Aurora Borealis
1 September 2016 CFA Institute Journal Review

The Cost of Private Equity Investing and the Impact of Dry Powder (Digest Summary)

  1. Biharilal Deora, CFA, CIPM

The private equity (PE) industry has grown over the years, and PE has become an established asset class. But it has also experienced decreasing returns, and the cost of investing in PE over time has increased because of unused callable capital funds.

What’s Inside?

As the private equity (PE) industry has matured, the increasing asset allocations have driven down existing alpha returns, and it has become increasingly difficult to generate outstanding returns. The cost of investing in PE, as measured by the spread between actual gross and net fund returns, has overall increased, showing a negative relationship with funds’ deployment rates.

How Is This Research Useful to Practitioners?

The authors note that unused callable capital for PE funds has a significant impact on the cost of investing in PE, and it has been increasing the cost since 1996. They raise important questions about asset allocation and the ramifications of overfunding, which potentially works negatively toward an asset owner’s interest. The findings indicate the need for having downside protection for general partners (GPs) to be compensated for limited partners’ (LPs) low deployment rates without compromising deal selection criteria. They also argue for the use of an anticyclical investment approach and self-evaluation by LPs on how much committed capital the PE industry can handle before the net returns are overly depressed below a level that does not reflect the risk and illiquidity.

How Did the Authors Conduct This Research?

The authors use a proprietary sample (selection bias) of funds invested in by two LPs investing in hundreds of buyout funds. The sample consists of around 358 mainly realized buyout funds headquartered in North America (184 or 51.4%), Europe (151 or 42.2%), and Asia (23 or 6.4%) with vintage years between 1983 and 2007. The authors use ordinary least squares (OLS) regressions with heteroskedasticity-robust standard errors clustered at the GP level with such variables as gross and net returns (both money multiplier and internal rate of return), deployment rates, and fund sizes along with merger and acquisition activity.
They find that, generally, the cost of investing in PE has decreased over time, but when they control for the regression of falling gross money multiplier returns, the finding turns to PE investing actually becoming more expensive over time, with a major break in returns happening after 1996. The authors go on to check whether the reason is a change in fund terms and/or changes in GP investment behavior.
Because fund terms have been quite stable over time, the authors did not collect data on fund terms in the initial sample used and relied on the findings of Stoff and Braun (Journal of Applied Corporate Finance 2004). To check the effect of GP behavior on the cost of investing in PE, they use a simple regression that includes GP origin, time fixed effects, and the deployment rates, which displays a negative relationship with return spread.

Abstractor’s Viewpoint

The traditional fees structure for the PE industry (i.e., 2/20) is no longer the industry benchmark. Now LPs are facing pressure about the 2% management fees as well as pressures to deploy capital faster. There are enough incentives already built into the structure, such as the manager’s track record, raising new funds, performance drag, and so on, to stop LPs from behaving like robots. Also, the issue of low deployment should be seen in light of a fund’s mandate (i.e., buyout fund versus growth/special situation or emerging market fund), which may require slower deployment or patience, waiting for the situation to play out.

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