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Private Equity, High Fees and Risk: Oct 26, 2014

John Gorlow | Oct 26, 2014

Behind The Private Equity Curtain Lurk Excessive Fees and High Risk

As recently as last year, and for the first time in 80 years, federal regulators lifted a ban on advertising allowing hedge funds and private equity buyout firms to now promote their products to the general public. This piece of legislation fundamentally changed the way in which private placement issuers raise money and affords them an opportunity to collect even more in management fees. For decades the private offering giants persuaded institutions and university endowments to entrust them with investing billions of their dollars while promising diversification and better returns than the general market.

What is happening now?  Simply put, the private offering titans are busy crisscrossing the country with cleverly designed marketing campaigns specifically designed to target investment advisors to pitch private equity access to their clients. And as hedge funds have lost some of their cachet amid poor performance, many investment advisors are giving into private equity offerings as a way to make up for their lost fees.

The private equity industry sees individual investors as a largely untapped source of capital. But investors must understand that private equity products carry some of the highest risk and include some of the most punishing fees.  The terms of these products, including what investors pay to participate in them, are convoluted and often hidden from view. For example, in addition to annual fees paid to the financial advisor, investors typically pay 1 to 2 percent of their capital plus 20 percent of any profits to the private equity fund. And, if a middleman is involved between the private equity fund and the investment advisor, investors who put up the capital may pay an additional 1 to 2 percent in fees plus expenses on their capital on top of the 1 to 2 percent of assets charged by the private equity fund in which they invested.

By way of background, private equity firms raise funds to buy stakes in operating companies that are not publicly traded on stock exchanges.  And often, these companies are leveraged with debt in the process, a tactic that adds risk. The firms typically hold the companies for three to five years, seeking to revamp their finances and hopefully sell them for a profit. Investors who provide equity capital to these ventures get to share in the profits, although their money is typically locked up for at least three years and sometimes up to ten years before they see the result.

In short, no informed investor or fiduciary should trade the transparency and liquidity of public equity markets for the false promise of additional returns and supposed diversification benefits of private equity.

Case in point, former banker Peter Morris analyzed the returns on 110 private deals in the UK and Europe over a decade extending from 1995 to 2005. The average rate of return on those deals was 39% of which debt accounted for 22% and a rising stock market accounted for 9%. The other 8% came from the contribution of the private equity manager. But given that the average annual fee in the private equity deals in the Morris study was at least 8 percent, investors who provided the bulk of the capital would have been better off borrowing and investing in the market directly.

To paraphrase Eugene Fama and Ken French, insofar as private equity managers adding value through the application of their skills, bear in mind that any additional return tends to go to the manager themselves.  Fama and French also point out that returns from private equity deals tend to have a wide range of outcomes making it very difficult for anyone to discern whether the returns they are paying for are due to luck or skill.  Finally, Fama and French also dispute the notion that private equity is a so called “diversification tool”. In their estimate, the type of targets chosen by private equity, namely small companies, tend to be highly sensitive to the market.

While private equity can generate impressive returns, once these returns are adjusted for high risk and excessive fees, there is virtually no chance for the manager to add return over what the market would have delivered anyway. Not to mention that if some manager were lucky enough to generate some additional spoils, these would tend to go to the manager and not to the investor. All that shines is not gold. Investors beware.


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