Most US leveraged buyout private equity funds deploy committed money quickly, but take as long as 12 years to exit the majority of assets and produce lacklustre after-fee returns, a new study has found.
The promise of a leveraged buyout (LBO) private equity strategy is to improve the growth prospects, operational efficiency and profitability of a company by bringing on experienced business strategists and seasoned entrepreneurs.
The deep experience of these professionals in turning emerging or struggling companies into lean, mean, profit-generating machines lies at the basis of potential fabulous investment returns.
At least, that is what investors have been told.
But a new study by the Johns Hopkins Carey Business School paints a less rosy picture of the state of the US LBO industry today.
Many well-known funds struggle to exit their investments, rely on their own valuations for assessing the worth of an investee company and barely outperform a passive 60/40 portfolio, according to a draft paper by Jeffrey Hooke, a Senior Finance Lecturer at the business school.
Yet, these private equity managers seem to have little trouble raising money for the next fund. And they deploy it quickly; the median number of years for an LBO manager to invest all of a fund’s commitments was a mere 4.2 years, the study found.
High-profile fund families required 12-plus years to liquidate 90 per cent of deal values in their PE funds
“The high-profile fund families required 12-plus years to liquidate 90 per cent of deal values in their PE funds,” Hooke concludes in his paper, “Performance Perspectives on Prominent Private Equity – Leveraged Buyout Fund (PE-LBO) Families”.
“[But] neither a high proportion of unsold investments, nor a mediocre result in a prior fund deterred LPs (limited partners) from buying into new funds, throwing into question the exact criteria used by LPs in selecting new funds for investment.”
Quality of Due Diligence
[i3] Insights spoke to Hooke about the paper and asked why institutional investors would still invest in US-based LBO managers if returns were so lacklustre.
Hooke says this has partly to do with the relatively modest resources that are allocated to the due diligence of these strategies. Often, pension funds, especially in the US, rely on consultants to do the due diligence for them, but are not prepared to spend much on consultant fees.
“In theory, the pension plan managers or the investment staff should spend a lot more on due diligence. But when I’ve talked to them, they say: ‘Well, we don’t have the money for it,’” he says.
“[But] how can you invest US$500 million in a private equity fund and then say you can’t spend $500,000 or $1 million on due diligence to see if it’s a good deal or not?”
How can you invest US$500 million in a private equity fund and then say you can't spend $500,000 or $1 million on due diligence to see if it's a good deal or not?
Before Hooke joined academia, he had a long career as an investment banker, largely in the field of mergers and acquisitions (M&A), including for Lehman Brothers, The World Bank and Focus Investment Banking.
He argues due diligence on private equity LBO funds could be a lot more rigorous.
“You investigate the valuations of the immediate predecessor fund and do background checks, just like I would do in the M&A business. We would lift up every rock before we bought a company. And yet when you buy a private equity fund, there’s almost no due diligence,” he says.
He finds many investors simply rely on the information provided by the manager.
“You take the manager at its word on all the valuations and the rates of return and whether they use leverage at the fund level as opposed to the portfolio company level, sell good deals first, all this kind of stuff that you should be looking at. No one does it,” he says.
Asked if institutional investors would do a better job if they had an in-house investment team looking at PE funds, rather than relying on consultants, he says this could possibly improve the due diligence process.
“Yes, I think they would do better at it by bringing it in-house; it would be cheaper, perhaps,” he says.
Hooke is not against private equity allocations in pension funds, but believes most strategies are simply too expensive for the returns they produce. This causes fee drag and, in many cases, endowment-style portfolios with large allocations to alternative assets struggle to outperform a traditional 60/40 passive fund.
“I guess maybe there should be a small place in the portfolio for these alternatives, just to keep the public markets honest, but it’s way overblown. I think the private equity business should be cut in size by maybe two-thirds,” he says.
“Now, the next thing is private credit, which is the next bandwagon everybody’s jumping on because private equity is not doing so well.”
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.