Private equity is an asset class that can provoke strong reaction from current and potential investors. Those who favour it believe that the information advantage it allows, the ability to grow/change a business without the quarterly scrutiny being publicly traded requires, and the multiple financing structures it employs all translate into superior returns, especially for skilful managers. It is one of the few assets classes where there is a persistence of returns among top quartile managers. It is also one that often maintains an information advantage that can be exploited for profit.

Detractors focus on the asset classes lack of liquidity (10+ years), the expensive fees (2% and 20% for direct funds, plus an additional 1% and 10% for funds of funds), and the returns which are often below those of public equity for the majority of managers, especially when fees are taken into account.

The press has become very interested in the current class of private equity managers, often seen as this generation’s Masters of the Universe. General partners (GPs) have been called greedy, locusts, and have been vilified for their slash and burn approach to cost cutting without regard for the people it affects.

The U.S. government has been actively interviewing GPs to determine whether carried interest should be taxed at a higher rate (as income as opposed to capital gains), while the British and European Venture Capital Associations (BVCA and EVCA) have set up codes of conduct for GPs to fend off criticism and attempts to regulate private equity managers. It appears that the EVCA may go further and begin to self regulate. More recently, some of the largest private equity firms have agreed to adopt the UN principles for responsible investment. In a complete about face, many detractors are now actively courting GPs to function as a white knight–to provide much needed capital to struggling banks.

Investors and observers alike have watched too much money being raised, first in venture capital (1999-2000) and then in the large buyout space (2006-2007). As well, prices paid for businesses during these two bubbles were excessive and have led (are leading) to write downs and sub-par returns. Some estimate that investments made in 2006/7 will be written down by as much as 20% to 30%. December 2008 valuations are trickling in and suggest that 20-30% may be conservative for some funds, but overstated for others. Excessive use of debt to structure buyout deals is strangling many otherwise good companies. So, it is natural to ask the question, is private equity worth the effort? Can it really provide all the benefits that its champions tout?

To be fair, many of the criticisms are valid, and are based on a large enough sample group to make many of the conclusions statistically relevant. However, there is much that is true about the benefits as well. Not every manager raised a $20 billion fund, nor did every GP use covenant-lite and pik toggle financing to structure their deals. Mid-market returns have been relatively stable and strong in the US and Europe. Venture funds appear to have learned from their mistakes and have been raising smaller funds with fewer limited partners. The biggest threat to these market segments is the recession and not the size of their funds or use of debt.

One criticism that does have legs is that private equity is expensive. The magic 2% management fee plus 20% carried interest was developed when general partners were newly formed, struggling to establish themselves and raising small funds (less than $500 million). This type of fee structure was necessary to pay the rent, ensure the lights were turned on etc until carried interest could be earned following the ultimate sale of improved and profitable companies.

As funds became larger and larger, no one really questioned whether this was a valid model anymore. With prospects of diminished returns and outsized paychecks to GPs, the question is certainly being asked now. Excessive money raised is being returned to limited partners, and GPs are in some cases reserving remaining capital for follow on investments in their portfolio companies, forgoing further fees. Whether this translates into a lower fee model going forward, only time will tell.

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