Private equity: who profits?

Private equity has been growing rapidly in recent years, presumably reflecting superior performance? Maybe not. A new study for the European Commission by Oliver Gottschalg from HEC business school in Paris suggests a quite limited improvement in returns, and which is scooped up in management fees. Martin Arnold reports in today's Financial Times: Doubt cast on buy-out firms' huge profits

Based on data from 6,000 private equity deals and about 1,000 buy-out funds, the survey shows that average private equity returns have underperformed the benchmark S&P 500 share 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," Oliver Gottschlag, who compiled the research, 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 adviser 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.

In a related piece, Another black mark, Gottschlag explains why reporting of equity returns is misleading:

He argues the internal rate of return (IRR) measure used as a benchmark by most buy-out firms is "misleading" as it exaggerates profits and disguises poor performers.

"Our research shows the way private equity fund performance is most often reported overstates the truth," Mr Gottschlag writes in next month's Harvard Business Review.

The IRR measure assumes that any cash proceeds returned early to investors is reinvested at the IRR rate over the investment period, which risks inflating performance.

Stripping out this inflationary effect - by assuming early cash to investors is invested at a 12 per cent return - Mr Gottschlag said the IRR of the top performing fund in his sample of 1,184 firms fell from 464 per cent to just 31 per cent.

I cannot find the UC paper on the web. But an earlier working paper, Performance of Private Equity Funds, is available online.

Comments

[Lafayette]

The fact that buy-outs (consolidations, fusions, etc.) have never added one cent to public stock-holder value has been amply proven stateside. Several studies have demonstrated this less than illustrious fact. (Private equity, however, is admittedly something else.)

Those who make the money are the "Masters of the Universe". (From the book, Bonfire of the Vanities, by Tom Wolfe.) That is, those who work for the Investment Banks (like Goldman, Sachs). These "merger consultant" (or management) fees can be as much a 1 to 1.5% of the TOTAL VALUE of the transaction, shared by the officers of the Investment Bank.

It is one of the factors that has lead to the Income Inequality ravaging America today.

Never has so much been paid to so few for so little.

NB: Worse yet, in terms of moral indecency, is the cyclic fadishness of mergers and breakups. Mergers happen supposedly "to benefit from economies of scale". Breakups happen supposedly to "get closer to the customer". The reasons management put forward are often hilarious. What is less exhilarating however is how these manipulations always seem to favor financially Top Management and not the stock holders.

[Arthur Eckart]

Lafayette, "Income Inequality ravaging America today." You seem to believe income inequality is something to be avoided. The U.S. raises absolute living standards and promotes upward mobility for almost everyone in the country, including millions of Third World immigrants. That seems to be better than attempting to make everyone more equal at huge costs. Unfortunately, income redistribution through government intervention hasn't had the desired effects. Perhaps, more ethics should be taught in school instead (for both upper and lower income students).

[Lafayette]

AE: You seem to believe income inequality is something to be avoided.

And you're blind.

America has about the same Gini coefficient as China. (Look it up.) That's something America should be proud of?

Not reasonably.

[Arthur Eckart]

Lafayette, the Gini Coefficient only measures relative income inequality and only reflects the production side of the economy. Obviously, U.S. absolute income is much higher than the E.U., while the U.S. consumption side has a great equalizing effect. Some E.U. economic countries actually promote inequality, along with immorality, in their attempts to reduce inequality.

[Lafayette]

AE: Some E.U. economic countries actually promote inequality, along with immorality, in their attempts to reduce inequality.

Do come back to the forum when you think of something that makes sense.