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Excerpt from The Myth of Private Equity: A Glimpse into Wall Street’s Transformative Investing by Jeffrey C. Hooke. Copyright (c) 2021 Jeffrey Hooke. Used in consultation with Columbia Business School Publishing. All rights reserved.
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When a publisher receives a book proposal, it is not uncommon for the publisher to ask outside authors, experts, and academics to review the proposal and provide comments on the content and marketability of the book. This book outlines the mediocre performance of leveraged buyout funds and the funds’ continued ability to hide that fact. A reviewer of a future editor of the book said:
Mr. Hooke can’t be right about the leveraged buyout industry. If it were, the participants in this part of the capital markets would suffer from mass hallucination!
This reviewer’s opinion is just wrong. The buyout phenomenon that has gripped numerous educated and experienced businesspeople is not a hallucination. Rather, it is a manifestation of the irrationality that grips Wall Street from time to time.
The private equity industry is no longer the same as it used to be
The buyout business is no longer what it was twenty years ago, and it thrives on a reputation for high returns that is undeserved today. This conclusion goes against the accepted wisdom of Wall Street – but as one bond trader said of common beliefs in the financial markets, “It is accepted wisdom until it is not.” It happened with the abrupt end of mortgage-backed securities and the dot-com stock craze . Despite numerous statistical studies that show that buyout funds are not performing as advertised, there is still a positive response in the industry at the moment. For example, in the past eighteen months, six new funds worth more than $ 10 billion have opened, and 2020 has been the best year for buyout fundraising. Last year, Calpers, the $ 400 billion California retirement plan that is the best cow for hundreds of institutions, announced that it would increase its allocation to private equity funds for better returns. However, the total value to deposit ratio of the plan for private equity investments over 35 years is only a modest 1.5 times, which moves the plan’s PE portfolio in the neutral territory compared to stocks.
To what extent has the mystique of the industry remained unchallenged over these many years and has a lifespan two to three times longer than other investment trends? In part, the secrecy of the industry and the complexity of its data prevented the undaunted doubt Thomas from confirming suspicions. The mortgage-backed securities and dotcom assets were publicly traded, and over time, skeptics could point out negative information over and over again to build credibility. In contrast, the returns, fees and diversification features of the buyout asset class are shrouded in a fog of numbers. An examination of the performance over the past fifteen years depends on the value of the unsold companies in the industry, even if the high proportion of unsold investments – most recently 56 percent – suggests that only a few portfolio companies are willing buyers at reasonable prices to have. Otherwise, the funds would have sold the investments and moved on.
A self-sustaining feedback loop
Meanwhile, a self-sustaining feedback loop enables the industry to operate in a parallel universe where the laws of financial physics do not apply. To illustrate, buyout managers sell their product to beat the stock market. However, over the past fifteen years, the average fund has lagged the S&P 500. Managers say the product has lower risk than the stock market and low correlation with it, but both claims are disproved by the proven effect of leverage on the performance of company value. The established relationship between debt and equity is based on 60 years of classical finance theory and is supported by Nobel Prize winners such as William Sharpe, Harry Markowitz and Merton Miller. Dedicated, agency-approved accounting rules allow PE managers to market their own portfolios with minimal oversight and allow institutional investors to ignore expensive carried interest fees. This curiosity is reinforced by the fact that carried interest can also set in if a fund does worse than the stock market. “Don’t ask, don’t tell” becomes the institutional refrain of such high fees. A lack of regulatory standards gives the funds the leeway to choose between several benchmarks for performance evaluation and the top quartile ranking. Reliance on easily manipulable internal rate of return (IRR) measurements instead of the more neutral total value to deposit ratio skews actual economic returns at a time when investors need accuracy. The industry’s main customers – state and municipal pension schemes, university foundations, funds of funds, and charitable foundations – have administrators who oblige their employers to maintain careers on private equity, as the logical investment decision – a low-cost public equity index fund – eliminates the need for their own jobs. Regulatory agencies such as the IRS, the SEC, and the Department of Labor are noticeably lacking. And that closes the feedback loop that keeps the business running.
The longevity of the feedback loop rests on an important foundation, according to one observer: “Everyone makes money except the beneficiaries (the institutional investors), so the system lives on.” Private equity managers, investment advisors and institutional executives earn at the expense of government and local governments Pensioners, university students, umbrella fund customers and endowment scholars make a living.