Weighing the cost of private equity’s appeal

Ask asset owners across Asia Pacific how they are investing, and the conversation inevitably turns to alternatives.

The desire of pension funds, insurers and others to ensure a minimum level of return amid volatile equity markets and low-yielding bonds has led many to eye less liquid asset classes. Real estate investments remain a staple favourite, but increasingly private equity funds have become a priority.

An analysis by the Oxford Said Business School based on the Burgiss database that was reported by the Financial Times noted that institutional investors ploughed $2 trillion into US private equity funds over the 10 years since the global financial crisis of 2006. Asset owners in Asia have been similar; some Korean pension funds now have 50% of their assets in alternatives, with private equity funds comprising a sizeable chunk.

The investors have done so in the hope of securing superior returns to public markets. There’s just one problem: many aren’t working. And it’s largely because of the greed of the fund operators.  

According to the Oxford Said Business School analysis, which was based on data from 163 US public pension schemes, private equity funds offered an annualised return of 8.6% net of fees between 2006 and 2015. In comparison, the S&P 500 returned an annualised 9.14% over the same period.

In large part, the different fee levels made a critical difference. An index fund tracking the S&P 500 only costs a few basis points to invest into. In contrast, general partners of private equity funds often charge a large performance fee if they return an IRR of over 8% a year, plus a management fee and other expenses.

The study estimated that private equity fund managers may have earned up to $400 billion over the past 12 years ­­– equivalent to 20% of the total assets invested by their clients.

HEDGE FUND LESSONS

History suggests this situation is not sustainable.

During the early to mid-2000s, the alternative asset class of choice for many institutional investors was hedge funds. Hedge fund operators rewarded themselves handsomely from the deluge of money they received, typically charging a 2 and 20 fee model, or 2% management fee plus 20% of any net outperformance.

Then reality struck. The global financial crisis of 2008 triggered a flood of redemptions from panicked investors, while hedge fund returns collapsed. In the years that followed many funds failed to outperform difficult market conditions. Their clients did even worse after fees were applied.

Hedge funds have also seen their returns disparagingly compared with that of vanilla stock indexes. The global hedge fund industry returned only 2.02% in 2015, according to alternatives research provider Preqin, causing a $109.8 billion net asset outflow the following year (despite returns improving to 7.74%). Last year the average industry’s return was 11.41%, but this was still well below the S&P 500’s 18.74%.  

To staunch their asset haemorraghing, hedge funds have cut their fees. HFR, another data provider, estimated that the funds charged a management fee of 1.56% on average last year, while performance fees stood at 17.3%.

More is likely. An investment consultant told AsianInvestor that further tranching of hedge fund fees is likely, as they seek to engage more institutional investors and fend off competition from smart beta investment strategies and multi-asset funds.

“Some hedge funds are looking at how to charge different rates for different types of investment; if you want the lowest rate maybe you have to lock up your capital with the firm for a longer time,” said the Singapore-based consultant.

LEARNING THE LESSON

Private equity funds also suffered during the global financial crisis, as asset valuations collapsed, but they haven't had the same backlash.

In part this was because they didn't enjoy the same popularity with asset owners at the time. But over the past decade this has changed, as institutional investors have increasingly ploughed funds into private equity.

As a result, a record number of funds were established by early 2018, according to Boston Consulting Group. Yet the pace of deals isn’t keeping up; in 2017 a total of 4,053 private equity deals were executed, worth $538.2 billion, according to Pitchbook – equivalent to 2016 volumes.

A greater number of gluttons eyeing a similarly sized pie is having predictable consequences. Asset costs are rising, and funds have piled more debt onto deals to keep returns up. Pitchbook noted that the median debt percentage of private equity deals climbed from 50% in 2016 to 55% last year, while the median debt/Ebitda multiple rose from 5.2 times to 5.8 times over the same period. 

“This is the highest debt/Ebitda multiple recorded in PitchBook’s dataset,” the company noted.

Despite this, overall returns are slipping. A study by Preqin notes that private equity funds formed in the years after the crisis returned 14% to 15% a year, but those since 2013 have seen returns slip to 9.5% to 13.5% on average (although their relative youth means this could change).

The biggest danger is that interest rates keep rising only to be followed by a sharp turn in market conditions over the next year or two. That would likely cause company valuations to founder, leaving private equity funds of a recent vintage heavily indebted and sitting on assets that that has lost value. That may sound pessimistic, but given uncertainties such as an expanding trade war, the risks of such a scenario appear to be rising.

For asset owners, the volatility of today’s equity markets may well burnish the appeal of private equity funds. But they appear to be getting riskier, even as their returns slip. Ultimately the onus is on institutional investors to decide whether it’s worth spending so much to lock their money away for years at this moment.

Increasingly, the answer could be ‘no.’