Institutional investors are clearly attracted to private equity, but remain wary of the sector for its perceived lack of transparency and ability to be measured, high fees and a sense that they cannot invest into the sector as truly equal partners.
“It’s clear that now is a time with a lot of flux in private equity,” said Josh Lerner, the Jacob H Schiff Professor of Investment Banking and head of the entrepreneurial management unit of Harvard Business School.
“On the one hand we can see that certainly institutions want private equity in their portfolio…for the return characteristics, and so forth.
“But at the same time it’s also clear that there is some unhappiness, not so much with private equity per se, but with private equity funds.”
One issue, Lerner told the Fiduciary Investors Symposium at Harvard University, is that the fees charged by private equity managers really haven’t declined even after the global financial crisis.
“One might think given the wrenching changes that happened with the financial crisis they would have seen dramatic adjustments taking place. But when you look at for instance the movement in management fees, yes it has come down, but I guess to describe it as evolutionary would be kind. It’s been glacial in terms of the speed of adjustment.
“One can see why there is this degree of unhappiness [in] many corners of the limited partner community, which has manifested itself in, for example, interest in separate accounts.”
There’s also disquiet about how the returns to limited partners compare to returns to general partners when co-investing.
“We did a project recently where we looked at seven of the largest global limited partners who’d played in the co-investment game for a decade or longer; where they shared their data with us on a confidential basis,” Lerner said.
“I’ll just highlight one remarkable fact, which has to do with the cornerstone of most institutions’ direct investment programs, which is the co-investments. In particular we looked at these guys, who were all sophisticated…and had been doing it a long time, and what we found if you compared their returns on a net basis…with the returns of the same funds they were co-investing with, again on a net basis, [was that] much to our amazement…the co-investments underperformed the funds they were co-investing with – not on a trivial basis, but by 8 per cent a year, which to us was really, really shocking.
“Initially we thought we must have mis-programmed the computer…but unfortunately the computer was right.”
Lerner said one of the issues that emerged was that “these tended to be the largest deals that the funds were doing”.
“For whatever reason it seems our smart, sophisticated LPs sauntered into a bunch of deals that were really in some sense the worst that [were on offer],” Lerner said.
“The question is, is there really going to be a cure that addresses these things?”
Mark Szigety, vice president of risk and quantitative analysis for Harvard Management Company, said private equity is important to HMC and represents “a large portion of our assets”.
“From my perspective there are two main areas of concern,” Szigety said.
“The first is in risk management. We spend a lot of time trying to understand the underlying factors that are driving the returns of private equity.
“We also look at issue related to cash flow modeling. This is a major concern of ours as well. Harvard had a difficult time during the [financial] crisis in terms of its liquidity needs. That was enterprise-wide and not just centred in private equity, but the idea of making sure we understand and have a better sense of how cash flows and NAV evolves over time is important to us in terms of making sure our liquidity is where it needs to be.”
Szigety said HMC also has concerns around asset allocation and benchmarking.
“We have thought about [benchmarking] extensively and we are not, I don’t think, happy with any option that has presented to us. Again, a concern for us is how we think about benchmarking our managers, and the asset class.”
Will Kinlaw, a senior managing director and head of portfolio and risk management research for State Street, agreed that benchmarking is an issue for private equity investors, not only for the asset class, but at a manager level.
“One of the things we’re hearing more and more is we don’t just want an index at an aggregate level that tells us what the median manager is doing,” Kinlaw said.
“Another challenge is clearly portfolio construction, and that’s both at the asset allocation level but also within the asset class.”
Kinlaw said another issue was understanding factor exposures and risk exposures of private equity.
“Some of the work we’ve been doing there has been related to, particularly, the sector exposures that private equity managers are making.
“Another challenge big institutions seem to be having is they’re not able to maintain or reach the target allocation they have for private equity.
“They’re looking for, I wouldn’t say a replication because it’s impossible to replicate private equity in the public market, but ways to get a little bit closer along sector lines and factor lines in the public market as a tool, as a place to park some of the capital that’s earmarked for future private equity investment.”