Private equity business is ‘not all it’s made out to be’

Newswise — According to Jeffrey C. Hooke, senior lecturer at Johns Hopkins Carey Business School, private equity (PE) “is a current manifestation of the irrationality that grips Wall Street from time to time.” The private equity industry harbors a certain mystique, he says, because the lack of public information about it blocks the scrutiny enjoyed by public equity markets. Private equity firms and fund managers claim that their investments offer better returns than the stock market. But is it true?

In his latest book, The Myth of Private Equity: An Insight into Transformative Investments from Wall Street, Hooke likens the current private equity craze to the internet stock boom of the late 1990s and the mortgage-backed securities craze that led to the 2008-09 financial crisis. He explains the foundation of private equity and why, despite the industry’s recent downward trend, a “protective ecosphere” allows it to endure, to the detriment of its investors and their beneficiaries. In the following Q&A, the author explains the central themes of the book and why he felt compelled to write it.

What is private equity?

Private Equity is an asset class for investing in companies not listed on the stock exchange. Private equity firms such as Blackstone, KKR and Carlyle, to name a few, raise capital from large institutions such as public pension funds, university endowments and charitable foundations. Private equity funds, which typically have a 10-year lifespan, are managed by investment bankers, with a sprinkling of management consultants. The funds buy private companies, then try to improve and sell them, all within the 10-year window. The sequence of events resembles a “house flip”.

How do private equity firms make money?

Private equity firms make a profit on the annual management fee (paid by their institutional investors). If companies sell a business that has improved in value, they get a share of the profits. Fees are 3 or 4% of the annual asset value, which is much more than what you pay for public mutual funds. Most fees are paid if the underlying funds perform well, and private equity funds invest very little of their own money to share in the profits. It doesn’t get better than this on Wall Street. Many people confuse private equity funds with their distant cousin, hedge funds. Hedge funds also pool capital and invest it, but hedge funds primarily trade in publicly traded stocks and bonds, not private companies.

So what are some of the problems with private equity?

PE describes itself as the greatest thing since sliced ​​bread, but its big marketing claim that its returns are crushing the public stock market is blatantly untrue. In fact, returns over the past 15 years have been pretty mediocre, either just par with the stock market or below.

Since 2010, private equity funds have not sold more than half of their investments. Unlike public stocks that are priced daily, investors must trust what private equity funds say these unsold investments are worth. So basically the PE industry is rating its own homework.

PE premium returns tend to be produced only in the top quartile of funds, but as many as 75% of funds insist they are in the top quartile. Industry is a real life version of Garrison Keillor’s Lake Wobegon, where every child is above average.

The industry is not at all transparent. Even investors complain about secrecy. Investigative journalists, investor advocates and others struggle to get accurate information about returns and fees. The industry manipulates the little published information to cast poor performance in a favorable light. Unfortunately, regulatory oversight is absent and there is no sheriff in town despite the PE being a multi-billion dollar business.

So why are institutions still investing?

I often get this question. Most institutional boards are smart people with little investment savvy. They leave portfolio choices to the institution’s investment managers, and the career and compensation interests of these managers are not properly aligned with those of the institution’s beneficiaries. Fiduciary duty thus becomes an abstract concept. I’m not the only one saying this.

But surely there is something good about investing in private equity. Blackstone’s stock is up 80% over 12 months.

Law. PE is good business for managers, like Blackstone. They make significant fees whether their underlying funds beat the market or not. However, just to clarify, my book does not focus on public stocks, like Blackstone or Carlyle. My problem concerns the private equity funds managed by these companies.

One advantage of holding private equity is the diversification of the portfolio into unlisted companies. Moderate returns and high fees reduce this advantage.

Industry supporters say private equity is good for America.

Proponents of private equity like to go up to Capitol Hill and say that private equity is good for the country because private equity buys distressed companies and rehabilitates them. This notion is a fairy tale, an urban myth. Most private equity deals involve a sound, lucrative business that is then burdened with debt. Banks lend money to businesses that have a profitable track record. Turnovers do not fall into this category.

How does the private equity myth persist?

The protective ecosphere of industry is strong. A coterie of enablers, some unwittingly, maintain the myth. Regulators have been absent and afraid to challenge the PE giant. Federal and state lawmakers are coddling the company. The accounting profession enacts special accounting rules for EPs that encourage concealment. Consultants, who are paid more for pushing exotic asset classes, recommend private equity over higher-yielding public stocks. And, of course, as I mentioned, managers at clients (i.e. large institutions) promote private equity, because pegging a portfolio to just a public index is a career threat .

Business media covers the sexy side of the industry – fund managers, new deals, etc. The few people who want to investigate the company come up against a brick wall. Other journalists think that writing critical articles prevents access to the industry. Who would want to do that?

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