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Private equity performance

Private equity returns have mostly been poor when adjusted for the risk taken. Leveraged long only is hazardous. Most large private equity funds focus on big career-making deals and asset-gathering INSTEAD of generating alpha. In my experience and having conducted due diligence on many funds, most private equity firms have no risk management ability. Brilliant salesmen but weak investment skills.

Those nice-looking IRRs are just the result of leveraged beta in most cases. Investing in private companies is a great portfolio diversifier but big LBOs have dire risk/reward profiles. The easiest way to make money out of private equity these days is to buy listed LBO candidates and sell out to the private equity "geniuses" when they launch a bid to buy it from you. Yes you can arbitrage the unskilled! Capture alpha out of these simple beta repackagers.

Of course there are plenty of good, mostly boutique, private equity firms out there. Doing smaller, higher returning, less leveraged deals often in industry sectors they have domain expertise. Actually restructuring portfolio companies instead of using them as an ATM for the General Partners. Raising money that can optimally be put to work rather than what looks good on the resume and charging 2% "management" fees on committed capital but uninvested cash.

Why are several prominent private equity firms trying to IPO when taking other businesses private is apparently such a good idea? In general those firms have dubious performance calculation methods, use high leverage resulting in their risk-adjusted performance being poor, maintain little control of fund size and receive scant attention from regulators despite the far higher systemic dangers they pose than hedge funds.

Stockholders would love to bill companies for owning their stock and sending an invoice whenever they speak with a firm's management for the "monitoring". Maybe stop waiting for the stock to go up and just get companies to borrow even more money to pay stockholders a "special" dividend. Get an obedient bank to originate, advise, fund and ultimately extricate them from the deal. Then simply cook up a "valuation" and a high IRR and tell the LP's what a great job they've been doing. This would be unacceptable in ANY other field of finance but standard practice in private equity.

Private equity is on a roll because past performance has allegedly been good. We don't know the real numbers because of all the tricks used to game IRR's but they are much lower than the GP's claim. Lemming performance chasers are all over the asset class and private equity firms are all over each other trying to raise the BIGGEST fund instead of managing the BEST fund. They should be focusing on generating the biggest returns NOT biggest deals but that is usually not where their skills lie. And why are so many institutions with fiduciary duties investing in this non-diversifying strategy? Mainly because private "benchmarks" are easy to beat. There is NOTHING alternative about private equity as far as major LBOs go. Large investors usually own the existing LISTED stock already in their public equity allocation.

Big private equity is just leveraged long only equity beta. It is NOT an alternative investment. There is little skill, no hedging and zero risk management. If you calculate a real private equity IRR and adjust for risk and leverage, there has been NO alpha created by most of the "famous" firms. The big groups' restructuring and value creation abilities have generally been overrated and blessed by an ideal environment to disguise their luck as skill.

Coming off the large drop in the equity markets in 2000-2002 there were indeed some companies around to take private. Low interest rates and a benign credit market created a perfect habitat for leveraged buy-outs. But the low hanging fruit are gone and now there is too much money reaching for yield where the risk/reward equation is unfavorable. Paying off all that debt will be difficult WHEN credit markets run into already overdue problems and the economic "soft-landing" turns out to be a major recession.

By Hedge Fund Creative Commons License

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