Illustration by Tom Humberstone
Private equity firms and hedge funds with their hidden fees don’t just skew markets – they often aren’t even very good. So why is your pension probably invested with one?
The London district of Mayfair, the European home of hedge funds and private equity firms, is a latticework of elegant streets immediately east of the hyper-expensive expanses of Hyde Park. Its understated architecture is the central London staple: white-painted Victorian buildings with black-painted iron railings, and short stone steps up to the front door and down to basements. You won’t find vulgar advertisements for the hedgies here: the best indication of their presence might be, if you’re lucky, a small brassy plaque with a single name engraved on it. Inside, discreet receptionists glide across thick carpets to greet guests eager for a chance to play in the big leagues. The money is still rolling in to this corner of London. Yet all is not well.
In the 2012 US election campaign the private equity industry was exposed to public scrutiny as never before. The Republican candidate, Mitt Romney, who co-founded the private equity giant Bain Capital, became a symbol for the industry titans and their excesses: their aggression in hunting corporate prey, asset-stripping, outsourcing, layoffs, busting the unions and borderline legal behaviour, not to mention their lobbying, their devious offshore tax shenanigans and their risky debt-loading.
The charge sheet is ugly, but one point was rather overlooked in the frenzy: that the private equity industry is, collectively, a gigantic waste of investors’ money. As David Swensen, who manages Yale University’s $20bn endowment assets, wrote of the situation in the go-go years before the financial crisis: “Investors should stay far, far away from private equity investments.” And you can say pretty much the same thing for hedge funds. Mayfair would be far more economically productive if it were turned into a giant waste-disposal centre.
The sheer uselessness of private equity and hedge funds in delivering returns for investors is an open secret in the City. This raises the trillion-dollar question: why are investors – who probably include your pension- fund manager – still pouring cash into the Mayfair money machine?
The value of global hedge-fund assets rose by a record $122bn in the first quarter of this year to $2.4trn, according to Hedge Fund Research. The private equity industry is even bigger, with total global assets under management of more than $3.2trn in 2012, greater than the previous year, and the twelfth successive year of increase since records began in 2000, according to the data provider Preqin. Private equity now owns as much as 5 per cent of the entire UK corporate sector and holds nearly 10 per cent of all corporate debt.
To understand why investors are still investing, we must first explain briefly what private equity and hedge funds do. In both cases, outside investors – who might be a rich person, or an institution such as your pension fund – contribute their money to a pool of capital, which is then juiced up further with borrowed money and invested. The insiders who receive and handle this money typically rake off 2 per cent of the total assets each year in fees (so the managers are in clover even when their investments make a loss) and also take 20 per cent or so of any gains on the investments. The formula is known as “2-and-20”, though it’s a bit more complicated than that: among other things, private equity firms in particular extract various other, hidden fees.
The key thing to understand here is that the managers aren’t the same as the poor, gullible outside investors (your pension fund). The former extract gargantuan annual fees from the latter.
The big difference between private equity and hedge funds lies in what they buy. A private equity firm generally makes concentrated bets on just a few companies, often taking complete control of them. They will shake them up using management consultancy expertise and try to extract profits. This can take years. Hedge funds, by contrast, are flightier and can flip in and out of liquid assets at high speed if necessary: stocks, bonds, dangerous derivatives, commodities, foreign exchange, and so on. They can hold them for seconds, or “go short” in order to profit when the assets fall in value – that is, they can “hedge” against market downturns, hence the name.
So what is the problem? Let’s start with private equity and Mitt Romney, before he’s completely forgotten. Last year, while researching an article on him for Vanity Fair, I saw a Deutsche Bank report on Bain Capital’s investments from 1984-99, roughly the period when Romney was running the company. The Deutsche Bank report, aimed at luring investors into a new Bain fund, made some stunning claims. Here is one: “Bain Capital’s first five private equity funds achieved an averaged annualised rate of return of approximately 173 per cent per annum on all realised investments and 88 per cent per annum on all investments through December 31, 1999.”
Deutsche Bank was using pretty standard private equity calculation methods; if that 173 per cent didn’t get investors slavering, nothing would. Obviously Romney was a genius. But not so fast. A quick look at the numbers reveals one of the great illusions about private equity. The Bain Capital Fund Limited Partnership of 1984 took in an initial $32m from outside investors. Grow that by 88 per cent a year for 15 years and you would have over $400bn. At 173 per cent annually, it grows to well over $100trn: three times the world gross domestic product that year. If Bain’s funds had grown quite that fast, someone might have noticed.
Private equity firms like to use a metric called the internal rate of return (IRR), a common business tool – but which, in the hands of a private equity cheerleader, can make a pedestrian performance look stratospheric. An example from the report helps us see what Deutsche Bank’s bean-counters did. One firm in which Bain Capital invested was the financial information company Experian, which it bought into in 1996, paying $88m for its share of the firm, which it sold for $252m. That was a 185-ish per cent gain. But Deutsche Bank claimed its “implied annual IRR” was 6,638 per cent.
In his e-book The Romney Files, Brett Arends, formerly of the Wall Street Journal, explains: “The reason? The deal went through in seven weeks. On an annualised basis, it’s amazing. But that’s only relevant to investors if Bain Capital were able to come up with a string of identical deals for a full year.”
Which it didn’t. What’s more, these numbers are net of fees. More on that later. There are many other ways to put rocket fuel under the public numbers, but you get the point.
Arends calculated that Bain investors in fact earned between 20 and 30 per cent annually overall from 1984 to 1998. Not to be sniffed at, but the Dow Jones Industrial Average rose twelvefold during that time, including dividends. Borrow money to juice up your leverage to the same extent as Bain Capital did, and you earned 30 per cent.
“The clients could have just picked stocks out of the newspaper at this time, gone fishing, and earned about 20 per cent a year,” Arends wrote. “No Mitt Romney. A dartboard, a copy of the stock prices page of the Wall Street Journal, and a fishing rod.”
Bain Capital is, admittedly, just one private equity company, but the big picture is probably far worse. I say probably, because the industry-wide numbers are so bent by selfserving manipulation that it is impossible to be completely sure of anything. Even though precisely a quarter of all private equity funds are in the top quartile of performers (that, after all, is what “quartile” means) a study by Oliver Gottschalg of HEC School of Management in Paris shows that over three-quarters of private equity funds can use established methods to claim to be in the top quartile.
Still, a little investigation reveals a lot. Last year the Kauffman Foundation looked at its own record of 20 years of investing in venture capital (VC, a small subset of private equity). Its report, subtitled The Triumph of Hope Over Experience, found that returns from its VC investments were dreadful. Among the 100 funds in which it invested, nearly two-thirds of a sample underperformed the public markets and over three-quarters failed to reach their hoped-for targets. “Investors like us succumb time and again to narrative fallacies,” it said. “The investment model is broken.”
A well-known financial writer, Felix Sal – mon of Reuters, summarised the report: “The VC industry, as a whole, is being incredibly successful at extracting rents from dumb institutional investors.”
Reminder: that’s probably you, via your pension-fund manager.
There is plenty of this kind of evidence. An influential 2009 paper by Ludovic Phalippou of Oxford University, entitled Beware When Venturing Into Private Equity, looked at the whole sector and concluded that investor returns on the average buyout fund were lower than returns on the Standard & Poor’s 500 Index of leading US stocks. “The average private equity fund return is comparable or inferior to that of public equity, a finding that is in sharp contrast to what industry associations report,” he said.
Granted, Phalippou was using data from the years before the financial crisis of 2008. But when I asked him recently if he’d use the same title again, he replied: “Yes – big time.”
So why are these moguls so poor at making money for their investors? The main answer boils down to one word: fees. As the old Wall Street adage goes: “Where are the customers’ yachts?” A study by Andrew Metrick of Yale University and Ayako Yasuda at the University of California found that private equity titans get two-thirds of their earnings from fixed fees (the 2 in “2-and-20”), regardless of performance. And in his 2010 report Private Equity, Public Loss? the investor Peter Morris described the end result: “These investments on average are very profitable for the people who run them, but not for the owners of the capital invested.”
If private equity is a disaster area for investors, hedge funds must be better, right? Once again, it’s hard to be sure, given the stew of flaky numbers stirred up by the industry. Perhaps the best-known recent study is The Hedge Fund Mirage by Simon Lack of SL Advisors in the United States, an experienced investor. It is, as the Financial Times put it, “a devastating little book”.
Lack looked at returns for hundreds of funds and concluded that if all the money that has ever been invested in hedge funds had been put into low-yielding, plain-vanilla treasury bills (short-term, government-backed securities), “the results would have been twice as good”, he wrote. The $450bn of investors’ money vaporised by hedge funds in 2008 probably destroyed “all the value that hedge funds ever created”, he wrote. Not only that, but from 1998-2010, judging by one way of calculating it, investors received just $9bn, all things considered, while the hedgies took $440bn. So the hedgies took 98 per cent of the winnings, leaving investors with 2 per cent. That is monstrous.
As Lack’s study only goes up to 2010, I asked him recently how his numbers might stack up today. He hasn’t crunched the numbers in detail, but he was sure that the results would be “even worse”. Over the five years to the end of 2012, the HFRX Global Hedge Fund Index lost 13.6 per cent, while the S&P 500 added 8.6 per cent.
Yet just as surprising was how hedgies responded to Lack’s preliminary conclusions before his book was published. “I mentioned that to friends in the industry, and they would stop for a minute and say, ‘Yeah, I kind of thought so; I’m not really shocked.’”
Even since the book came out, he said, the reactions have been positive. “I’ve had quite a few hedge-fund managers I’ve never met who say, ‘You’re absolutely right, there is a tonne of mediocrity out there – though obviously my fund is different.’”
The big broadside came from the Alter – native Investment Management Association (Aima), a global hedge-fund lobbying group. Given its job, Aima had no choice but to issue a rebuttal. But it is interesting that it took the association six months to publish it. And after Felix Salmon examined the rebuttal, he concluded that Lack had, among other things, underestimated the fees extracted. “If a high-profile hedge-fund industry association spends months putting forward a point-by-point rebuttal,” he wrote, “and that rebuttal is utterly underwhelming, then at that point you have to believe that the book has pretty much got things right.”
The big bone of contention here is whether to measure the hedgies’ numbers on a timet weighted basis (that is, you imagine investing a dollar at the outset and see how it performs) or on a money-weighted basis (where you adjust returns according to how much is invested in the industry at a given time).
Back in the 1990s returns were great but there wasn’t so much money invested – so a time-weighted measure makes the hedgies look very good indeed, while a moneyweighted measure makes them look like grasping hucksters.
Which is the better standard? The industry, obviously, wants everyone to take the time-weighted approach. But from an investor’s perspective the industry would be wrong. Lack’s point is that the industry did quite well when it was small, but once it got above a certain size – much less than half the size of today – it lost its edge. “The best returns come from obscure areas and strategies, where there isn’t a lot of competition,” he explains. “By definition, those are small strategies.” Once too many investors pile in, the edge may disappear.
“If you say the industry only did well when it was small and once it got above a trillion dollars it kind of sucked, is that an accident? Or is there actually a reason?” he said. “The time-weighted analysis doesn’t contemplate a situation where the industry has too much money.” Lack is surely right. Time to build that waste-disposal plant in Mayfair.
Given that investors can easily find all this out, why are they still scrambling to rain (your) money on hedge funds and private equity? Talking to bankers, investors and analysts, I’ve gleaned seven and a half answers. One is fairly feeble, one is sad, one is a scarily bad reason, two involve illegal behaviour, and two are quite frankly pathetic (you won’t want to know those). The halfreason is just silly.
The first reason isn’t so awful. There are many crappy hedgies and private equity titans out there – but there are a few stars. Some outperform for the same reasons that if you get enough gibbons to throw darts at printouts of investable stocks, a few will soon get invitations to Downing Street to meet Bono, Tony Blair or George Osborne. But there are also some George Soroses out there who know what they’re doing. That’s why Lack, Phalippou and others who have seen through the puff are careful not to rubbish the whole industry.
The trouble is, the good ones are hard to discover, and even harder to get your money into, unless you’re already very rich and well connected. That most likely excludes your pension-fund manager. As Chris Brightman, director and head of investment management at Research Affiliates, puts it: “The hedge funds that produce these kinds of results will never manage your money.” Soros’s hugely successful Quantum Fund was hard to get into, and it closed in 2011.
The second reason is not great, but it’s simple: investors are fooled. They time-weight the returns, or they believe the hype. Layers of devious, hidden fees in private equity deals, for instance, can be even greater than the brazen shakedown of the advertised 2-and- 20 fee structure.
The third reason is scary. Equities and bonds offer feeble returns these days, and investors want to do better. So they invest in riskier, edgier sectors promising higher returns – such as hedge funds and private equity. But you could lose a lot, too. This approach is a bit like saying, “This sector is so bad that it has got to give me high returns.” If you really want to take high risks, then borrow money yourself to buy a dirt-cheap index tracker.
The fourth reason people invest is less wholesome: bribery. As the Guardianreports: “In 2009 Carlyle agreed to pay $20m to New York State after Hank Morris, a political adviser, directed chunks of the state’s multibillion- dollar pension fund to private equity firms, including Carlyle, that used him or his associates as paid intermediaries. The Morris episode did not prove to be isolated.” Bribery might be a minor factor, but it does help crystallise the incentives that are at play.
The fifth reason is insider trading. Most funds don’t do this but some do. Numerous employees of SAC Capital, the hedge fund led by Steve Cohen, described in a Forbes article in June as “the undisputed heavyweight champion of the hedge-fund business”, have been charged with insider trading and Cohen has been summoned to testify before a federal grand jury. Although Cohen’s case is still in court and he has not yet been found culpable, in the words of Preet Bharara, US attorney for the Southern District of New York, announcing charges against several hedgefund officials: “Given the scope of the allegations to date, we are not talking simply about the occasional corrupt individual; we are talking about something verging on a corrupt business model, for the defendants seem to have taken the concept of social networking and turned it into a criminal enterprise.”
I couldn’t believe the sixth and seventh reasons when I first heard them from a player in this sector. Investors (such as your pension- fund manager) choose these sectors first for reasons of status, and second for fun. These are sexy sectors. Lack says he looked at 3,500 hedge-fund proposals when he worked at JPMorgan and that “there were no boring meetings. You meet some of the most talented people in investing: that is pretty cool. What’s not to like?”
Phalippou says investors have told him time and again how boring it is to invest in staid old, low-risk sectors. “They say, ‘I work in this bank. I am bored to death. I just have to invest in these equities and bonds. You can only invest passively: you don’t trade, you don’t turn over your portfolio, you try to minimise costs and taxes. How boring is that? If I don’t invest in private equity and hedge funds then I am the biggest loser ever.’”
How piteous is that? The manager of your pension fund is throwing your money at these hucksters because it makes him look cool and because it’s more fun. One can only wonder how modern financial theory deals with this.
There is perhaps an eighth reason, if you could call it a reason at all. The hedgies and private equity moguls, knowing that there’s a whole lot of dross out there, put on strenuous performances of hard-to-get to make investors think they are exclusive and therefore a desirable, top-quartile pearl amid the pig – swill. So they might get an investor to express interest and then make him wait six months for a meeting. Or they might hike their fees above 2-and-20.
As Don Steinbrugge, a hedge-fund marketing official, put it: “Charging too low a fee can actually reduce the chance of raising assets because people might view the organi – sation as a lower-quality firm.” Perish the thought. As a result, they all have to operate out of the priciest places they can think of – such as Mayfair. And they pay for that by extracting more fees.
Overall, the only half-decent reason for investing in these sectors is that somewhere in the heaps of the dross, there are gems. But for every outperformer there is an underperformer. If only the insiders get access to the outperformers, then that leaves the dumb investors saddled with the underperformers.
Against this one, questionable half-positive sits a crowd of other negatives. First, and perhaps most importantly, there is the enormous cost to society. For years, mainstream academics have argued that financial-sector growth was good for a country’s economy. Now, after the eruption of the global financial crisis, studies are emerging from the IMF, the Bank for International Settlements (BIS) and others which show that, above a certain size, financial centres turn bad and start to reduce growth. Britain passed this point long ago. One reason, as the BIS notes, is that “finance literally bids rocket scientists away from the satellite industry. The result is that people who might have become scientists, who in another age dreamt of curing cancer or flying to Mars, today dream of becoming hedge-fund managers.”
A short e-book I’ve just published, entitled The Finance Curse, describes a multitude of other reasons – some related to private equity and hedge funds – why having an oversized financial sector often harms the host country’s economic performance. The full list of negative effect is longer still.
There is the tax, of course. In Richard Brooks’s superb new book The Great Tax Robbery: How Britain Became a Tax Haven for Fat Cats and Big Business, he describes how the UK tax subsidies to a single hedge fund amounted to the cost of a major new hospital every year. That’s not to mention the taxes avoided by non-domiciled fund owners. Then there’s the inequality, as cunning insiders blag hundreds of billions from gullible, starstruck investors.
What’s more, look at how private equity makes its money. Most private equity deals aren’t about venture capital, investing in exciting start-ups to create the next Facebook. Instead they take existing, successful companies with juicy cash flows and financially engineer those cash flows to extract profits.
There are many ways to do this but the key is to borrow money. To be precise, the private equity barons aren’t on the debt hook themselves: they force the companies they buy to be the borrowers. It’s a bit like buying a house and renting it out – but making sure it’s the poor tenants, not the rich landlord, who get saddled with the mortgage.
This possibility creates terrible incentives. One way to make money is to buy a company, make it more productive and com – petitive, and then sell it for a profit. This “good” option does happen, though not nearly often enough. The darker way involves two steps. Say you buy a shoe company. First, you cut costs to juice up the operating cash flow. Often this has been done by bashing the unions, worming out of pension obligations, stiffing creditors and contractors, and more – sometimes illegally.
Now comes step two. Let’s say that costcutting is expected to save the company $5m a year. You take that new projection to a banker and borrow against it. You persuade the banker that the $5m saving will be repeated year after year. So she lends you $20m on that basis. You take that $20m and you pay yourselves (and your co-investors) a “special dividend”, worth $20m. (And you won’t stop at that; you will financially engineer the company’s entire available cash flow this way.) Here’s the fun part: you haven’t taken on that debt, it’s the shoe company that’s now saddled with it.
With demoralised, deunionised, depensionised employees, the heavily indebted shoe company may well collapse – but you can simply leave the mess behind and, with your extracted millions, move on to the next one. The faster you can flip companies this way, the more money you make.
This was never how “creative destruction” was supposed to work. This is not wealth creation but what economists call unproductive rent extraction.
Tamara Mellon, the co-founder of the luxury leather goods company Jimmy Choo, remembers her extensive involvement with private equity companies as “a burden” and cites the appalling incentives created by debt. “None of these private equity firms have actually put capital in the business for growth,” she told me. “It draws a different type of personality . . . I think the private equity model is open to people who are more vultures and parasites.” Louis Brennan, a professor in business studies at Trinity College Dublin, says the core business model is akin to “grand larceny”, where not only is value extracted from companies, it is destroyed overall.
Even if, on balance, private equity firms did make the companies they buy more productive – so what? That is what ordinary company managers do anyway, all the time. Why don’t they get the same adulation from Downing Street? It gets worse. The result of all this borrowing is an economy more suffused with debt, and with higher inequality. The latest Bank of England quarterly bulletin notes that companies owned by private equity firms are more heavily indebted than their peers, and that “the increased indebtedness of such companies poses a risk to the stability of the financial system”.
Hedge funds and private equity are like the zombies that won’t die. The investors keep coming and they keep getting screwed. It’s time to stop mollycoddling them with tax subsidies and invitations to Downing Street. Collectively, they serve no useful purpose, to investors, employees or society at large. They exist purely, after all, to serve themselves.
Nicholas Shaxson is the author of “Treasure Islands: Tax Havens and the Men Who Stole the World” (Vintage, £9.99)
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