfolios given the present value of anticipated pension payment obligations. But - high fees and other investment manager favorable terms can significantly degrade investor returns from private asset classes.
From a due diligence perspective, PE needs:
- Active, fully independent administration service providers, tasked to obtain independent data to support asset existence and asset valuation, and engaged to co-ordinate cash movements of investor cash independent of the PE manager.
- Active, independent audits - with a prohibition on auditors providing other services to PE managers (e.g. tax services to the manager and pre acquisition / post acquisition consulting services in relation to underlying portfolio companies).
- Corporate fund structures rather than LP structures, enabling the appointment of independent directors. We see the current LPAC arrangements as a materially conflicted construct. The lack of independent, vigorous governance oversight is a clear deficiency in the current LP structure favoured by PE managers and their attornies.
- Independent performance calculations, completed in accordance with GIPS, as above.
- Clarity as to PE manager assets under management. The AUM of a PE firm is NOT the total commitments raised since inception of the firm: rather, AUM is calculated as current NAV of invested assets plus uncalled commitments.
- Independent validation of all fees and expenses, including waterfall carried interest calculations. Effective independent administration calculations could respond to investor requirements in this area.
- Transparency in audited financial statements of "other" expenses, including broken deal costs. Exactly what have the investors paid for?
- Independent valuation. Private assets should be valued by third parties, using third party (not investment manager) models / methodologies / assumptions, with all data underpinning valuations independently obtained from the underlying portfolio companies. We continue to be surprised at how frequently appraisal agents - and auditors - rely on information given to them by the investment manager when preparing valuation information.
- A limit to fees paid to lawyers, especially during the capital raising stage. Fees of US$1,000 per hour and up (and up a lot from $1,000!) are not justifiable when capital is provided by public / union pension funds.
- Standardization of management fee arrangements, such that the management fee covers all costs related to investment research, travel, internal diligence and related employee costs. The costs of complying with investor side letters is NOT, for example, an expense which should be borne by investors - that's a cost that the manager should bear as a cost of doing business.
- Transparency as to use of SPVs and other tax avoidance structures. A statement that "all cash is at State Street" is not correct when assets are held through SPV "chains" which flow through numerous banks in jurisdictions such as Luxembourg, Ireland, Holland, Malta, Cayman and Bermuda.
- An integration of ESG into all investment decisions, with transparency as to meaningful ESG integration for each investment, including tax structuring.
That's 12 points which come to mind pretty quickly - and there are likely 100 more.
Plenty to consider in each ODD review, as always!