The New Tycoons

by Jason Kelly

  “You either have a superior insight, specialization, an angle that helps you pay a little more than the others, or you nudge the debt package and pay a higher price because you need to invest,” Neil Harper, managing director at Morgan Stanley’s private-equity fund-of-funds unit in Europe, told Bloomberg in 2010. “The concern is that you have more of the latter than the former. This will affect returns.”8

  Investors also worry because there are fees involved in every transaction, and those are ultimately paid mostly by the backers of private-equity funds. At one point in late 2010, almost half of the buyouts by value in Europe involved this type of deal, known technically as a secondary buyout. One investor estimated that the cost of buying and selling a company amounts to 2 percent to 5 percent of the purchase price. Using that math the $35.3 billion in global secondary deals during that period in 2010 cost as much as $1.8 billion.9

  While taking a company public may not be the fastest way to get money back and passed on to investors, there’s an argument that it’s the most equitable and sensible, when done right. It also seems to align the investor with the company and its future shareholders, since they have a stake in the company going forward for some period of time.

  Let’s go back to Dollar General. KKR had a heavy incentive to take the company public at a time and a price where the company could continue to grow its earnings and, therefore, its stock price. If the stock price continued to go up, KKR and its co-investors could methodically sell their shares for more and more money down the line, a theory that played out for the first two years after Dollar General’s IPO.

  That would seem to be ideal for everyone across the private-equity equation. The money goes in, is put to work, and in a reasonable amount of time starts to come back, in measured amounts that add up to a hefty return for the investors. Meanwhile, the company has a chance to thrive in the public markets, giving other investors the chance to participate in its growth by buying and selling the public shares. The original investors retain a large enough stake in the firm for a time that they have an incentive to encourage the company to keep performing.

  A crucial element of the entire conversation around private equity is not just the ultimate returns, but how they are measured and, ultimately, how they are judged. One way that argument has played out in recent years is a nerdy debate on evaluating a firm on percentage returns versus cash returns. Call it the “You can’t eat IRR” debate.

  The measuring stick for private equity has long been internal rate of return, or IRR, and you can’t have a conversation with any manager without talking about that metric, or being told unprompted if it’s especially good. We all measure investments in terms of returns, whether we’re talking about our 401(k) or the appreciation of our house or how much stock in Home Depot has gained or lost in a week, a month, or a year.

  What private equity’s backers learned the hard way is that looking at performance purely on that basis isn’t going to cut it. Internal rate of return is basically a fancy way of saying how much your money appreciated, on average, over the time that it was invested. What’s important to note is the time element. That is, the quicker the gains are booked, the higher the IRR and the better the manager looks when he goes to market his next fund.

  Here’s the issue: Pensions can’t use IRR to fund a retirement plan. A university endowment can’t give financial aid or pay a maintenance worker in IRR. They need cash, real money that can be deposited in a bank. For a private-equity fund to really be of use to its investors, it needs to deliver those returns in the form of money coming back, in healthy multiples of what the pension or endowment put in. An analysis by Bloomberg News in 2009 showed how much a handful of public pensions had at stake in private equity. From the beginning of the decade, three big pensions in California, Washington state, and Oregon had together committed at least $53.8 billion to private-equity funds. As of the end of 2008, they’d only gotten $22.1 billion back.10

  A thawed IPO market and overall stabilizing economy helped jumpstart distributions in 2010 and 2011, leading to the record Carlyle number. KKR distributed $5.6 billion that same period.11 Still, the gap that emerged during the first decade of the century showed just how much pensions and other investors had on the line with private-equity funds, and how a nasty couple of years could derail the gravy train. Staff at the plans made it clear that they were growing more and more interested in the actual cash returns, not just IRR numbers. Gary Bruebaker, whose Washington State Investment Board has been one of the biggest contributors to private-equity funds, put it bluntly.

  “I work for over 400,000 employees, and they can’t eat IRRs,” he said in 2009. “At the end of the day, I care about how much do I give you, and how much money do I get back.”12

  As it is with jobs, the academic research around performance of private-equity firms is far from voluminous, and therefore it’s difficult to get a definitive answer on how we should think about how private equity does vis-à-vis the public markets. After all, one of the simplest questions should be: Given the chance to put money in private equity or stocks, what should a person or institution do?

  It’s worth reiterating here that this is a purely theoretical exercise for the average person, who can’t in fact invest in a typical private-equity fund. They are by design limited to accredited investors, which means meeting a threshold of net worth of $1 million in liquid assets or $200,000 in annual income for a single person. This, of course, cuts both ways. It protects the retail investor from putting her money at undue risk. It also prevents her from participating in the lush profits that can be generated through these vehicles.

  Returns, of course, are at the very core of how private-equity firms pitch their services to investors. The most-frequently heard characterization is that a fund is “top quartile,” meaning it’s in the top 25 percent of its peers, better than three-quarters of the rest. The frequency of the claim has become a running joke in the industry, like the contention on the radio show “A Prairie Home Companion” that all the kids in the fictional Lake Wobegon are above average. In other words, it’s mathematically impossible.

  Oliver Gottschalg, the HEC professor, and colleagues conducted an exercise in 2009 that illustrated this very point and underscored how much leeway the managers have in representing their performance. What they found is that private-equity funds rank themselves according to so-called vintage years. But a fund usually takes several years to raise, giving them a range of years to choose from. In addition, there are a couple of different benchmarks to select; the researchers identified both Preqin and VentureXpert. Those benchmarks varied wildly as well, sometimes more than 10 percentage points for a given year. Factoring in that variability to the spread of years and the choice of benchmarks, the researchers identified 500 funds raised during a proscribed number of years. The result: 66 percent of them could justifiably boast of being top quartile on some basis.13 Yet the larger question of how private equity stacks up as an investment on average remains. Investors ultimately need to justify paying fees to these managers far in excess of what they’d pay to stick the money in a mutual fund.

  Steven Kaplan is one of that small cadre of academics who spend their time almost exclusively thinking about and researching private equity. A professor at the University of Chicago Booth School of Business, he’s a widely quoted expert on the industry, and when I checked in with him in early 2012, he was inundated with calls about Mitt Romney and this mysterious club known as private equity. His research on returns is seen as the most rigorous and comprehensive.

  In 2011, he released a new study that surprised some people, largely because it partially contradicted some of his previous work. At issue was a 2005 study by Kaplan and Antoinette Schoar of the Massachusetts Institute of Technology that found average net returns for buyout funds were roughly equal to the S&P 500 Index. That was disheartening, to say the least, for private equity and its investors. The study did point out that the data showed a wide range of performance and “persisten
ce,” that is, that a successful fund tended to spawn more successful funds by the same manager, as well as draw more money for later pools. Still, the main takeaway—private equity was a wash with public stocks on average—was troubling to say the least for the industry’s participants and proponents.

  In the intervening years, Kaplan and others found a problem with his original data set, which was culled from Venture Economics (the basic issue was that Venture Economics appeared to understate returns). In the new paper, written with Robert Harris of the University of Virgina’s Darden School and Tim Jenkinson of Oxford University’s Said School, the researchers used a broader data set, relying primarily on a commercial database from Burgiss that gathered information from limited partners. They used several other sources, including Preqin, Cambridge Associates, and Venture Economics again.

  The result was markedly different: “[I]t seems very likely that buyout funds have outperformed public markets in the 1980s, 1990s, and 2000s,” they wrote. Specifically, they found that between 1984 and 2008 across nearly 600 funds, $1 invested in private equity returned 1.2 times a dollar invested in the S&P.14

  “The bottom line,” Kaplan told me, “is that until 2005 the returns were terrific. For 2006 and 2007 and 2008 it’s probably not going to be as good. It’s too soon to tell.”

  That last thought goes to a couple of other findings beyond the major revelation that returns weren’t so middling after all. One is that as commitments spiked from investors, returns tended to go down. This was bad news for the megafunds spawned in the middle of the first decade of the century. The study also found that multiples of invested capital, not IRR, were a better measure of performance relative to the public markets, more evidence that Bruebaker’s “can’t eat IRR” approach was sound.

  In the quest for simplicity, there is one element of the private-equity conversation that seems clear: Returns are going down. The data bear this out, both in the aggregate and anecdotally, especially at the larger firms. Take CalPERS, whose commitment to private equity is well demonstrated: Over the years, it has committed $66 billion to its alternatives program. Examining the last decade’s worth of performance bears out the theory of falling returns. CalPERS concedes that it’s unfair to judge a fund before it is four to five years old, so it has a chance to make investments and start returning money, or at least pegging a value to what it owns.

  Funds raised in 2003 delivered a 24.3 percent IRR for CalPERS, and 2.1 times its money, right in the range of what most private-equity managers promise. Every year since then, through 2006 when the CalPERS data end, that performance has dropped, to 16 percent, 8.1 percent, and 2 percent, respectively. The multiples, too, have fallen, to 1.5, 1.3, and 1.1.15

  What’s most worrisome for those following CalPERS and other big pensions is the sheer volume of money directed to private equity since then. For 2007 vintage funds, CalPERS committed $14.8 billion to various funds, roughly the same amount the pension committed in the three previous years combined. As of September 2011 (the most recent data available at the end of the year), it was too soon to tell how well those investments would do in the aggregate. Of the $14.8 billion, about $10.8 had been called by the private-equity managers. The cash out and remaining value (the total of realized and unrealized gains, taking into account the current value of the investments) stood at $12.4 billion.

  Dig into the individual funds’ performance, also made available by CalPERS and a handful of other pensions like Washington State and Oregon, and the same trend of declining performance is there. Take KKR’s results at Oregon. The firm delivered undeniably amazing results during the 1980s, when it was the only private-equity manager Oregon invested in. The 1986 fund ultimately returned Oregon $918 million on a $201.8 million investment; Oregon calculates the IRR at 26.3 percent.

  Fast-forward almost two decades. KKR’s Millennium Fund, raised in 2002, won a huge commitment from Oregon; the pension ultimately gave KKR more than $1.3 billion. As of late 2011, about eight years into the fund, the performance was merely respectable. Oregon estimated the IRR at about 17 percent. For Oregon’s $1.31 billion, the pension had thus far gotten $1.33 billion back. Oregon estimated that the remaining value of the investments was around $748 million.16

  Looking at the Oregon list, which is organized by year committed, is an interesting lens to view the incredible growth of the private equity industry, both in terms of the size of the commitments and therefore the size of private-equity funds and the sheer number of funds being raised. After committing money to a total of 27 funds in the 13 years ending in 1994, Oregon committed to 29 funds in 2006 alone.

  The competition for deals surely has hurt returns, according to most experts, and that’s a simple product of a maturing market. The best returns come from investments where there is an information advantage—in other words, I win because I simply know something you don’t or before you do. You never even have a chance to play the game, or my understanding is so far superior that it’s not a contest. A shrinking world and the Internet have helped accelerate that phenomenon; almost nothing is for sale without multiple parties knowing about it and getting a chance to bid, either formally or informally.

  The sheer number of private-equity firms plays a related role. A business this lucrative for its practitioners and its investors can’t stay secret, despite their best efforts. Competition drives up the price buyers have to pay to win an auction; that’s Economics 101. Higher prices on the front end often lead to lower returns. If the ultimate value of what I own is static, my profit from buying it and selling it hinges on how good a deal I can get to begin with.

  This leads to one of the more uncomfortable conversations for private-equity managers, who have long defined themselves in terms of absolute returns—that is, delivering upwards of 20 percent a year no matter what. That may be an egotistical, misguided approach, more and more managers argue. What they should really care about is returns that are good for their investors relative to the public markets.

  Jay Jordan, in addition to running his eponymous investment firm in New York, is the chairman of the endowment at Notre Dame, his undergraduate alma mater. He contends that limited partners ultimately want to put significant amounts of money to work and get a predictable return over a prescribed period of time. As long as that return is several percentage points above their target return (in most cases 8 percent), they are happy. “All they really need to go for is 12 to 15 percent,” he said. “Everyone was so focused on IRRs and not as much on multiples of invested capital. Ultimately, this is about matching to their liabilities.”

  Focusing on lower, less risky returns is something of a radical concept in private equity, but Jordan argues that the most consistent returns come from less risk. “We place a higher premium on losing no money,” he says.

  Big investors’ appetite for predictable returns, even at the risk of bypassing outsized gains, was at the core of the discussions in 2011 that led to the deals between the Teacher Retirement System of Texas and Apollo and KKR, as well as the tie-up between Blackstone and New Jersey’s pension. It is not a coincidence that big pensions are lining up with big private-equity managers, and a number of smart people in the industry predict this represents an inflection point for the buyout industry that will help define the business going forward. It’s a phenomenon that dominates any big conversation about private equity and its future.

  It’s the barbell theory of private equity. On one end there are the bulge bracket names best known on Wall Street and in the world at large: Blackstone, KKR, Apollo, Bain, Carlyle, and TPG. These firms measure their total assets under management in tens of billions, or in some cases hundreds of billions. It’s highly unlikely that they limit their business to private equity. Blackstone is the most extreme example, with about 28 percent of its assets and less than 20 percent of its 2011 revenue coming from private equity. But even Bain and TPG, probably the least diversified of that set of firms, have some combination of hedge funds, real estate, and credit inves
tments in various stages of development.

  On the other end of the barbell are the mono-line private-equity firms, those who have actively chosen, or passively accepted, that they’ll focus almost exclusively on the buyout business. This is where firms like CCMP Capital, the private-equity firm that spun out of JPMorgan Chase; Clayton Dubilier & Rice, Permira, and hundreds of other much smaller firms live. The Private Equity Growth Capital Council, the industry’s chief lobbyist, estimated in 2011 that there were roughly 2,400 private-equity firms headquartered in the United States.17 “As we’ve seen what’s happened in the market, the model has changed, and you have two kinds of players: public and diversified and private and focused,” Colony’s Tom Barrack said. Managers at the firms where private equity remains the main, or only, business argue that they’re the only ones who can generate the sort of returns that the industry originally delivered and has promised ever since. “This asset class is not going away,” said Thomas Lister, co-managing partner of Permira. “There will be people who continue to make 20 percent IRRs off a reasonable pool of capital. I’m not a believer in just making 5 points over the S&P. I believe in 2.5 times your money and 25 percent returns.”

  Private-equity guys talk a lot about alpha, a Greek letter that’s taken on many meanings in the modern world, especially in finance. It’s a given that private equity, as an adjunct to Wall Street, has its share of alpha males, fellows who strive to be the leader of any pack. But in investment terms, alpha generally means a return that’s achieved beyond what can be generated by the market at large. It’s based on some amount of skill or ability to see something different. Investopedia defined it this way: “Simply stated, alpha is often considered to represent the value that a portfolio manager adds to or subtracts from a fund’s return.”