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August 2020
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PE Panorama: Red faces for pension funds

sustainable investing photo with coin stacks
By Paul Mackintosh  
July 13, 2020

Institutional investors in private equity, especially pension funds, must right now be feeling all kinds of red on their faces and their balance sheets. A recent paper, An Inconvenient Fact: Private Equity Returns & The Billionaire Factory, by Ludovic Phalippou, a professor of financial economics at Oxford’s Said Business School, has seemingly opened the floodgates for criticism of pension fund and institutional investment in private equity as an asset class.

But given the amount of dry powder the industry is sitting on right now, any substantial warning couched within the gleeful criticism may be too little too late.

According to a recent Financial Times report on the topic, quoting papers by US investment consultant Richard Ennis, “high fees have morphed into a benefit-free annual donation”. The point being that private equity has changed fast within living memory. In the pioneering 80s and 90s days of Forstmann Little, buyout firms really could outperform the market by orders of magnitude. Forstmann Little scored profits of up to 500% on some deals.

Even back then, Teddy Forstmann was already castigating Henry Kravis and the leveraged buyout industry for crushing American businesses under junk bonds. “His money isn’t real,” Mr. Forstmann railed in a New York Magazine report published about 30 years ago. “It’s phony. It’s wampum. It’s funny money. These guys are getting away with murder.” Forstmann Little refused to use junk bonds, and in some cases withdrew from auctions where competitors were using them.

Fast forward three decades and the crushing junk bond debts are still there, but not the 500% profits. That’s because just too many competitors jumped onto the opportunity. Buyout deals fell victim to a law of diminishing returns that has driven the asset class’s performance down to below index trackers, thanks largely to the huge additional costs that, according to Mr. Ennis’s estimate quoted by the FT, amount to a levy of US$400 billion on the US pension sector over the past ten years.

With that kind of additional income, it’s no wonder buyout funds have no financial incentive to reform private equity’s fee and compensation structure. And the private nature of the business means that pension funds have little in the way of objective data to go on when gauging actual performance.

Private equity isn’t getting much of a cheer on the investment side either. A July 2 New York Times opinion piece by Mehrsa Baradaran blames the industry for “more than 1.3 million job losses in the last decade”, due to the bankruptcy and liquidation of debt-saddled targets.

Meanwhile, a new conservative think tank, American Compass, has set up a project called Coin-Flip Capitalism to help its followers understand how alternative assets work. With a title like that, it obviously isn’t doling out unalloyed praise for the “lavish compensation through fees charged to public pension funds” and other sins of the private equity and venture capital worlds.

Maybe all that criticism from across the political spectrum and the stark and unflattering spotlight on returns mean there really is enough animus out there for the private equity folks to lift their heads from the two-and-20 fee trough. For a moment or two at least.