Beware of Venturing into Private Equity

Transcription

1 Beware of Venturing into Private Equity Ludovic Phalippou Associate Professor of Finance University of Amsterdam Business School 2009 LUDOVIC PHALIPPOU 1

2 Private equity can seemingly do no wrong in investors' eyes. The industry is raising record amounts and returns have outstripped those from equity markets in the past few years. (3 April 2006, Financial Times) Really? Performance? Conflicting interests? Compensation? Risk? 2

3 Regulating private equity buyouts 3

4 How are funds structured? Background: How are funds structured? Most private equity is invested via partnerships of a limited duration Commitments by investors in multiple closings Cash flows from investors Cash flows to investors 1 year 10 years 3 years Marketing Draw down/investments Divestments Extension Follow-on fund Marketing 4

5 Presentation outline Fees charged by private equity funds Salient fees: Management fees Incentive fees Hidden fees: fees on portfolio companies Quantifying all the fees Risk and performance of the private equity fund industry (Potentially) Misleading investor information (Potentially) Misleading compensation contracts Shrouded relevant performance information for due diligence (Potentially) Strategic grouping of funds or investments Misleading performance metric 5

6 Presentation outline Part A: Fees charged by private equity funds Salient fees: Management fees Incentive fees Hidden fees: fees on portfolio companies Quantifying all the fees 6

7 Management fees Annual management fee is 2% of capital commitments until the end of the investment period. Thereafter, it is 2% of funded capital commitments outstanding. The management fee is payable semi-annually in advance. Investors pay a fixed (load-type) fee at the beginning: Organizational expenses usually $1 million 7

8 Presentation outline Part A: Fees charged by private equity funds Salient fees: Management fees Incentive fees Hidden fees: fees on portfolio companies Quantifying all the fees 8

9 The working of carried interest Example Assume a $250M average buyout fund made 2 successive investments of $110M each. Both investments return 8% on assets per year and are exited after 5 years. Capital divested from each investment = $220M Fund manager gets 20% of $110M ($220-$110), which amounts to $22M of carried interest) after year 5 and after year 10 Investors get $220-$22 = $198M after year 5 and after year 10 9

10 Comments 1 Compensation contracts are like in any other asset class at first sight. But, they are long, complex, and details are the main drivers of the fee bill. 10

11 Comments 1 Compensation contracts are like in any other asset class at first sight. But, they are long, complex, and details are the main drivers of the fee bill. 2% management fees p.a., but Watch out for the basis Management fees end up being, respectively, 10% in the first year, 5% in the second year, etc. of the capital invested (relevant basis). Doubles fees! In our example: 250M*2%=$5M p.a. versus 110M*2%=$2.2M p.a. 20% incentive fees, but Watch out for the basis, and for the claw-back provision (is it there? accrued interests? Tax?), is it a hard hurdle or a soft hurdle? In the example, manager gets $22M (soft hurdle). A soft hurdle would have given 20% of ($220-$110*(1.08^5)), i.e. $11.7M; half! 11

12 Presentation outline Part A: Fees charged by private equity funds Salient fees: Management fees Incentive fees Hidden fees: fees on portfolio companies Quantifying all the fees 12

13 Fees on the portfolio companies Investors pay a) All external expenses: expenses related to proposed but unconsummated investments (lawyers, accountants, advisors), taxes, litigation, annual meetings etc. b) Part of internal expenses: i) expenses related to the purchase, holding and sale of portfolio companies (usually 50% of total) ii) advisory and monitoring fees (usually 80% of total) iii) director fees (usually 100% of total) These fees are high and we know little about their magnitude; their exact amount are not specified in the summary of terms and conditions. 13

14 Comment 2 Exact refunding rule is important. Contractual. Wide variations. Transaction fees: 12% of funds do not refund anything, of those that refund something, 1/3 refunds all transaction fees, 1/3 refunds 50%, 1/3 refund an amount in between these 2 numbers. Some firms do not charge any. Monitoring fees: most funds refund 80% of these fees to investors, some firms do not charge any. Amounts charged are not contracted ex-ante How to get protected against hold-up? Note: Non-salient Huge conflicts of interest! E.g. Over-charge? Hire preferred investors? Any kick-back on external fees? 14

15 Presentation outline Part A: Fees charged by private equity funds Salient fees: Management fees Incentive fees Hidden fees: fees on portfolio companies Quantifying all the fees 15

16 Fees - Average fund (with size of $250M) Management Carried Portfolio Company fees Cash flows Date Fee Interest Transaction Monitoring Net Gross Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec NPV Yearly fee 1.67% 2.59% 2.07% 1.74% Multiple IRR Fees: 7+% p.a % 17.98% MIRR 10.27% 12.85% For poor perf. 16

17 Comment 3 Huge reward even when performance is poor Most fees are fixed, and not variable Investors do not see 75% of the fee they pay Steep incentive to manage large funds and not to maximize returns (It is much better to manage $1 billion returning 10% net than $100 million returning 50% net). 17

18 BUT: Co-investment opportunities They can affect significantly your performance but Which deals do you get invited to (superior, inferior, riskier, )? And affect significantly your fee bill (co-investments are fee-free) but How many will you get invited to and, again, how good are they? No public studies on this topic key to assess the weight of fees and to know performance Note: Enable a first order discrimination in fees (also via side letter) 18

19 Conclusion: Research on fees Fees are high, even for relatively low performance (7-8% p.a. for average fund) Fixed part of fees is large (although portfolio company fees may increase with performance) Compensation via co-investments is the missing part of the picture Compensation contracts are at first sight like in any other asset class. But, they are long and complex, and details are the main drivers of the fee bill There is (hidden) wide heterogeneity across compensation contracts The salient fees are small; most fees are non-salient 19

20 Presentation outline Fees charged by private equity funds Salient fees: Management fees Incentive fees Hidden fees: fees on portfolio companies Quantifying all the fees Risk and performance of the private equity fund industry (Potentially) Misleading investor information (Potentially) Misleading compensation contracts Shrouded relevant performance information for due diligence (Potentially) Strategic grouping of funds or investments Misleading performance metric 20

21 Conclusion: Research on risk and return Average fund underperforms S&P 500 by 3% p.a. net of fees (Phalippou and Gottschalg, RFS 2009) it is not a good add to a diversified portfolio Both venture capital funds and buyout funds underperform the S&P 500 NAVs of mature inactive funds are largely overstated Beta of venture capital is in the range of 3 and 1 for buyout (Driessen, Lin and Phalippou, 2008) Other database of buyout investments, although upward biased confirm these numbers (PPM dataset: Lopez-de-Silanes and Phalippou, CEPRES dataset: Franzoni, Novak and Phalippou) 21

22 Presentation outline Fees charged by private equity funds Salient fees: Management fees Incentive fees Hidden fees: fees on portfolio companies Quantifying all the fees Risk and performance of the private equity fund industry (Potentially) Misleading investor information (Potentially) Misleading compensation contracts Shrouded relevant performance information for due diligence (Potentially) Strategic grouping of funds or investments Misleading performance metric 22

23 Presentation outline Part C: (Potentially) Misleading investor information (Potentially) Misleading compensation contracts (see above) Shrouded relevant performance information for due diligence (Potentially) Strategic grouping of funds or investments Misleading performance metric 23

24 Presentation outline Part C: (Potentially) Misleading investor information (Potentially) Misleading compensation contracts Shrouded relevant performance information for due diligence (Potentially) Strategic grouping of funds or investments Misleading performance metric 24

25 Current performance reporting standards Accounting information often missing; difficult to judge accuracy of valuations (new regulation should help) Accounting is conservative at first, then aggressive for older investments. Duration (missing, date first investment/exit) Useless to provide a multiple without duration (or with wrong one) Leverage Useless to provide a return without leverage Net-of-fees performance not reported (more likely for bad funds) Missing fee details information (portfolio company fees etc.) Shrouded negative internal rates of return Selected track record (past experience or specific investment focus) Can group funds can be used in a strategic way (see next section) 25

26 Shrouded negative IRRs Multiple range All US Liquidated ( ] (166) (95) (98) ( ] (367) (195) (178) ( ] (402) (200) (120) ( ] (1458) (641) (603) ( ] (1539) (794) (1029) ( (715) (476) (536) All (4647) (2401) (2564) NB: If multiple is zero then IRR is not reported in 98% of the cases 26

27 Keeping losers at cost Non liquidated investments valued at a loss, at cost or at a gain Age (years) Loss At cost Gain Nobs (0-1] (1-2] (2-3] (3-4] (4-5] (5-6] (6-7] Main problem with accounting: investments not written down, especially in early years bias overall performance figures Exacerbated by the convention of showing separately partially-exited/exited investments and non-exited investments. Best is to exclude all investments over previous 3 years 27

28 Presentation outline Part C: (Potentially) Misleading investor information (Potentially) Misleading compensation contracts Shrouded relevant performance information for due diligence (Potentially) Strategic grouping of funds or investments Misleading performance metric 28

29 Illustration: The case of IRR Date Fund 1 Fund 2 Fund 3 Fund 1&2 Fund 1&2& IRR 162% -6% -10% 153% 152% MIRR 20% 5% 1% 16% 14% About 50 percent of the firms pool all their investments. Further research will investigate the characteristics of those pooling to see whether funds with early successes are more likely to pool, but preliminary results are consistent with this assertion 29

30 Presentation outline Part C: (Potentially) Misleading investor information (Potentially) Misleading compensation contracts Shrouded relevant performance information for due diligence (Potentially) Strategic grouping of funds or investments Misleading performance metric 30

31 Why can IRR be misleading? IRR suffers from re-investment assumption; particularly problematic in private equity b/c of potential strategic timing. Top performance is exaggerated by definition (Gottschalg and Phalippou, Harvard Business Review, Nov 2007). So is dispersion. Cannot average IRRs; particularly problematic in private equity b/c correlation between performance and duration is large. Sample of 3,600 buyout investments: average value-weighted IRR is 34% (gross-of-fees). 34% is obviously extremely large and may be responsible for perception that past buyout performance is large. But, good returns do not last for as long as bad returns. In this sample the correlation between duration and IRR is -35%. If weight each IRR by both duration and size, average IRR is 15%. Obviously less impressive for a gross-of-fees return. Note: Cannot compare IRR to public equity returns 31

32 Conclusion: Research on return reporting Current reporting standards make past performance information useless and misleading (except for very low performers) 32

33 Private equity can seemingly do no wrong in investors' eyes. The industry is raising record amounts and returns have outstripped those from equity markets in the past few years. (3 April 2006, Financial Times) Really? Performance? Conflicting interests? Compensation? Risk? 33

34 Contact information This presentation is based on an article to appear in the Journal of Economic Perspectives (Winter 2009) Part of this talk can be heard on a CFA institute podcast: Related research articles are available on SSRN.com: 34