Private Equity, who gets rich? Guess?

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larryswedroe
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Private Equity, who gets rich? Guess?

Post by larryswedroe » Tue Nov 27, 2007 9:57 am

Private equity underperforms market
By Martin Arnold, Private Equity Correspondent
Published: November 22 2007 16:48 | Last updated: November 22 2007 16:48
Private equity has on average underperformed the stock market in the last decade, according to a detailed survey of the buy-out industry submitted to the European Parliament on Thursday. Oliver Gottschlag, assistant professor of strategy at the HEC business school in Paris, compiled the research, which undermined the stereotype of private equity cutting costs at companies and making colossal profits from selling them soon afterwards. The research – based on data from 6,000 private equity deals and about 1,000 buy-out funds – shows
that average private equity returns have underperformed the benchmark S&P 500 sh are index by 3 per cent, after fees charged to investors.
“This does not correspond with the stereotype of the industry making its investors extremely rich,” Mr Gottschlag told the Financial Times. “Investors have not had much fun in this asset class, even though
they have all been obsessed with gaining access to the best-performing funds.” Excluding fees and carried interest (a widely used profit sharing scheme), returns from private equity outperformed the S&P 500 by 3 per cent. “So private equity is generating value somewhere, but its fee structure means the general partners capture double the out-performance they generate,” said Mr Gottschlag, who is also head of research at Peracs, an advisor to buy-out investors.
The research was based on data collected from investors in 852 private equity funds raised before 1993, to be sure they had sold all their assets. But Mr Gottschlag said analysis of more recent funds showed
their performance had been similar.

This new study confirms the work of previous studies I looked at in doing research for my upcoming book on alternative investments.

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larryswedroe
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url for the full study

Post by larryswedroe » Tue Nov 27, 2007 11:01 am


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ddb
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Re: Private Equity, who gets rich? Guess?

Post by ddb » Tue Nov 27, 2007 11:17 am

Excluding fees and carried interest (a widely used profit sharing scheme), returns from private equity outperformed the S&P 500 by 3 per cent. “So private equity is generating value somewhere, but its fee structure means the general partners capture double the out-performance they generate,” said Mr Gottschlag, who is also head of research at Peracs, an advisor to buy-out investors.
Okay, so private equity has outperformed the S&P 500 over some time period (before fees), and Mr. Gottschlag concludes that the managers are "generating value"? Does he really think that the S&P 500 is a reasonable benchmark for this asset class, and that a before-fee outperformance indicates value-added?

Without knowing too much about the private equity asset class, I'm going to guess that private equity managers are typically buying small companies that they perceive to be undervalued. So perhaps Small Value would be a much more suitable benchmark, which would completely eliminate any perception of value-added by these managers (as SV has historically outperformed the S&P500 by more than 3% per year).

While somewhat interesting, the results of this study are not-at-all surprising. Hedge fund and private equity managers are the new Wall Street brokers. "Where are all the customer's yacths?" Good work if you can get it!

A good friend of mine was recently recruited by a small NYC private equity firm, and I must admit to being envious of his compensation and bonus structure!

- DDB

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Post by larryswedroe » Tue Nov 27, 2007 12:21 pm

DDB

Yes one should adjust for risk-and the author notes that for example these funds use significant leverage and their reported returns should be adjusted for that.

And yes small value stocks or microcaps would be a better benchmark--
So what?

That would only make the data look even less favorable for private equity.

I am certain that the data surprises most people--otherwise how do you explain why all this money is flowing into private equity despite the poor returns?

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ken250
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Post by ken250 » Tue Nov 27, 2007 12:24 pm

Swensen issued the warning on PE several years ago in "Unconventional Successs"...basically, individual investors should avoid PE because they are not being compensated for the risk taken.

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stratton
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Post by stratton » Tue Nov 27, 2007 12:28 pm

This pretty much validates Swensen's observations from Pioneering Portfolio managment. The top 25% of PE managers have incredible returns and show repeated high returns. The bottom 25% have repeatedly bad returns. The middle 50% aren't too great either. Unless you can get the top 25% managers you might as well not invest. The top managers have no problems getting funds and we don't have access too them.

This is one area where management does count.

I'm not sure how Business Development Companies fit in. They are not private equity in the sense of Swensen and probably the cited report.

Paul

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Post by ddb » Tue Nov 27, 2007 12:53 pm

larryswedroe wrote:And yes small value stocks or microcaps would be a better benchmark--
So what?

That would only make the data look even less favorable for private equity.
Exactly! Mr. Gottschlag concluded that on a pre-cost basis, private equity may actually offer some value. But with a proper benchmark, the strategy hasn't even been useful on a pre-cost basis (unless, I suppose, it has very low correlation with other more traditional asset classes, but I suspect this isn't the case).
I am certain that the data surprises most people--otherwise how do you explain why all this money is flowing into private equity despite the poor returns?
Yeah, it will surprise most people, but probably not most of us who spend time here. The fact that so much money is trying to get into private equity is a good enough indication that it isn't a worthwhile strategy!

- DDB

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The Economics of Private Equity Funds

Post by Barry Barnitz » Wed Nov 28, 2007 4:16 am

The Economics of Private Equity Funds by Metrick, Andrew and Yasuda, Ayako, (September 9, 2007). Swedish Institute for Financial Research Conference on The Economics of the Private Equity Market
This paper analyzes the economics of the private equity industry using a novel model and dataset. We obtain data from a large investor in private equity funds, with detailed records on 238 funds raised between 1992 and 2006. Fund managers earn revenue from a variety of fees and profit-sharing rules. We build a model to estimate the expected revenue to managers as a function of these rules, and we test how this estimated revenue varies across the characteristics of our sample funds. Among our sample funds, about 60 percent of expected revenue comes from fixed-revenue components which are not sensitive to performance. We find major differences between venture capital (VC) funds and buyout (BO) funds, the two main sectors of the private equity industry. In general, BO fund managers earn lower revenue per managed dollar than do managers of VC funds, but nevertheless these BO managers earn substantially higher revenue per partner and per professional than do VC managers. Furthermore, BO managers build on their prior experience by raising larger funds, which leads to significantly higher revenue per partner and per professional, despite the fact that these larger funds have lower revenue per dollar. Conversely, while prior experience by VC managers does lead to higher revenue per partner in later funds, it does not lead to higher revenue per professional. Taken together, these results suggest that the BO business is more scalable than the VC business.
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Post by astroturf » Wed Nov 28, 2007 9:08 am

ddb wrote: Yeah, it will surprise most people, but probably not most of us who spend time here. The fact that so much money is trying to get into private equity is a good enough indication that it isn't a worthwhile strategy!
Another indication is that some of the private equity firms are going public, e.g., Blackstone. This stock has gone from a high of $38 to around $21.

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Robert T
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Private equity

Post by Robert T » Wed Nov 28, 2007 9:34 am

.
Below is an extract from the Yale Endowment Annual Report 2000. Several striking numbers for private equity (leveraged buyouts and venture capital).

Over the 10 years to 1999.
  • - The range of returns among private equity mangers was huge at about 25% of an annualized basis between the first and third quartile – in contrast to the corresponding 4% dispersion for US large cap stocks.
    - The median private equity returns are similar to US equities
    - The third quartile private equity returns were lower than the returns of US treasuries.
Since inception (1973) the Yale Endowment Private Equity returns have been over 30% on an annualized basis (i.e. within the first quartile of manager performance).

My take: Manager selection drives private equity portfolio returns. Entities like the Yale Endowment have the capacity, resources, assets to select the best managers, individual investors are at a significant disadvantage. The private equity funds ‘accessible’ to individuals are likely closer to third quartile returns than first quartile. Why take the manager risk, time and energy to try to invest in this area when equities have provided close to median private equity returns.

Dispersion of Active Management Returns

Code: Select all

Asset Returns by Quartile. Ten Years Ending December 31, 1999

Asset Class              First     Median    Third 
                        Quartile            Quartile   Range
U.S. Fixed Income          8.3       7.8      7.3       1.0 
U.S. Large Cap Equity     19.5      17.6     15.3       4.2
U.S. Small Cap Equity     21.8      17.9     15.1       6.7
International Equity      13.0      11.7     10.3       2.7
Emerging Markets Equity   16.7      13.9      9.2       7.5
Real Estate                8.7       5.8      1.3       7.4
Leveraged Buyouts         29.8      18.6      5.2      24.6
Venture Capital           30.7      16.7      4.3      26.4

Source: Yale Endowment 2000 Report
Here's and extract from one of Grantham's letters April 2007.

"Private equity has been growing in the last 3 years even faster than hedge funds with the leading firms leap-frogging each other in the size of new funds raised, with several already well over $10 billion. The dirty secret here is that their ‘2 and 20’ fees are not justified by any positive alpha (or outperformance of the asset class) at all....

...there is a huge and remarkably consistent difference between the best and the worst of them, so this is an area where endowments and others with the resources, talent, and pull have exercised those advantages. Accordingly, the early moving and skillful institutions have picked the better managers that are now largely closed. These better managers have produced wonderful performance in the range of 20% to 30% compounded per year. In stark contrast, the larger, later arrivals have barely averaged a return that is even positive. More to the point perhaps, the cap-weighted average is at best, depending on the analysis you read, equal to the S&P 500. It does this, however, by sometimes leveraging over 4 to 1 in today’s market. 2 to 1 leverage on the S&P 500, let alone 5 or more would have produced a much higher return, order of magnitude 21% compared to 14% max for private equity (source: Private Equity Performance: Returns, Persistence and Capital Flow by Steven N. Kaplan and Antoinette Schoar, November 2003). However, fees of ‘2 and 20’ charged on 21% could account for this gap, so there may not actually be a negative alpha pre-cost – lucky investors!"

Robert
.

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Diver
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Post by Diver » Thu Nov 29, 2007 4:36 pm

I wonder what would explain excessive Red Rocks Listed Private Equity Index returns ? the domestic one has 20.96% for last 10 years (ETF: PSP) and international one has 22.22% for last 10 years (ETF: PFP)

even if S&P500 is not appropriate benchmark, the PE indexes still beat SV indexes (1,3,5, 10 years):

Russell 2000 Value Index 6.09 12.51 18.70 10.07
S&P Citigroup Small Cap Value Index 10.02 13.03 18.41 9.81
Dow Jones US Small Cap Value Index 3.44 9.66 14.55

not picking on anything, just curious. I also wonder what is correlations of this 2 above menioted instruments with S&P500 and EAFE ? anyone has the numbers ?

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Post by stratton » Thu Nov 29, 2007 4:58 pm

Diver wrote:I wonder what would explain excessive Red Rocks Listed Private Equity Index returns ? the domestic one has 20.96% for last 10 years (ETF: PSP) and international one has 22.22% for last 10 years (ETF: PFP)
Those are backtesting results and not actual indexes. The funds in question have only been out for the last year or so.

Paul

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Diver
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Post by Diver » Thu Nov 29, 2007 5:00 pm

so the index was invetned and constructed by looking back ? i was under impression that index existed for all this time

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