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GUEST COMMENT: Institutional investors are lazy, private equity investors really aren’t

I work in private equity, and I’m fed up with whingers and their half-baked comparisons of the returns we offer to those of listed stocks and index tracker funds. Their criticisms show up their own lack of insight into the buyout sector (forgivable) and basic knowledge of investing and portfolio allocation (unforgivable).

The idea that returns from P.E. are equivalent to (or less than) increases in the stock market is ludicrous. We deserve our performance fees just as much as the average halfwit fund manager deserves their much smaller salary.

The studies themselves contradict one another: an M.I.T report claims underperformance of stocks by P.E., another by London Business School and H.E.C. of Paris says we’ve outperformed by almost 20%. A third by Cambridge Associates, Thomson Reuters, Preqin and State Street agrees.

Private Equity is fundamentally a different asset class. Money goes in at the start and comes out several years later. Unlike shares which pay dividends, you don’t get a drink along the way (dividend recaps were largely an exhibit of the credit boom and won’t happen anymore). Investors deserve, and get, a premium for that illiquidity.

“Leverage risk” is a ridiculous premise. Borrowing, if used properly, enhances equity returns due to significantly different views of “reasonable returns” on debt (low) & equity (higher). Therefore greater returns follow greater risk. That is Portfolio Management 101.

Additionally, risk depends entirely on the underlying asset one decides to lever up. Consider whether you prefer an unlevered bet on a Lebanese cotton factory, or a 3x levered investment in a German utility?

The value of Private Equity is in finding neglected & unloved sub-sectors, ones better suited to higher contractual returns (interest payments) than the scrutiny of quarterly stock market reporting. It takes persistence and insight to find these assets, especially when they’re not covered by the equity research analysts that fund managers rely on.

Public equity managers are unwilling to fully dig into the balance sheets and income statements of the stocks they own. Notwithstanding that their stakes are smaller, how many of them really understand their investments in the way P.E. managers do?

Fundamentally, it is the institutional investors who are lazy. They were captivated by the allure of “absolute return.” Ask them to roll up their sleeves and calculate their actual returns excluding transaction costs, or taking into account entry and exit timings, and it “all seems a little too much like hard work”.

Public markets need Private Equity and vice versa -portfolio company exits via re-listings return cash to investors and the takeover premiums paid in buyouts boost returns to fund managers’ portfolios.

However, I’ll leave you with a final observation: I sit next to my boss and I see him log into his stock portfolio several times a day – the irony of a P.E. principal hedging his bets in the public markets is not lost on me.

Comments (10)

Comments
  1. Private Equity makes great returns for PE mangers..hE IS RIGHT ABOUT ONE THING: Pensions are lazy and stupid and have been duped into this guys nonsense..he is wrong about the HEC/LBS study…PE only outperforms the index if you weight PE funds by size…if you weight them evenly, the index outperforms!!!!!!

    STAY AWAY FROM THE PE RIPOFF; if you like PE, I have a life settlement and a bridge in NY to sell you

  2. “Leverage risk” is a ridiculous premise. Borrowing, if used properly, enhances equity returns due to significantly different views of “reasonable returns” on debt (low) & equity (higher). Therefore greater returns follow greater risk. That is Portfolio Management 101.

    He should read, “Corporate Finance” by Brealey & Meyers…then he will understand what he is doing with debt a little better….

  3. “The value of Private Equity is in finding neglected & unloved sub-sectors, ones better suited to higher contractual returns (interest payments) than the scrutiny of quarterly stock market reporting. It takes persistence and insight to find these assets, especially when they’re not covered by the equity research analysts that fund managers rely on”

    Eh? I could swear it was about buying dull companies, outsourcing what you can, take out a whopping great loan, pay yourself a dividend then flog to someone else based on fanciful projections.

  4. Another idiot giving us a lecture…….

  5. “The value of Private Equity is in finding neglected & unloved sub-sectors, ones better suited to higher contractual returns (interest payments) than the scrutiny of quarterly stock market reporting. It takes persistence and insight to find these assets, especially when they’re not covered by the equity research analysts that fund managers rely on”

    From memory the leverage boom on 2005-7 was about buying ever larger, well respected companies with decent market positions at high takeout multiples and even higher leverage and wait for market growth to do the rest for 5 years. I wonder if any company bought for over EUR 5bn EV in that period by PE will make a 20% IRR…

  6. Your knowledge is pathetic. You don’t understand portfolio theory at all- from Institutional investors perspective.

    If you understand how smart institutional investor manage alternative asset class, the risk and return aspect of it context of total portfolio, your thinking will change. Understand how those managers are assessed and all grandiose things what you are saying will be reduced to something not very significant.

    You seems to be one of the mediocre guy who has got into the system during bullish market. Read Corporate Finance well as someone suggested or read CFA texts. You are not alone by the way, I have met a similar VC in med tech sector who was a graduate, spent some time at bulge bracket and had similar thinking like yours.

  7. A mixture of a little sense and a lot of nonsense. Rather than lecturing us “whingers”, I suggest you try and understand the CAPM and M&M. Also think about how higher risks and higher returns manifests across the financial sytsme as a whole – here’s a clue, it doesn’t show up as uniformly higher returns to everyone. It is true that PE has a place, but since the number of unloved subs/divisions/companies etc is limited, and the number of good management teams is also limited, the more PE money there is, then the lower the average returns – that is very simple maths.

  8. “Leverage risk” is a ridiculous premise? What a twit… read up on your Miller-Modigliani theorem and the financial crisis has already shown that it is a significant risk. Most PE funds outperform the FTSE index in that most firms in the FTSE index are not 80% geared. Studies have shown that if you take out gearing (comparing like for like) and take out the management fees (2%) and preferred returns (20%) above hurdle that PE charges, most people are better off investing the index. Of course there are PE managers that outperform but given the quality of the contributor’s comments I would think that he is not working in one of them.

  9. thammond65, not wishing to be insulting, but 15+ years and you still don’t know that CAPM doesn’t work?? its a nice theory but it *DOES NOT WORK*.

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