Private Equity Demystified - Again

Today the postman brought me a box of freshly printed copies of the new 4th Edition of “Private Equity Demystified”. It was a bitter-sweet moment because my co-author and friend Mike Wright died 11 months ago. So it is with sadness that I am writing this without his council or company.

Has anything changed in Private Equity since Mike and I last wrote an edition in 2014? Well, in summary, quite a lot, but here are a few thoughts on the topical issue of mean returns.

·      Simple Investment Returns Comparisons Are Probably Meaningless

When this statement is made it usually precedes a discussion about how returns are presented or manipulated. I now happen to work at Oxford Said with two of the leading academic voices in this debate – Profs Tim Jenkinson and Ludovic Phalippou. 

Tim works with others, and has a long series of papers on the question of returns that use a large dataset from Burgiss to assess the performance of funds using a variety of metrics. Broadly what that stream of work finds is that PE outperforms and almost always has public markets, but that the outperformance has been falling and is currently quite small. Tim’s last joint paper summarising much of the research in the Finance Journals was “Private Equity Accomplishments & Challenges” Journal of Applied Corporate Finance, Vol. 32, Issue 3. It was not reported by the FT.

Ludo focusses on returns to LPs and has argued that the measures are misleading, manipulated and if corrected for risk, show that the managers get upside but little downside. That makes the overall sector a poor risk adjusted investment, especially in recent years. Journalists publish stories based on this analysis frequently. Ludo’s latest working paper was “An Inconvenient Fact: Private Equity Returns & The Billionaire Factory”, it featured extensively in the FT.

·      Apples vs Tomatoes in a Fruit Salad

Our point is not that either of these is right or wrong, but to be transparent I lean towards Tim’s analysis and my sense was that Mike was usually somewhere in the middle but was sceptical about data biases. 

What we emphasise in our work is that all these papers and analyses are not measuring or reporting on the same thing over time, so the time series is not as simple to interpret as it once was. Funds used to be 10-year commitments that drew down as the money was invested. There was a “J Curve” where cash was invested at the start of the fund and returned at the end – in the shape of a “J” when graphed. Today funds use credit facilities and other loans to flatten and manipulate the J Curve. This means that LPs cashflows do not accurately reflect their risks and rewards. Today there are new contingent liabilities, because LPs guarantee the fund’s banking facilities. they do this either directly as investments are made, or indirectly if the fund borrows secured on the assets they own, often to accelerate distributions. Furthermore, secondary transactions move assets between LPs and between funds that muddy the cashflows further.

Add to this the fact that not all LPs get the same return from the same fund, due to tiered investment terms, and you can start to sense how uncertain the analysis can become. The effect is to make any comparison across time very, very problematic indeed, especially if you use IRR or any other time weighted cashflow measure, as your yardstick.

You are comparing apples and tomatoes – both may be fruit, but both do not belong in a fruit salad.

·      PMEs Don’t Help Much

There are new measures galore these days, all sheltering under the phrase “Public Market Equivalents” or PMEs. Academics love PMEs and they are starting to feature in the industry, but they have been around in one form or another for years. They basically compare what you get from a PE commitment to what you would have got if you had invested in some public market index. Without going down a complex rabbit hole (it's in the book!), there are all sorts of ways you can calculate and therefore game PMEs. They therefore need a healthy degree of scepticism and a good hard kick of the tyres before driving off in them.

The issue we have with PMEs is that they also ignore the contingent liabilities of the LP’s, tiered investment terms and the secondary transactions. There are moves afoot to unpick funds cashflows to show what the LPs would have invested and received if there were no fund level borrowings, but these are not widely adopted, reported, or researched.

We therefore argue that any analysis that looks across time is not straightforward and is unlikely to allow anyone to boldly assert either that Private Equity under-performs or over-performs the alternatives. Not a great headline I grant you, but it is the situation we find ourselves in.

·      Is Private Equity Even “A Thing”?

We go on to argue that Private Equity is no longer “A Thing”, but has become a wide spectrum of things, making the mean return broadly, meaningless. 

VC and PE have always been separated and treated as such in most commentary. Emerging private strategies in real estate and infrastructure are also usually, but not always, treated separately. But even in the “old world” of private equity, we now have a huge array of investment strategies being deployed, ranging from, say, small early development capital in emerging markets to large buyouts in developed markets, via rescues and carve outs with buy & build thrown in for good measure. Unless you carefully disaggregate the different strategies, you are comparing wildly different things with wildly different risk/reward profiles: More apples and tomatoes in the same dish.

The bigger the fund the more the data leans towards those funds returns. So, if you aggregate across all funds you will be biased toward those writing the biggest cheques. There are attempts to pull apart the data to reveal these nuances, but outside the dark nerdy corners of PE land, nobody really pays much attention and in academia it is often just too hard to do. Besides, what kind of headline would you get? “Medium Sized Funds in Growth Sectors have Lower Variance than Big Funds in Asian Tech and Pan-European carve outs Shock”? It doesn’t really trip off the tongue or grab the reader’s attention, does it?

“Private Equity Demystified: 4th Edition” by John Gilligan & Mike Wright will be Published by Oxford University Press on 4th November 2020.

https://www.amazon.co.uk/Private-Equity-Demystified-Explanatory-Guide/dp/0198866992