David Rubenstein, private equity legend and co-executive chairman of Carlyle Group, gave his helicopter view on the state of private equity during an appearance on a Bloomberg television programme last week. Much of the discussion focused on private equity’s prospects and predicted returns for the asset class. “The rates of return of private equity firms used to be in the net 20% internal rate of return [IRR] area,” he said. “Today I’d say 15% net is closer to what you can really achieve.”
He wasn’t on air explicitly to answer Warren Buffett’s recent comments on private equity firms overstating their returns, but the subject definitely came up. While stating that he wasn’t in the business of contradicting Mr. Buffett, whom he described as “the greatest investor of our lifetime”, Mr. Rubenstein said commentators and investors should focus on the net IRR.
But he admitted that “people in the private equity world do like to talk about their gross IRR, pre-fees and other kinds of considerations”. Even so, he emphasised that “the net IRR of private equity over the last five, ten, 15, 20 years has outperformed any other asset class around the world, and so it’s still pretty attractive”.
That’s true as far as it goes. But it does miss out some important historical context over that period and beyond. Average IRRs of 20% are nothing like what was achievable in the founding days of private equity.
Take for example American Research and Development Corporation, one of the earliest true venture capital firms. It achieved a 500%+ return on investment and an annualised rate of return of over 100% when its US$70,000 investment in Digital Equipment Corporation in 1957 reached a value of $355 million at the company’s initial public offering in 1968.
Then there is Teddy Forstmann’s firm Forstmann Little & Company, which achieved an estimated annualised rate of return of over 55% on its funds from its founding in 1978 until 2001.
These are the kinds of returns that the industry’s reputation was built on. They are also the kinds of returns that underwrote and justified the industry’s standard two-and-20 compensation structure, which first came into vogue in the 1960s. Is it any wonder that limited partners have started to balk at this kind of structure and look at other means to access the same returns potential, including side pockets, sweetheart deals, and do-it-yourself direct investment?
According to Mr. Rubenstein, “you just have to have lower expectations for rate of return”, and he’s surely right about where the industry is moving. If so, isn’t it about time that general partners started to lower their expectations about fees and carry proportionately?