Private Equity: Can the Numbers be Trusted ?

In recent years, private equity has boomed. It might be due to better management and greater efficiency, or maybe to the overall increase in multiples across industries and decrease in interest rates, allowing the private equity firms to better leverage their portfolio companies. Either way, private equity is seen as an asset class that has outperformed the public market for many years. In fact, the private equity return has been in positive territory since 1994, whereas the S&P 500 had four down years.

However, how could we be absolutely sure of such returns, since most information is – as its name suggests - private? If most people struggle to properly monitor their financial advisor true performance, how could they even pretend knowing if the numbers inherent to the so-called private markets are adequate?

Unless you are a large institutional investor to a private equity fund, the private equity firm has no formal obligation or incentive to disclose information regarding fee, performance, and valuation - and historically private markets wanted to keep it that way.

“We try to hide religiously. If anyone has his picture in the paper and a picture of his apartment, we will do more than fire that person. We will kill him. The jail sentence will be worth it.” (2009. Stephen Feinberg, co-founder of Cerberus Capital Management).

It can still be acceptable to this point, since the vast majority of investors are accredited and informed ones. Although, in a democratization effort, private equity is becoming more and more accessible to retail investors who might not have the proper understanding to navigate these waters. Once again, can the private equity numbers be trusted and understood?

This publication aims at highlighting the aspects an investor should bear in mind when making an investment decision to the private markets.

Takeaways

-Private equity markets are less regulated and have lower transparency. -Private equity firms have a lot of discretion over the valuation. -Performance metrics are ill-fitted in assessing the performance. -Nevertheless, progress has been made and self-regulation played a major role. -Data provider platforms also help drive metric assessment.

Opacity in the Private Market

Smart moneys are not the only ones entitled to private equity anymore. As the asset class is increasingly integrated into portfolios, the ambiguity and complexity of current performance standards will be felt more intensely by the market - improvements to those standards should consequently be framed by new regulatory activity.

While private equity investing is not a purely scientific process, its metrics serve a crucial purpose by providing quantifiable benchmarks and comparative data. Unfortunately, both managers and investors (differ depending on the type of investor) often use diverse and inconsistent approaches when calculating historical returns. These fragmented data points, paired with irregular cash flows that distinguish private equity from other asset classes, contribute to the ambiguity surrounding valuation, performance and cost measurements nowadays.

The last point to be made is the lack of understanding from many investment actors, whether they are retail investors, accredited investors or institutional professionals. The confusing world of private investing comprises many disconcerting aspects and, as we all know, the devil lies in the details! So let's review the most important aspects of the metrics used.

Key Concerns Over the Metrics

Private Equity Transparency

The most obvious concerns is the lack of transparency, since private equity firms have no disclosure obligation. Thus many information remain in the dark. For instance, private equity firms have the discretion over the mark-to-market valuation frequency and could in theory only proceed to the portfolio valuation at the exit date. Since there’s a cost to monitoring the valuation, smaller shops tend to do it less frequently, and be more opaque, than larger ones.

It is of equal importance to understand the accounting standard differences between private markets and public markets. Private company accounting standards require a lower degree of financial information, and since the metrics are less precise, private equity firms have to use their best judgment in including those missing data inputs to their conclusions. The lack of transparency is therefore originated at the source and firms do their best in their analysis.

It is also noteworthy that private equity numbers are hard to track, even with the recent technological advances by independent private market data providers such as Prequins, Pitchbook or Efront, some discrepancies persist. As recently outlined in an article published by The Economist, it is easy to get confused when trying to find information. "Is the dry-powder 1.5 Trillion or 2.5 Trillion? Was the amount raised last year 474 billions (Pitchbook) or 595 billions (Prequins)?" Such interrogations are hard to answer since guidelines followed by private equity firms vary quite a lot and disclosure is not distributed uniformly between different types of investors - institutional investors get access to more information than limited partners. In other words, the apparent opacity in the market is more a consequence of accessibility, and sometimes it is for obvious reasons such that would be required for a permanent tracking and disclosure.

“In the future, more private equity funds may come to the realization that their success in raising and retaining client assets is directly correlated to transparency.” (Samuel K. Won, founder of Global Risk Management Advisors)

Regardless of that apparent opacity, it is important to understand that private equity firms are in many cases actively involved in ensuring a proper disclosure and adopting guidelines recommended by different agencies (i.e. Private Equity Reporting Group ¸[PERG], Walkers Guidelines, Alternative Investment Fund Managers Directives [AIFMD], EU Benchmark Regulation [BMR], UK Financial Conduct Authority [FCA]…). Since the adoption of best practices, can prevent legal battles and improve the overall reputation, private equity firms are usually inclined to follow those guidelines.

So even if some critics persist over the private markets lack of transparency, we could make the argument that private equity shops act in good faith and try to generate less complex information since it is also in their best interests.

Private Equity Valuation

As discussed, portfolio companies are usually valued at the discretion of general partners who, in the best scenario, follow disclosure and valuation guidelines more than any official framework. But assuming general partners act in the markets best interests, the valuations could still be influenced by different factors.

Let us start with the factors inherent to the valuation process itself. When performing a valuation, the general partners will have to select an approach, and whether the discounted cash flow, the earning multiple or another method such as market comparable is being used, the value can be significantly different. When performing the valuation then, the quality of the numbers and assumptions used are directly derived from the quality and transparency of data inputs. For instance, the accuracy of the valuation by the private equity firm can be influenced by factors such as : unaudited financial statements, use of accounting standards for private companies, incentive from the management in place to boost numbers (i.e. earn-out provision) or the quality of underlying assumptions. The point here is that even if the private equity firms have good intentions, those factors limit the quality of market valuations since they leave room for interpretation. An attentive reader would also note the complexity of private equity valuation and the correlation it has over the frequency of this process. Additionally, this lower frequency is also believed to be the main factor explaining the very low volatility of that asset class.

Then we must consider the private equity firm position when performing the underlying investments valuation. The most obvious one, as found in a Schulich School of Business and University of Frankfurt joint-research, is the incentive by fund managers to overvalue their as-of-yet-unsold investments in order to attract investors to their follow-on funds. Another one would be to have a better overall reputation and attract the best deals. In general, fund managers have a lot of discretion over valuation and considering the attractiveness incentive they could be tempted to make core assumptions that favors them.

Consequently, we understand that the valuation process has biases that could push the funds to overvalue their core investments. However, and to their defense, valuing private companies is a complex operation that takes a lot of time, and again if the exit valuation was to be lower than the previously reported one it would be of great reputational damage. Thus there's a nuance to be made.

Private Equity Performance

Closely related to the valuation, the performance of private equity investments can be influenced by numerous factors and poorly reflect the real rate of return. The argument against a proper performance calculation can be split in two main categories, which are the way we calculate returns and how we benchmark them.

First, the private equity firms’ favorite calculation tool: the IRR (Internal Rate of Return). If the IRR isn't a bad measure in itself, as it can adequately be used at the GP level to decide if they want to go forward with an investment or not, it is not the ideal measurement for investors. Indeed, IRR' returns are calculated by money-weighting them in contrast with the time-weighted returns of the public market and has a reinvestment assumption that does not exist in real life. Money-weighting returns create a problem when there's an associated temporal qualification (example : the 2018 Yale Endowment Report suggest an 165% per annum), because by definition, such money-weighted measures cannot have temporal qualification since the disclosed return does not feature any information about the underlying investment amounts to allow compounding. The last factor that I will outline here is the cash drag period. The cash drag refers to the period during which the capital is unallocated/not yet called. It is important because when a private equity fund disclose an annual performance of XX%, it might not be for the entire fund-life period, the performance calculation only starts when the capital is called.

“The amount committed can be technically deployed somewhere else than on the money market meanwhile, but the lack of visibility on capital calls makes it difficult to properly time the rebalancing and the corresponding sales.”

Secondly, benchmarking is an important aspect as it is needed to define a portfolio’s allocation, to monitor performance relative to target returns, to assess individual fund manager performance relative to peers and objectives and to calculate performance fees. As previously discussed, the IRR is an internal measure and can hardly be compared. Consequently, another measure has been developed in a comparability effort. This measure, called the Public Market Equivalent Return (PME), replicates the fund’s cash flow outcome under listed market performance constraints and then compares the resulting capital amounts. Though this measure is valuable when trying to compare the investment to similar public markets selected by the PME, it is fund-specific and cannot be applied equally to different funds in order to compare them. Which private equity firm performs the best if they cannot be compared adequately?

As explained it is difficult to assess the exact performance of private equity. The main method of calculation being ill-fitted and the benchmarking not allowing comparison between different private equity funds. Thus it is important to remain independent an cautious while assessing the performance.

Private Equity Costs

Another aspect to consider is the private equity costs. Private equity funds usually disclose the management fee (around 2% per annum, starting on the inception date, whether capital is called or not) and the performance fee (around 20% of the excess returns after a hurdle rate goes to the private equity firm). In addition to those fees, others are harder to determine and thus disclose. Even if the structural costs could hardly be reported, it is important to keep them in mind when making an investment decision over private equity. Those structural costs are related to illiquidity, the lack of transparency and its inherent risks, the lack of diversification since many private equity funds focus on a particular strategy/industry and the cash-drag effect.

As in any business, there's a cost of doing business that comes on top of the private equity specific fees, however those are directly integrated in the investment company itself and doesn't affect the disclosed return.

Bottom line

Is Everything all Bad?

In the previous section of the article, I’ve highlighted the possible shortcomings of private equity metrics. However, common sense and empirical studies explain why private equity numbers can still be trusted.

First, let’s remember that portfolio companies have to be sold at one point in order to accrue gains. That normally happens through an IPO or a sale to another private equity firm. Therefore, the process surrounding such a transaction requires a lot of transparency as the buyers or regulators will need to complete their own analysis to ascertain the quality of information previously disclosed by the private equity firm. This practice encourages transparency and better applications in all private equity firms. Similarly, we could say that the private equity world acts as its own regulator if firms want to maintain their reputation and stay in business.

We also have to recognize the progress that has been made by regulatory bodies. Whether it is in Europe with the EU Benchmark Regulation (BMR) or in Canada with the Canadian Venture Capital & Private Equity Association (CVCA), many associations have joined forces and developed guidelines for private equity firms. Those guidelines aim to ensure a valuation process that follows the best practices, that limits the asymmetry of information, and that protects the investors interests. It is also worth mentioning that the level of scrutiny will grow as more retail investors flood this asset-class.

Individual Investors, Family or Multi Family Offices

Private equity remains one of the most attractive investments for a select class of investors. The reason is simple: if you’ve made fortune building businesses and managing businesses then there is probably no better investment than investing in tangible companies. To get some sense of control and influence over it, or at least to know that a select group of people will be working to make grow your wealth. Furthermore, general partners usually have their skin in the game so if you lose you loose, and believe me, they don’t want to lose. A publication by KKR & Co. also highlights the fact that wealthy investors prefer private equity above almost any other asset classes. 

The previously mentioned shortcomings, which are the lack of transparency, the difficulty to assess valuation/performance and the complex cost structure are part of the game and even if we’d prefer not to deal with them they are part of it. Nevertheless, private equity shops are on the line just as much as private equity investors are and this acts as a self-regulatory body that can and should give you confidence over the numbers. Finally, it is important to note that family and multi-family offices are best equipped to verify and challenge those metrics since they act as personal institutions and can pressure private equity firms to disclose important information. 

Private equity investing is not for everyone. Please contact your professional.

For comments, questions, or additional information please contact the author.