Why Private Equity Will Disappoint

Investors chasing performance to drag down returns.

December 20, 2011

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tic tac toeWith dismal public market returns since 2007, many institutional investors are looking to meet their plan’s required rate of return in private markets. But their expectations may be higher than warranted, suggests a new poll.

Bfinance, a London-based consultancy for institutional investors that specializes in private equity, reported recently that 90% of investors expect more than a 10% internal rate of return on private equity.

Unfortunately, this expectation flies in the face of the (historical) facts. Notes bfinance: “To achieve their objectives, investors would probably have to devote the very greatest care in selecting their managers and would need to actively manage their investments. In fact, according to the Preqin statistics on a sample of 1,906 funds launched since 1980, the median return from private equity expressed in terms of net Internal Rate of Return (IRR) came out at 9.5%. In other words, less than half of Private Equity funds generated an IRR higher than 10%, as hoped for by nine institutional investors out of ten.”

That isn’t to say that private equity investments can’t be worthwhile. Indeed, there are a number of reasons to try to tap private equity returns: to enhance portfolio returns, to get access to other, non-public, sources of returns and to reduce volatility. “Private equity’s historical median performance, all strategies taken together, is still respectable given the current outlook for returns offered by other asset classes held within institutional portfolios,“ bfinance reports.

That’s the objective. The favoured means to carry it out is problematic.  “In selecting their managers, investors place most importance on the quality of the private equity firm’s investor base and reputation. These two criteria are of the sort that encourages herd mentality. However, from experience, channelling too much new investment money to a single manager or to a given strategy generally results in a lower level of returns.” While funds of funds have a smaller footprint, there is still a reliance on direct funds, and indeed, a reliance on general partners, particularly in reporting returns. Larger investors, however, do seek out third parties for due diligence.

One consequence, bfinance reports, is that instead of holding for the long term, with a manager who is skilled at shifting investments, smaller investors simply “vote with their feet” and chase performance.

Private equity commitments not yet called, bfinance notes, are now up to  $900 billion. That’s a lot of money waiting to depress returns.

So how can one avoid following the crowd? Bfinance suggests that venture capital performs well below expectations, while LBOs seem to meet expectations. Private debt, however, seems under-regarded, despite its volatility-dampening characteristics.

“For investors who invest in private equity opportunistically,” bfinance writes, “the expectation of significantly lower returns from these debt/mezzanine strategies deserves to be re-examined from the angle of lower dispersion in performance: 800 basis points between the net IRR of top quartile funds and third quartile funds (for a median return of 8.8%), against a range of over 2,000 points for venture capital strategies (median return of 6.4%) and a range of 1,800 points for special situations (median return of 13.6%).”

The risk/reward expectation surfaces in another one of bfinance’s analyses. Thus, in a separate report on infrastructure investing, it notes:

“While Canadian, Australian and Korean pension funds and sovereign wealth funds buy stakes in UK airports and water companies, UK pension funds’ exposure to the asset class is less than 1%, compared with 8-15% in Australia and Canada. Consultants attribute this to UK pension funds’ risk aversion and dislike of leverage, inexperience in striking such deals, lack of resources to manage large infrastructure assets and the disappointing returns in 2007-09.“

Again, this may be attributed to overly high expectations before the financial crisis, this time tamed by disappointment.

“Infrastructure is a broad term, encompassing many different types of assets and deal structures. It can be accessed through bonds, private debt or private equity. On the private equity side, if cash-flows are availability-based (and assuming the sovereign counterparty is sound) rather than user-pay, held for the long term and prudently leveraged, then one might argue its position as a bond substitute,” says Vikram Aggarwal, Director, Private Markets at bfinance. “However, in general, infrastructure funds often behave in the opposite way, by holding assets for relatively short time periods, using a lot of leverage which is often in the form of short term borrowings, leaving it vulnerable to re-financing issues and real risk of capital loss.”

The message, it seems, is know your asset class – and your horizon.

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