Private Equity : the tricks of the trade

Private equity has a serious image problem – an overhaul of its practices is overdue. The industry has always been seen as hardheaded, but now there is a growing perception of a callous attitude to other stakeholders. Private equity now faces attacks from regulators, investors and politicians.

Against a weaker economic background, a re-run of pre-financial crisis practices may not be socially acceptable. Laying off workers to restructure and improve efficiency is now less palatable. Society’s attitude to the financial sector has changed, and private equity looks like the laggard in updating its culture.

It might be a bumper year for private equity, but the industry is as unpopular as ever. The surge in IPOs, mergers and acquisitions has boosted profits but also brought additional public scrutiny. The latest attacks began in the US, with regulators focusing on disclosure of costs and overall performance reporting. The industry has been accused of playing games with fees: using vague language in agreements with investors that allows broad scope for charging fees to underlying portfolio companies. Some private equity firms have been reported as employing outside consultants or operating partners, but paying for these through the fund or portfolio companies without adequate disclosure.

Andrew Bowden, director of the US Securities and Exchange Commission’s compliance inspections office, has recently criticised the industry for poor disclosure, and noted weaknesses in controls.

Other studies have pointed out that private equity investing imposes a heavy burden on investors, in high management fees, carried interests and illiquidity. Private equity firms – the “general partners” – need to create a lot of alpha to offset these costs for their “limited partners” – the outside investors. By keeping down the cost of debt and encouraging leverage, low interest rates help, but only in part.

Unlike other areas of investing, much of the private equity sector remains opaque on expenses. This secrecy might have been justified when the industry was much less systemically important, and its activities were confined to smart money. Now it looks out of touch with society.

Increasingly, less sophisticated investors are being drawn into the private equity world. Many wealth managers recommend it as a component of long-term portfolios, and there are also big allocations from many public sector funds, sovereign wealth and endowments. Private equity can be commingled with conventional stockmarket investment in mixed funds, or made accessible to the public via investment trusts.

Many of these newer fans of the asset class may simply not have the experience to understand all the tricks of the trade. The SEC recently warned that investors had done a poor job in negotiating complex private equity documents. Most investors do not have the skills or information to monitor their private equity general partners.

Until early this year, IPOs were soaring after flotation, and fund managers seemed happy to buy all that private equity would sell. There was little concern about quality, and new buyers scrambled for maximum stock allocations. Few seemed concerned about conflicts in the allocation process or the huge uplifts that private equity was achieving.

Now, in a much soggier market, fund managers are more critical. Many of this year’s London IPOs are now at discounts to issue price, and it seems that some of the businesses and advisers drawn into the frenzy do not have staying power. Private equity needs to show it can maintain an interest in the success of a business after flotation, and structure exits to leave something on the table.

Politicians are also uneasy about the favourable tax arrangements private equity generally enjoys, typically in terms of treatment of debt and carried interests. Use of tax havens and other minimisation schemes can cut tax paid to very low levels. Firms backed by private equity regularly feature on lists of successful businesses paying little tax.

Money printing by central banks – driving down borrowing costs – makes leverage attractive. And although private equity firms may structure deals to risk relatively little of their own capital, they are still treated as entrepreneurs, rather than financial engineers.

While private equity has made some improvements to the credibility and consistency of valuations, there is still much room for improvement. Valuation can involve subjectivity, and projections can even be embedded in performance data. Methodology can be changed from period to period. The conflicts involved in earning fees based on subjective valuation is clear, and not solved by audit. Incentive fees can be helped a lot by favourable timing of uplifts. This is because it is not simply cash flow that matters, but how accounting recognizes that versus the hurdle rates that determine manager incentives.

The industry should develop a recognised standard for performance measurement in the way that Global Investment Performance Standards, developed by the fund management sector in the US, is used for active managers with listed investments. That would drive transparency and change.

Private equity is growing, and set to present more systemic risk. Secondary market transactions are booming, as cash begins to pile up in private equity funds. Globally, estimated unspent funds now exceed $1 trillion. Almost half of this is dedicated to company buy-outs and acquisitions. As a result, prices paid for businesses bought by private equity are going up, as is average leverage. The surge in fundraising and leverage is encouraged by default rates that have remained very low by historical standards.

The industry is now important; to financial markets, economic growth and employment. That merits greater scrutiny and demands transparency. A recent private equity conference heard a call from Thomas Van Koch of EQT Partners for the industry to step up to develop partnerships with portfolio companies to deliver value for society as a whole. This should involve the long-term health of the businesses they own – delivering sustainability matters now, rather than quick turnarounds. If the industry does not move with the times and reform itself, more regulation will be needed.

A version of this article was published as an Op-Ed in Financial News on July 7 2014.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. I have no business relationship with any company mentioned in this article. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

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