Private Equity: Public Injustice?

The largest investors in private equity are U.S. pension funds -— but a new study finds that these investments may not be benefiting the retirees they were meant to help.

“Sunlight is said to be the best of disinfectants,” Louis Brandeis said in Other People’s Money: and How the Bankers Use It, originally published in 1914. His words still ring true today.

Shining light on a problem might cure it. This is what Peter Morris is counting on in his compelling paper, “Private Equity, Public Loss?” published by the Center for the Study of Financial Innovation in London. In it, Morris makes the case that pension funds that invest in private equity are not making sufficient return for their pensioners for the level of risk they are taking. This even though others on the private-equity food chain are making out like bandits. As a result, employees, employers and others will have to make up for the shortfall or the pensioner will have to be satisfied with a diminished retirement fund. In the worse possible case, the taxpayer will have to step up to the plate to pay.

Morris begins his paper with the assumption that private equity must produce positive real returns in order to be attractive. Private equity is money invested in nonpublic companies by investors who want to diversify their assets and increase returns. Morris basic premise is that it should outperform the market after being adjusted for any extra risk it takes plus fees.

Though most private-equity firms report a positive return, Morris is unconvinced. For example, the Private Equity Council states that the top 25 percent of private-equity firms made net returns of 39 percent between 1980 and 2005. After Morris examined the data, he looked at another study of the internal rate of return of 110 completed deals in the U.K. between 1995 and 2005. Though the total annualized return was 39 percent, he found that 22 percent of that total came from interest payments and 9 percent was attributed to the rising stock market -- so just 8 percent of the total return was related to active management. Worse, this amount was absorbed by management fees.

However, appearances can be deceiving. In this case, the data don’t take into account the possibility of investment declines. The debt which was responsible for over half of the return -- though positive on the upside for all -- is dramatically negative on the downside for investors. This is especially true because they have “skin in the game.” The private-equity firm manger only loses its management fees based on performance. In other words, the so-called sophisticated investors in the guise of pension managers are taking risk for which they aren’t being compensated.

By exposing this scandal of sorts, Morris draws attention to yet another pressing matter that affects the financial health of Americans and others adversely. The solution, he believes, must fall to policy makers because many so called sophisticated investors (including North American pension funds) have not questioned private-equity results sufficiently. And policy makers, as we all know, are influenced by their public.