Reposting: Breaking Open Private Equity

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This was posted on December 4 in the Asset Owner category.
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Last month, Gary Gensler, the chair of the U.S. Securities and Exchange Commission, gave a speech to members of the Institutional Limited Partners Association (IFPA).  At the top of the list of issues he addressed were fees and expenses:

Private funds have multiple levels of fees — among others, management fees, performance fees, and for many private equity funds, portfolio company fees.

I wonder whether fund investors have enough transparency with respect to these fees.  I wonder whether limited partners have the consistent, comparable information they need to make informed investment decisions.

He also called out the lack of transparency regarding performance:

There’s a debate about whether private equity outperforms the public markets net of fees, or taking into account leverage and liquidity.

I’m not here to weigh in on that debate.  The point is, when people debate the fees and performance of mutual funds, they draw on a great deal of knowledge and information.  In contrast, basic facts about private funds are not as readily available — not only to the public, but even to the investors themselves.

Regardless of that overall economic debate about whether various forms of private funds outperform public markets on a risk-, liquidity-, and leverage-adjusted basis, there may be benefits to fund investors to increasing transparency of the performance metrics.

Six weeks before, a paper, “An Economic Case for Transparency in Private Equity: Data Science, Interest Alignment and Organic Finance,” was posted online.  The work of Ashby Monk, Sheridan Porter, and Rajiv Sharma, it proposes a new paradigm for reporting by the managers who serve as the general partners (GPs) of private equity funds, offering greater transparency to the asset owners who are their limited partners (LPs).  A short summary of the paper by the authors was published by CAIA, but it should be read in its entirety by those involved with private equity.

The current landscape

The authors write that “there is a pressing need to substantiate the economic case for private equity,” and they propose a framework that “uses data science technology to operationalize private equity data and institute a scientific approach to performance measurement.”  The information is intended to be “a pathway of facts through the investing value chain, allowing a comparison, at every stage, of investment options to facilitate efficient capital allocation.”

The ideas fit with the concept of “organic finance,” a philosophy “underpinned by greater information transparency between investors and the sources of investment return (base assets).”  Using that terminology, most current private asset strategies would be considered “inorganic,” since those sources of return are largely obscured, resulting in a misalignment of interests.

Surveys show that most asset owners — from those with sizable exposure to those who have just dipped their toes in the water — intend to add to their holdings.  Yet, because of the lack of good information, the authors pronounce “the economic case [for it] unclear.”

There are the well-known problems with IRR, the most-cited metric for performance evaluation, including the inane but often persuasive “since inception” numbers for legacy providers whose early wins are amplified unjustly.  More recently, the ability to game the metric has led to aggressive use of prescription lines of credit and “purposeful engineering of early outflows.”

Additional performance measures are used by GPs and LPs, but “private equity’s attempts to quantify active management remain largely deficient; the value bridge is theoretically flawed and the representativeness of the public market equivalent (PME) is conditioned on a subjectively chosen benchmark.”  All of it results in “the confusion of trustees and beneficiaries unable to connect a reported return to the portfolio valuation or their account balances,” and “creates the illusion of high returns and props up outdated investment models, effectively ossifying the industry.”

The GPs pull the levers that drive the ultimate payoffs to LPs, but also control the flow of information, which leads to a misunderstanding of the sources of return and the GP choices that shift risk in ways that benefit their interests rather than those of the LPs.  For example, it is well known that GPs are conservative in their valuation assessments in order to smooth returns, which are attractive but misleading for those in governance roles at asset owner organizations.  That incentivizes GPs “to retain data and metrics that underestimate risk in the portfolio.”

The industry practice of reporting net-of-fees returns also obscures what’s going on throughout the process — and hides questionable expense allocations by GPs.  The inability to see all of the pieces of the puzzle (from the performance on the underlying assets to GP fees and expenses) prevents LPs from making proper price-to-value determinations or assessments of GP skill.

A pathway of facts

As a remedy, the authors advocate for a new approach to create the desired “pathway of facts” by clearing away the fog that prevents LPs from proper understanding of their investments:

The goal of transparency, then, is to remove performance ambiguity and reform the model with explicit accountability to alignment and economic sustainability.

Thus, the “organic finance framework”:

In private equity, the source of investment value and risk is the operating company held by the fund.  Within an organic framework, therefore, reported data begins with accounting quantities from these companies and includes their cash flows from and to the fund.  The fund’s accounting quantities are then added to the dataset, including capital flows and commitment schedules, valuations of base assets, fees, carried interest, and holdings data.  Authorized service providers may add quantities to the dataset, e.g., an independent valuation.  Data flow describes the movement of this data through a ‘security network’ – the machines and software of authorized parties – ultimately compiling a full, multi-dimensional dataset that provides traceability between the LP and the base asset producing value and risk.

The digital flow of that organic information would be light years ahead of the current state of the art, “where much of the data from holdings are truncated and transformed by GPs into detail-poor visualizations and/or replaced with forward-looking descriptions locked in slide presentations and pdf documents.”  It would lead to reduced costs and increased accuracy — and provide a great deal of information not currently available to LPs.

Using that data, there are obvious benefits on the performance measurement front from taking the aggregation (and beautification) of the results out of the hands of GPs.  In addition, other sources of information (especially on public market equities) can be used to calculate sufficiently accurate valuation estimates to allow LPs to have rough approximations of portfolio positions.  Obsessing over such numbers on a regular basis would be counterproductive for an LP, but that context would be invaluable in assessing the changing risks and options available (especially during times of stress) across the portfolio.

In addition, there would be new opportunities to “rank performance, quantify outperformance, and isolate value drivers.”  That’s a two-edged sword, in that performance is often drives manager selection activity more than it should, but it is preferable to the lack of good information available today.  The paper puts too much emphasis on isolating “the outperformers,” as if that’s a panacea, but rightly points out the importance of being able to disaggregate the elements of performance in new ways that would add value to the selection process.

The level of detail surfaced through the proposed framework would also allow the ability to assess portfolio-wide targets for exposure to thematic trends — or to judge the implementation of goals regarding ESG, for example, or mission-related initiatives.

The information for risk management would also be improved.  The authors specifically call out the recent growth in the leveraged loan market, where “LPs have gained exposure to both supply and demand sides via private debt and private equity, respectively.”  They point to this “loading up of downside risk” as concerning, given that:

Falling equity prices and widening credit spreads go hand-in-hand in financial crises, increasing the likelihood that the same factors that negatively impact private debt will also negatively impact private equity, i.e. increasing correlation between assets and asset classes.

To be able to implement the organic framework, LPs would have to upgrade their systems and investment processes.  But those capabilities are needed in other asset classes too, especially related to the complexities of derivative positions (through which risk exposures can change rapidly), so the positive impact from the new approach would not be limited to private equity.

An opportunity for GPs?

It may be tempting for the industry to accept opacity as a natural, permanent, and even desirable characteristic of private market investing.  Certainly it’s the way of the world now.

The misalignments of interest that have resulted are presumed to be intentional, since the GPs are the beneficiaries of the design.  That design has been accepted and institutionalized with the tacit consent of the LPs, who are, with rare exceptions, price-takers when it comes to the terms of the partnerships.

GPs may claim that the lack of transparency is important, that the disclosure of their methods would impede their ability to deliver good performance to the LPs.  But that’s a weak argument; these are not trading strategies with short shelf lives, where alpha decays rapidly as others copy them.  The assets are unique and the operational and financing choices discrete.

Why might GPs move in the direction of increased transparency?  We are at the point where the industry wants to bring in new investors, especially by way of defined contribution plans.  The authors argue that private equity firms can foster the next leg of growth in assets by finally providing the information needed to clear away the fog and show that they add value:

It is somewhat paradoxical that it may be in pursuit of trust (and capital) of “unsophisticated” investors that transparency finally gains purchase in the private markets.

It seems unlikely, though, for this innovation to be led by the large, entrenched managers.  Instead, imagine yourself as someone with a track record at a private equity firm getting ready to start a fund on her own.  Or maybe as one of the founders of a firm that has shown some early success.  Why wouldn’t you voluntarily sell this idea (or something like it) as part of how you do business?

If it solves problems for the LPs — and you have the bona fides to be otherwise considered as a good candidate — it would allow you to offer something that others won’t.  In a very competitive business, that matters.  And even if you thought such openness would truncate your personal economics a little, a successful fund company with a little less in the way of personal economics is still a wondrous thing.

Maybe this will all start from the bottom up.  That would be preferable to a regulatory solution.  Which LPs and GPs will step up to make it happen?