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Private Matters

Robin Powell  |  May 28, 2019

WISH YOU COULD invest in one of those exclusive investment funds that buy private companies? Maybe it’s lucky you can’t.

It’s easy to see why institutional investors and wealthy individuals are so keen on private equity. It’s a useful diversifier. It also offers the potential for higher returns than publicly traded companies at a time when, for a variety of reasons, pension plans, university endowments and other bigtime investors are under pressure to improve investment performance.

But that old mantra “buyer beware” is just as relevant to private equity as it is to public equity, and arguably even more so.

It might seem obvious—but needs stating anyway—that private equity fund managers have a vested interest in selling their products. They naturally want to make their merchandise appear as desirable as possible. There’s considerable temptation to make past performance look better than it is and to disguise the full extent of their fees and charges.

The latest concerns about transparency—or the lack thereof—have been voiced by none other than Warren Buffett. “We have seen a number of proposals from private equity funds where the returns are really not calculated in a manner that I would regard as honest,” Buffett told this year’s annual meeting of Berkshire Hathaway shareholders. “If I were running a pension fund, I would be very careful about what was being offered to me.”

Buffett was especially critical of the way, when calculating management charges, that firms generally include money that’s sitting in government bonds waiting to be deployed. That same money, however, is often excluded when calculating the so-called internal rate of return, which is the performance measure by which most funds are judged.

“It makes their return look better if you sit there a long time in Treasury bills,” Buffett told Berkshire Hathaway shareholders. “It’s not as good as it looks.”

His business partner Charlie Munger was more blunt, describing the practice as “lying a little bit to make the money come in.”

Interviewed by Bloomberg, investment manager Dan Rasmussen said “there are tons of issues” with internal rate of return. “The fact that IRR math is easily gamed is extremely well-known,” he said. Indeed, consultancy firm Cambridge Associates claimed last year that the IRR quoted by private equity firms can be as much as three percentage points higher than the actual figure.

When you also factor in concerns about cost transparency, the need for investors to be diligent comes into even sharper focus. To quote Oxford University finance professor Ludovic Phalippou, “We do not know the exact total of fees and expenses paid by investors because a lot of effort is spent by private equity managers to ensure this information remains as secret as the recipe for Coca-Cola.”

For Phalippou, private equity outperformance is a myth that needs to be debunked. The American Investment Council, a lobbying group for the U.S. private equity industry, claims that over the 10 years through June 30, 2018, private equity narrowly outperformed both the S&P 500 Index and the Russell 3000 Index. Phalippou says the true picture, once costs are taken into account, is that the average fund has failed to beat the returns from an S&P 500 index fund since 2006.

Mutual fund investors enjoy transparency about costs and performance. But it’ll likely be several years before private equity catches up. Until it does, investors should treat every claim that product providers make with the utmost caution—and everyday investors should be grateful they can’t afford the often-steep minimums required to invest in a private equity fund.

Robin Powell is an award-winning journalist. He’s a campaigner for positive change in global investing, advocating better investor education and greater transparency. Robin is the editor of The Evidence-Based Investor, which is where a version of this article first appeared. Follow him on Twitter @RobinJPowell.

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