In a recent post (as well as some from yesteryear), I discussed how many private equity (PE) funds have been systematically overvaluing their assets/NAVs, and that this is the real reason why they are struggling to realize assets (including via IPOs) and deliver cash distributions to their LPs (limited partners aka investors).
This has created a problem for PE LPs, who are
of often sitting on large paper gains, but are seeing precious little in the
way of cash distributions. They find themselves not only unable to realize these paper
gains, but also powerless to even repatriate their base capital. Moreover, many LPs are the likes of pension funds that increasingly need to fund cash payouts
to their beneficiaries who have started to age into retirement. They are finding
themselves overallocated, increasingly illiquid, and stuck.
The issue is that each additional layer of secondary and tertiary funds comes attached with an additional layer of fees. Moreover, these secondary and tertiary funds are generally marking their own NAVs to the face value of the underlying funds they are buying at putative “discounts”, booking immediate gains and often realizing cash performance fees on those gains. They are also using these paper gains to raise more capital. The whole circus goes something like this:
*A Layer 1 PE fund buys levered asset at $100 (the equity clip), and marks those assets up to $200 over time (typically by booking gains during up markets and keeping valuations flat in down markets), and charges perhaps 20% carry ($20) and also a base fee of say 1.5% on the marked up value of the assets. But the real equity value of the asset may be only $100 (so the base fee is actually 3% of the real NAV). The PE entity complains it can't market the asset at $200 because of "market conditions" and a “weak IPO market”, so LPs are stuck holding illiquid high fee junk generating hardly any return.
*A Layer 2 PE fund then comes along and buys out long suffering LP interests at a “discount”, at say $100 (a 45% discount to stated NAV of $180 net of original carry). “Discount” is put in quotation marks as the transaction actually occurs at a price more consonant with the real value of the assets (indeed a “price discovering” market transaction has just occurred).
*The layer 2 PE fund then typically proceeds to immediately mark that stake to its paper NAV of $180, and claims to have made an 80% profit. It then charges a 20% carry or performance fee on that gain ($16), and often the L2 manager can even realize this performance fee in cold hard cash. To add insult to injury, it then applies a further base fee to this marked up NAV of perhaps 1%. In time, LPs again find themselves with paper gains but stuck in illiquid junk with usurious fees.
*Now enters a Layer 3 PE fund, that buys out disenchanted Layer 2 LPs again at say $100 (likely even less if the additional fee layers are capitalized and the longer chain of illiquid vehicles is factored in, as it should be). It then proceeds to mark the interest from $100 to the notional $164 net of L2 carry, and then charges another 20% carry on the gain and yet another base fee on the marked up NAV, etc...
Through the chain, base fees may exceed 3% of the inflated NAV and perhaps as high as 5-6% of the real NAV, which will be consuming much – if not all – of the underlying earnings being generated by the L1 portfolio companies, even before we account for carry/PFs rips. It's probably only a matter of time before Layer 4 and 5 funds emerge as well.
It is astonishing that the practical effect of PEs overstating their NAVs, inflating returns, and delivering poor cash distribution outcomes to their investors is that it is enabling the industry to go back for a second and now third bite of the fee cherry on the very same assets! Seemingly, no bad deed goes unremunerated in PE.
This is daylight robbery, and it will be surprising if LPs of many PE vehicles eventually even get back their original capital, let alone realize any return. And this is in a bull market! I wonder what the funding status of many pension funds is going to look like if they have to take 50%+ haircuts to get out of PE funds, or are stuck with large portions of their assets in zero cash yielding, high fee assets for decades to come? This could have systemic consequences for certain pension funds and their beneficiaries, as the PE industry continues to systematically plunder peoples retirements savings seemingly without end.
A lot of this foolishness was highly predictable. Illiquidity was marketed as a feature but it was always actually a bug. None of these problems would exist if investors had continued to avail themselves of the transparency, liquidity, and low cost access that public markets provide, instead of chasing “something for nothing” – the idea that owning businesses that are unable to be traded rather than ones that can be, and via non-transparent high fee vehicles, would through some feat of alchemy enable higher returns with lower risk.
This alchemy is proving to be the mirage it always was. Investors rushed in, chasing the promise of high returns without risk/volatility, and will now have decades to repent at leisure as they are systematically raped by high fees; are unable to repatriate their capital; and whose only option is to exit on the secondary market at steep discounts (an option that may disappear in time as secondary and tertiary funds inevitably deliver poor returns). While the PE industry has engaged in a lot of bad behaviour, fiduciaries that have loaded themselves up in illiquid, high fee PE vehicles, and who should have known better, also bear a lot of the blame for grossly inadequate due diligence and risk management; following fashions rather than analysis; and trying to defer drawdown risk to pad their own bonuses.
Given the inherent illiquidity of the PE/PC industry, however, the excesses will take a long time to fully unwind, and significant amounts of LP pain will be amortized over decades. In the meantime, the PE industry will remain the single most effective means ever devised of converting peoples’ retirement savings into fees and bonuses.
LT3000
