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
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.
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.