Notes from a conversation among educated friends.
I had a useful conference call with five other investors on the pros and cons of private equity investments (PE). The following is a list, in no particular order, of what we concluded were important elements to consider [with my personal comments in brackets]. As always, all errors and omissions are mine.
A- The Good
- Diversifies sources of returns by offering opportunities not available through liquid markets [True.]
- Produces smoother returns. [As in the case of direct real estate investments, this is the effect of less frequent and non-real-time valuations; potentially subject to manipulations.]
- Keeps you invested at all times. [Cannot trade so cannot do silly things. Basically, pre-emptive jailing before committing a crime.(1)]
- Provides better governance. [Boards are staffed with senior managers of the general partners and with people they select.]
- Big institutions with long-term investment horizons have invested in PE successfully. [While the record is not uniform, some institutions have had exceptionally good records helped by preferred access, manager selection and fee reductions.]
- Socially attractive, provides entertainment value. [Not the ‘ESG/SRI’ variety of ‘socially’ but the ‘join-the-club’ and ‘sit-at-the-table-with-big-names’ one.]
B- The Bad
- It’s illiquid, and for a long time. [The reason A3 above is true.]
- It takes many years – 4 to 7 on average – to properly implement a program with vintage and sectoral diversification. [Music to the ears of mangers.]
- Costs are very high. [Net returns to investors are 20-30% less than gross returns: to obtain a net nominal annual return of 10% the investments have to earn 12.5-14.3% gross; for comparison, in the last 120 years US equities have returned a little under 10% per year.]
- Performance measurement, while mathematically accurate, is complicated and unclear, especially about the effects of leverage. [Subject to manipulation in presentations, often obscuring true results and their comparability to standard liquid indices.]
- To obtain solid and properly calculated results – see B4 above – you need the right manager. [Very difficult to find and to access.]
C- The Ugly
- Transparency in costs. [Few tell you upfront how much you pay in total fees. Often part of the costs is simply omitted.]
- Some managers charge on committed capital or, in the case of co-investments, on simply showing you the opportunity. [No comment.]
- Despite C2 above, performance is still reported on the basis of IRR or multiples. [A more sinister version of B4.]
- Sales material is often inviting but unclear. [Sometimes misleading, using unadjusted comparisons and plain wrong graphs.]
- Managers align their interests with yours by letting you know that ‘I put my own money in it.’ […forgetting to mention ‘but I don’t pay any fees.’]
Readers can draw their own conclusions. If I missed something I hope the other conference participants will mention it either in the blog comments or anonymously to me (for further insertion in the comments).
Roberto Plaja, April 16, 2021
Notes: (1) I also cannot help thinking of an old commercial for Black Flag’s Roach Motel, an insecticide box: ‘Roaches get in, but they don’t get out!’ (Please don’t accuse me of equating investors to roaches; I’m sure you get the point.)