Fees, Firepower & Funds: The Incentives Faced By Private Equity

I know very little about the private equity world, mindset, incentive structure and investment strategy, but I am eager to understand it better. I found a recent post, “Too Much Is Never Enough” at the Epicurean Dealmaker blog, to be informative reading, assuming the author knows what he is talking about. Plus, it came chock full of Seven Samurai quotes, which is pretty awesome:

Tempting as it may be to imagine Steve Schwarzman and Leon Black dressed in top hat, tails, and duck bill masks whooping and hollering atop $10 billion mountains of gold coins in swimming pool vaults deep under Midtown Manhattan streets, private equity firms almost never get to hold the actual money nominally under their control for longer than it takes to keystroke a wire transfer into somebody else’s bank account. The multibillion dollar funds they raise with such fanfare in the press represent commitments by their limited partners to invest up to that amount in appropriate investments described and limited by the master fund agreement, not actual currency sitting in a bank account. When the financial sponsor finds and buys a company, it levies a capital call on its investors, and they are contractually obligated to deliver those funds in a timely fashion so the general partner can purchase the target. The trillion dollars which Mr. Sorkin so gleefully describes is not actual money gathering dust under the Carlyle Group’s mattress but rather a promise to invest that much by the pension funds, university endowments, and other institutional investors who employ it and its brethren to make money.

Second, there is the issue of how long financial sponsors actually get to call that money from investors, the key issue at hand but one which Mr. Sorkin skips rather lightly over in his haste to portend doom. For while most private equity firms raise investment funds with lives of a decade or more, by the same token most of them have significantly shorter actual investment periods. Usually, if the general partner is unable to find appropriate companies to buy or other investments to make within four to six years of the initial closing of the fund, the limited partners’ obligation to fund further capital calls goes away. More importantly, from the private equity firm’s perspective, the fund agreement dictates that it can no longer charge its full (2%) management fee on the full committed amount. In other words, if financial sponsor Dewey Trickem & Howe only spends $4 billion of its $10 billion DTH Rape and Pillage Fund XXIII by year six, it can no longer charge its limited partners $200 million per year in management fees. Instead, it can only dun them for 2% (or less) of the actual money invested, $4 billion, or a paltry $80 million. Given that DT&H has lots of expenses to pay, including luxurious Park Avenue office space, oodles of advisors and consultants, and legions of sharp-toothed Henry Kravis wannabes, you can just imagine how little they want to let that $6 billion of uncommitted capital (and, more importantly, $120 million of annual income) slip through their fingers.

Gross these management fees up across the multiple funds which large asset managers run in parallel (Fund I, fully invested and in harvest mode; Fund II, recently fully invested; and Fund III, recently raised and currently being invested), and you can see the 2% management fees which these firms charge add up to some serious revenue. Spread it out across multibillion dollar investment firms which employ a relatively paltry few hundred professionals, and you may understand that incentives to make investments which actually make money for limited partners get materially blurred by the incentive to gather assets.

Video – Joel Greenblatt On Forbes

Intelligent Investing with Steve Forbes presents Joel Greenblatt, adjunct faculty member at Columbia University, co-CIO of Formula Investing

Major take-aways from the interview:

  • 70% of active managers can not be passive index funds like the S&P500 due to high costs, high fees
  • Unfortunately, for the 30% who beat the index over the last 3, 5 and 10-year periods, there is no correlation with how they do over the next 3, 5 and 10-yr periods
  • A disadvantage to standard index investments is that they are market-cap weighted; the more overpriced something is, the more of the index it represents, the more underpriced something is, the less of the index it represents
  • A superior alternative is equal-weight indexes, for example, in the S&P500, Stock #1 is allocated the same amount of capital as Stock #500; errors are therefore random rather than systematic
  • Greenblatt’s firm created a “value-weighted index”: the cheaper something is, the more weight it gets in the index
  • Key metrics for analyzing a business
    • High adjusted FCF
    • Returns on tangible assets
  • Why do good companies sell cheaply? People are worried that earnings power over the next few years will not be as good as the past so they’re willing to sell at a discount; institutional investors will systematically avoid uncertainty and provide you opportunity to buy cheap
  • Most business schools are teaching Efficient Markets theory, not Benjamin Graham; good news for value investors because it means you have less competition

The Infinite Regression Investment Philosophy

Courtesy of the 2012 FRMO Letter to Shareholders [PDF]:

If one were to look at the 100 US public companies with the largest defined benefit pension plans, one would find the likes of Exxon Mobil, General Electric, Pepsi, Verizon and UPS. As of the end of 2011, using these largest 100 as a proxy, American companies recorded perhaps the largest underfunded status ever, certainly within the past dozen years, both in dollar and percentage terms. And this follows a helpful three years of double-digit annualized returns on their plan assets.

Moreover, there is much reason to expect this position to worsen. The discount rates they use to determine the present value of all their future estimated pension obligations is about 3 times higher, at an average 4.8%, than it should be, since we know the average investment grade bond yield today to be about 1.3%. This means that the obligations are actually far larger than currently presented in these companies’ financial statements. Moreover, these pension plans, on average, still presume to earn almost 8% on their plan assets. Yet, over 40% of the plan assets are invested in bonds. Assuming, as one must, that 40% of these pension plan assets will earn 1.3% at best, then those bond portfolios, all else equal, can contribute only 0.5% to the return of the entire plan assets. This leaves the remaining 60%, most of which is invested in equities, to produce the balance of the 8% expected return, which means the balance must produce about a 13% return every year.

First, one is hard pressed to suggest that this reality will come to pass, so that one should expect much larger funding deficits in the coming years and, it follows, much larger contributions to those pension plans, which in turn must detract from shareholder earnings and earnings growth. That pending reality, though, is less interesting than this one: that these companies, by dint of their investment philosophy and practice, place the major portion of their equity assets in the S&P 500 (and other indices representing essentially the same, largest companies in the US), in order to attempt to earn the highest risk-adjusted expected returns. Yet the S&P 500 to a significant degree is composed of the set of companies with the largest pension plans, which are problematic as described above– these companies are investing in themselves for future returns to restore their pension plans, even as they themselves are problematic because of these pension plans. But this is their formulaic process, and the tools by which this process is measured and implemented are these self-same indices.

This is Free Lunch-thinking.

By the way, value investor Geoff Gannon (much beloved on this site) has written a lot about Dun & Bradstreet, a company with an underfunded pension liability sword hanging over its neck. He makes the case for why this is not something to worry about with DNB but I have to say it’s the one thing making me hesitate about jumping in to an otherwise compelling franchise opportunity.

In general, I try to avoid companies with employee pension plans, at least the defined benefit variety. They may be “private” and “voluntary” but to me they smack of socialism-lite. They’re uneconomic and based upon absurd assumptions and unrealistic expectations. They are, like Social Security, promises that can’t be kept and must eventually be broken.

The trouble is, shareholders will almost always be sacrificed first because we exist in a culture today that penalizes capital and sees the equity holder as a villain and cheat.