Practical analysis for investment professionals
14 July 2014

Is Private Equity Out of Tune with Society?

Private equity has never worried too much about its image problem. The industry has always been seen as hardheaded and focused on making money. But society’s values have changed in the wake of the global financial crisis, and private equity now looks out of touch with the times. Against a weaker economic background, a re-run of pre-crisis practices may not be socially acceptable. Laying off workers to restructure and improve efficiency appears callous and is less palatable. In the face of criticism from regulators, investors, and politicians, an overhaul of private equity practices is overdue.

The industry’s unpopularity comes during a bumper year. The surge in IPOs, mergers, and acquisitions has boosted profits but also brought additional public scrutiny. The latest attacks began in the US, with regulators focusing on disclosure of costs and performance reporting. Similar complaints have been echoed globally. The industry has been accused of playing games with fees: using vague language in agreements with investors that allows broad scope for charges allocated to underlying portfolio companies. Some private equity firms have been reported as employing outside consultants or operating partners and paying for these through the fund or portfolio companies without adequate disclosure.

Andrew Bowden, director of the SEC’s Office of Compliance Inspections and Examinations (OCIE), recently criticized the industry for poor disclosure, and noted weaknesses in controls. He said more than half of the private equity managers inspected in the last two years had either violated the law or had material weaknesses in how they handled fees and expenses. He also cited vague disclosures as a concern. Some potential conflicts may not have been appropriately disclosed, or can be so adverse to outside investors’ interests that it may be quite difficult to establish that sufficient disclosure has been provided.

Other studies have pointed out that private equity investing imposes a heavy burden on investors in the form of high management fees, carried interests, and illiquidity. Private equity firms — the “general partners” — need to create a lot of alpha to offset these costs for their “limited partners” — the outside investors. By keeping down the cost of debt and encouraging leverage, low interest rates help but only in part.

While private equity has made some improvements to the credibility and consistency of valuations, there is room to do better. Valuation can involve subjectivity, and projections can even be embedded in performance data. Methodologies can be changed from period to period. The conflicts inherent in earning fees based on subjective valuations are clear, and are not solved by audit. Incentive fees can be helped a lot by favorable timing of uplifts. That’s because it is not simply cash flow that matters, but how accounting recognizes cash flow versus the hurdle rates that determine manager incentives.

For these reasons, the industry should develop a recognized standard for performance measurement in the way that Global Investment Performance Standards, or GIPS, developed by the fund management sector in the US, are used for active managers with listed investments. That would drive transparency and change.

Unlike other areas of the investing world, much of the private equity sector remains opaque when it comes to expenses. This secrecy might have been justified when the industry was much less systemically important, and its activities were confined to the smart money. Now the industry impacts many areas of the economy and society.

Increasingly, less sophisticated investors are being drawn into private equity. Many wealth managers recommend it as a component of long-term portfolios, and there are also big allocations from many public sector funds, sovereign wealth funds, and endowments. Private equity can be commingled with conventional stock market investments in mixed funds, or made accessible to the public via investment trusts.

Many of the newer fans of the asset class may simply not have the experience to understand all the tricks of the trade. The SEC has noted that investors have done a poor job negotiating complex private equity documents. Most investors do not have the skills or information to monitor their private equity general partners.

Until earlier this year, shares offered via IPO were soaring after flotation, and fund managers seemed happy to buy all that private equity would sell them. There was little concern about quality, and new buyers scrambled for maximum stock allocations. Few seemed concerned about conflicts in the allocation process or the huge uplifts that private equity was achieving.

Now, in a much soggier market, fund managers have become more discerning. Many of this year’s IPOs are now trading at discounts to issue price, and it seems that some of the businesses and advisers drawn into the frenzy do not have staying power. Private equity needs to show that it can maintain an interest in the success of a business after flotation, and structure exits to leave something on the table.

Private equity is growing, and set to present more systemic risk. Secondary market transactions are booming, as cash begins to pile up in private equity funds. Globally, estimated unspent funds now exceed $1 trillion. Almost half of this is dedicated to company buy-outs and acquisitions. As a result, prices paid for businesses bought by private equity are going up, as is average leverage. The surge in fundraising and leverage is encouraged by default rates that have remained very low by historical standards.

Money printing by central banks, which drives down borrowing costs, makes leverage attractive. And although private equity firms may structure deals to risk relatively little of their own capital, they are still treated as entrepreneurs rather than financial engineers.

Politicians remain uneasy about the favorable tax arrangements private equity generally enjoys, typically in terms of treatment of debt and carried interests. Use of tax havens and other minimization schemes can cut tax paid to very low levels. Firms backed by private equity regularly feature on lists of successful businesses paying little tax. Society should grant tax privileges to foster enterprise and growth, not to facilitate leverage and downsizing.

The private equity industry is now important — to financial markets, economic growth, and employment. That merits greater scrutiny and demands transparency. Society’s attitude to the financial sector has changed, and private equity looks like the laggard. Attendees at a recent private equity conference heard a call from Thomas von Koch of EQT Partners for the industry to step up and develop partnerships with portfolio companies to deliver value for society as a whole. This worthy endeavor should be focused on enhancing the long-term health of the businesses they own.

Delivering sustainability rather than quick turnarounds matters now. If the private equity industry does not move with the times and reform itself, more regulation will be needed.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Photo credit: ©

About the Author(s)
Colin McLean, FSIP

Colin McLean, FSIP, is founder and CEO at SVM Asset Management, an independent Edinburgh-based fund management group. He is a member of CFA Institute and was elected to the Board of Governors in 2012. McLean is a fellow of the Institute and Faculty of Actuaries and a chartered fellow of the Chartered Institute for Securities & Investment. In 2012, McLean was appointed an honorary professor at Heriot-Watt University, lecturing in behavioral finance. He is a regular contributor to financial publications and has been a guest on Bloomberg TV & Radio, CNBC, BBC TV and Radio. McLean is also a frequent conference speaker on investment, hedge funds and behavioral finance.

4 thoughts on “Is Private Equity Out of Tune with Society?”

  1. Brad Case, PhD, CFA, CAIA says:

    Your sentiment is right but your reasoning is wrong, Colin.
    If private equity investment managers were genuinely delivering alpha, the sins of the industry would (or should) be forgiven. The truth, though, is that private equity investment managers–including buyouts, venture capital, and especially real estate–have generally delivered zero or negative alpha, and it’s damned galling to suffer illiquidity, hidden fees, flamboyantly high non-hidden fees, and sheer arrogance on top of negative alpha.
    The problem isn’t that the industry used to be confined to “the smart money”: it’s doubtful that “the smart money” ever invested with private equity investment managers. If the capital invested with private equity investment managers had been smart money, we wouldn’t have amassed 35-plus years of evidence showing negative alpha. For two annotated bibliographies of independent academic studies of private equity investment manager returns–both pro and con–see and
    The problem is that private equity has always been the segment of the investment industry in which it has been legal to report false investment returns. I don’t mean that private equity investment managers systematically overstate the value of their investments–although there’s evidence of that, especially when they’re in the process of raising the next fund. What I mean is that private equity investment managers systematically understate the volatility of their returns and their correlation with other asset returns, which means “the smart money” has always been able to delude itself into thinking that private equity returns offer greater diversification benefits than it really does.
    On top of that, private equity investment managers selectively report their performance–and, even then, rarely report performance net of fees–to promote the false idea that their returns are better than they really are.
    Given those problems, I don’t think even universal adherence to a GIPS-like system would be enough. Private equity investment managers would still be reporting returns based on appraised values–which means false values that systematically understate volatility and correlations–and therefore would still be able to claim false diversification benefits.
    The only answer is to spread the word that private equity has, for several decades, consistently delivered negative alpha to its supposedly “sophisticated” investors.

    1. Henry says:

      Great comment Brad. Addressed the true concerns of private equity fund management.

    2. Sooyoung Chae says:

      Both article and comment are very helpful to understand the current landscape of global private equity market. I will be looking forward to see more debates on this topic onward.

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