Hedge funds and private equity constitute the cornerstone of most private banking portfolios
KEY POINTS:
If we are to believe the glossy brochures, anyone who is seriously wealthy has his or her own private banker. Graeme Hart probably has a different one for each day of the week. But, aside from the free cheque account, what do private bankers really have up their sleeves and should mum and dad contemplating their modest retirement nest-egg be looking to get a piece of the action too?
London's Financial Times regularly surveys the investment strategies of Britain's private banking elite and it seems that along with ridiculous annual fee structures, double-barrelled surnames and unspecified tax advantages, there are two features which almost always characterise a private banking portfolio - yes, you guessed it, hedge funds and private equity. There, the secret's out - we can all be fabulously wealthy.
If you don't know it already, hedge funds promise to go up in value when everything else is falling apart.
Private equity, on the other hand, borrows billions of dollars at low interest rates to buy, at rock-bottom prices, companies which are about to go bust. Apply some restructuring, which the original owners never thought of, a good dose of financial engineering and, two years later, that same business, now fabulously profitable, is flogged off at a huge gain. Less fees, of course.
That's the legend of private equity. Of course, not all of it is "pie in the sky" - there have been some great deals done. A few years ago, Christopher Flowers, a US venture capitalist, teamed up with one of the Rothschilds and bought the Long Term Credit Bank of Japan, then a down-and-out Japanese bank. Three or so years later it was sold at a multiple of many times cost. That certainly was a great deal but, if your last name isn't Rothschild, you might not get access to the best deals and have to settle for something less.
But how much less? What is reasonable? Unfortunately performance statistics for the private equity world are unreliable as the vendors of private equity tend to remember their successes and forget the failures. Thus the general notion exists that private equity is a quick way into the rich list.
If you thought the business model of private equity sounded too good to be true, that indeed appears to be the case, according to some new research from two academics at the University of Amsterdam and the HEC business school in Paris.
Ludovic Phalippou and Oliver Gottschalg analysed the cash flows of 1328 mature private equity funds over the period 1980 to 2003 as part of a research project last year for the European Parliament. Their findings suggest that, like so many hot new investment ideas, private equity frequently resembles a treasure hunt without the treasure. But first some background.
Investors in private equity are typically institutions like pension funds, endowments and, of course, those high net worth individuals with private bankers. These investors, known as Limited Partners, commit a certain amount of capital to private equity funds, which are run by General Partners (GPs). GPs search out investments and tend to specialise in either venture capital investments or buy-out investments. In general, when a GP identifies an investment opportunity, it "calls" money from its LPs. When the investment is liquidated, the GP distributes the proceeds to its LPs. A fund typically has a life of 10 years, which can be extended to 14.
The key findings of the Phalippou/Gottschalg PG Study are as follows:
Before fees private equity outperformed the S&P 500 index (the US stockmarket) over the period 1980-2003. After fees payableto the General Partners, private equity underperformed the S&P 500 by 3 per cent a year.
Many funds which had reached the end of their 10-year life still had substantial residual assets which were yet to be onsold. Previous performance calculations have assumed these residual assets are readily able to be sold and thus converted to cash at the GP's valuation of them. The PG study is more conservative as it writes off residual values for funds that have reached the end of their 10-year life and have not had any activity for at least 18 months.
Previous private equity performance benchmarks have excluded poor-performing funds. Correcting for this lowers returns by 4 per cent.
Fees were understated in previous calculations of private equity performance.
Past performance of private equity managers is a good indicator of future performance.
The PG study concludes that performance estimates of private equity investments are only reliable for funds which have reached maturity - that is, those that have exited for cash all their investments. Most of the private equity funds around today are immature so over the years performance statistics will become more robust.
Having said that, the authors note that newly raised funds have a performance similar to the sample used. It is also interesting to note that in the more austere environment since the credit crisis made funding more difficult, most listed private equity funds are trading at substantial discounts to valuation.
It sounds as though unless you are very lucky, private equity isn't a passport to instant wealth and perhaps, like technology stocks recently and railways companies and tulips before that, expectations of the performance of private equity have run well ahead of reality.
With private equity underperforming and hedge funds having a bad year, it is perhaps fortunate that private bankers focus on the very rich. The rest of us probably couldn't afford them.
Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.
