Excerpted from The Myth of Private Equity: An Inside Look at Wall Street’s Transformative Investments by Jeffrey C. Hooke. Copyright (c) 2021 Jeffrey Hooke. Used by arrangement with Columbia Business School Publishing. All rights reserved.
When a publisher receives a book proposal, it is not unusual for the publisher to ask outside authors, experts, and academics to review the proposal and to make comments on the book’s content and marketability. This book outlines the mediocre performance of leveraged buyout funds, as well as the funds’ continuing ability to cloud this fact. One reviewer for a prospective publisher of the book had this to say:
Mr. Hooke can’t be right about the leveraged buyout industry. If he were, the participants in this part of the capital markets would be suffering from a mass hallucination!
This reviewer’s opinion is simply wrong. The buyout phenomenon, which has taken hold of 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 Not The Same As It Was Before
The buyout business is not what it was twenty years ago, and it is living off a reputation for high returns that is now undeserved. This conclusion contradicts accepted Wall Street wisdom—but as one bond trader said about commonly held beliefs in financial markets, “It’s the accepted wisdom, until it isn’t.” Such became the case with the abrupt endings to the mortgage-backed-securities and dot-com stock crazes. For now, despite any number of statistical studies that show buyout funds do not perform as advertised, the industry still has positive buzz. Over the last eighteen months, for example, six new $10 billion-plus funds have opened, and 2020 was the best year ever for buyout fundraising. Last year, Calpers, the $400 billion California pension plan that is the bell cow for hundreds of institutions, announced that it will increase its allocation to private equity funds to get a better yield. Yet the plan’s total-value-to paid-in ratio for private equity investments over thirty-five years is only a modest 1.5x, which puts the plan’s PE portfolio in neutral territory compared to stocks.
How has the industry’s mystique gone unchallenged for these many years, enjoying a lifespan that is two to three times longer than other investment fads? In part, the secrecy of the industry and the complexity of its data have blocked the most intrepid doubting Thomas from confirming suspicions. The mortgage-backed-securities and dot-com investments were publicly traded, and, over time, skeptics were able to point repeatedly at adverse information to build up credibility. In contrast, the rates of return, fees, and diversification attributes of the buyout asset class are shrouded in a numbers fog. An investigation surrounding the last fifteen years’ of performance remains dependent on what the industry says its unsold companies are worth, even as the high proportion of unsold investments—56 percent at last count—suggests that few portfolio firms have willing buyers at reasonable prices. Otherwise, the funds would have sold the investments and moved on.
A Self-Perpetuating Feedback Loop
Meanwhile, a self-perpetuating feedback loop allows the industry to operate in a parallel universe where the laws of financial physics do not apply. To illustrate, buyout managers sell their product as a way to beat the stock market; however, for the last fifteen years, the average fund underperformed the S&P 500. The managers say the product has less risk than the stock market and low correlation to it, but both assertions are refuted by the proven impact of leverage on corporate value movements. The established relationship between debt and equity is based on sixty years of classical finance theory and is endorsed by Nobel laureates such as William Sharpe, Harry Markowitz, and Merton Miller. Special accounting rules, approved by the appropriate authorities, permit PE managers to mark-to-market their own portfolios with minimal oversight and empower institutional investors to ignore expensive carried interest fees. Compounding this oddity is that the carried interest can kick in even when a fund underperforms the stock market. “Don’t ask, don’t tell” becomes the institutional refrain with respect to such elevated fees. A lack of regulatory standards provides the funds with the latitude to choose among multiple yardsticks for performance assessment and top-quartile ranking. The reliance on easily manipulated internal-rate-of-return (IRR) measurements, instead of the more neutral total-value-to-paid-in ratio, distorts actual economic returns at a time when investors need accuracy. The industry’s principal customers—state and municipal pension plans, university endowments, fund-of-funds, and nonprofit foundations—have administrators who commit their employers to private equity for career preservation, since the logical investment choice—a low-cost public stock index fund—obviates the need for their own jobs. Regulatory agencies, such as the IRS, SEC, and Department of Labor are noticeably absent. And thus, the feedback loop that perpetuates the business is complete.
The longevity of the feedback loop rests on a key underpinning, according to one observer: “Everyone makes money except the beneficiaries (of the institutional investors), so the system lives on.” Private equity managers, investment consultants, and institutional executives make good livings at the expense of state and municipal retirees, university students, fund-of-funds clients, and foundation grantees, so no one wants to blow the whistle.