5 Key trends that are redefining the Private Equity Industry in 2020
There was a series of interesting news in the private equity world the past 2 weeks.
As the DOL opens the 401k industry to PE investments and the Volcker rule may potentially open the way to banks to reinvest in private funds, the SEC issues an alert on fees and conflicts of interests in the industry while industry researchers question performance calculation methods.
1- Private Equity finally gains access to 401k
The U.S. Department of Labor, which oversees retirement plan rules, on June 3 issued guidance that opens the path to include PE funds in some retirement plans. The guidance doesn’t say that workers will have the option to pick one by themselves. Rather a PE fund might be included as part of the portfolio of another diversified fund. John Rekenthaler in an article on Morningstar says, “the letter does not permit 401(k) plans to offer stand-alone private equity investments. Instead, private equity must be used as an investment sleeve within a broader fund. This restriction eliminates several major concerns about adding private equity to 401(k) plans. Participants will be able to hold only a limited amount of the asset, and they will not select the managers. Nor will they be responsible for understanding the valuation process and how the returns are calculated. Those tasks will be delegated to investment professionals.”
The Wall Street Journal explains how the guidance came to happen. The Labor Department issued the letter at the request of Partners Group and Pantheon Ventures Ltd., both of which offer private-equity funds designed to be included in 401(k) plans. The firms wanted the guidance so that sponsors of defined-contribution plans would be less afraid of litigation if they included private-equity investments in their plans, said Susan Long McAndrews, a Pantheon partner.“ The idea was to try to get some clarification and give plan sponsors some air cover if they decided to innovate,” she said.
2- Banks coming back to Private Equity with recent Volcker rule changes
Another good news for the industry comes from the easing of the Volcker Rule. FDIC officials said they are loosening the restrictions from the Volcker Rule, allowing banks to more easily make large investments into venture capital. This is a major development, since the Great Depression, banks had lost the ability to invest directly in privately managed funds. A move that deprived the industry of a much needed source of funds. In addition to the Federal Reserve and the FDIC, the changes were endorsed by the Securities and Exchange Commission, the Office of the Comptroller of the Currency and the Commodity Futures Trading Commission.
In her Statement on the Final Rule titled: “Revisions to Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds”. Jelena Williams declared: “ To facilitate capital formation, the rule would enable banking entities to provide credit through fund investments that would increase the availability of capital for businesses across the country. For example, banking entities would be permitted to invest in qualifying venture capital funds and credit funds, subject to important safeguards. In addition, the rule would improve several existing exclusions from the covered fund definition to provide clarity and simplify compliance.
AP, CNBC, FDIC
3- The SEC alert on fees, conflicts of interests
in a public alert released last month, the SEC identified nine broad types of conflicts of interest it has seen in its exams, including giving preferential treatment to certain investors and having multiple companies owned by the same firm doing business with one another.
In Conflicts of interests: the SEC emphasized:
Conflicts related to allocations of investments:
- Preferential allocation of limited investment opportunities to new clients, higher fee-paying clients, or proprietary accounts or proprietary-controlled clients, thereby depriving certain investors of limited investment opportunities without adequate disclosure.
Conflicts related to multiple clients investing in the same portfolio company
- Lack of adequate disclosure about conflicts created by causing clients to invest at different levels of a capital structure, such as one client owning debt and another client owning equity in a single portfolio company,depriving investors of important information related to conflicts associated with their investments.
Conflicts related to financial relationships between investors or clients and the adviser.
- Lack of adequate disclosure about economic relationships between themselves and select investors or clients. In some cases, these investors acted as initial investors in the adviser’s private funds (also known as “seed investors”).
Conflicts related to preferential liquidity rights.
- The staff observed private fund advisers that entered into agreements with select investors (“side letters”) that established special terms, including preferential liquidity terms, but did not provide adequate disclosure about these side letters.
Conflicts related to private fund adviser interests in recommended investments.
- The staff observed private fund advisers that had interests in investments recommended to clients, but did not provide adequate disclosure of such conflicts.
Conflicts related to co-investments.
- The staff observed inadequately disclosed conflicts related to investments made by co-investment vehicles and other coinvestors, potentially misleading certain investors as to how these co-investments operate.
Conflicts related to service providers.
- The staff observed inadequately disclosed conflicts related to service providers and private fund advisers. For example, portfolio companies controlled by advisers’ private fund clients entered into service agreements with entities controlled by the adviser, its affiliates, or family members of principals without adequately disclosing the conflicts.
Conflicts related to fund restructurings.
The staff observed private fund advisers that inadequately disclosed conflicts related to fund restructurings and “stapled secondary transactions.
- Advisers purchased fund interests from investors at discounts during restructurings without adequate disclosure regarding the value of the fund interests.
Conflicts related to cross-transactions.
- The staff observed private fund advisers that inadequately disclosed conflicts related to purchases and sales between clients, or cross- transactions. For example, advisers established the price at which securities would be transferred between client accounts in a way that disadvantaged either the selling or purchasing client but without providing adequate disclosure to its clients.
Fees and Expenses
OCIE staff observed the following fee and expense issues that appear to be deficiencies under Section 206 or Rule 206(4)-8:
• Allocation of fees and expenses. The staff observed private fund advisers that have inaccurately allocated fees and expenses. For example:
- Advisers failed to comply with contractual limits on certain expenses that could be charged to investors, such as legal fees or placement agent fees, thereby causing investors to overpay expenses.
“Operating partners.” The staff observed private fund advisers that did not provide adequate disclosure regarding the role and compensation of individuals that may provide services to the private fund or portfolio companies, but are not adviser employees (known as “operating partners”), potentially misleading investors about who would bear the costs associated with these operating partners’ services and potentially causing investors to overpay expenses.
Valuation. The staff observed private fund advisers that did not value client assets in accordance with their valuation processes or in accordance with disclosures to clients (such as that the assets would be valued in accordance with GAAP).
- In some cases, the staff observed that this failure to value a private fund’s holdings in accordance with the disclosed valuation process led to overcharging management fees and carried interest because such fees were based on inappropriately overvalued holdings.
Monitoring / board / deal fees and fee offsets. The staff observed private fund advisers that had issues with respect to the receipt of fees from portfolio companies, such as monitoring fees, board fees, or deal fees (collectively “portfolio company fees”). For example:
- Advisers failed to apply or calculate management fee offsets in accordance with disclosures and therefore caused investors to overpay management fees. In some instances, advisers incorrectly allocated portfolio company fees across fund clients, including private fund clients that paid no management fees.
MNPI/Code of Ethics:
OCIE staff observed the following issues that appear to be deficiencies under Section 204A or the Code of Ethics Rule:
The staff observed private fund advisers that failed to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI as required by Section 204A. For example:
- Advisers did not address risks posed by their employees interacting with:
(1) insiders of publicly-traded companies,
(2) outside consultants arranged by “expert network” firms, or
(3) “value added investors” (e.g., corporate executives or financial professional investors that have information about investments) in order to assess whether MNPI could have been exchanged. - The staff also observed private fund advisers that did not enforce policies and procedures addressing these risks.
Code of Ethics Rule.
- Failure to establish, maintain, and enforce provisions in their code of ethics reasonably designed to prevent the misuse of MNPI. For example:
- Failure to enforce trading restrictions on securities that had been placed on the adviser’s “restricted list.”
The alert is intended to help private-fund advisers improve their compliance programs and give investors information on what to look out for, the agency said
3- The inconvenient report
It started with French scholar Phalippou highly disputed study on private equity fees, returns and billionaire machine. The report supports the view that despite being sold as independent from public market whims, PE funds have been unable to beat public markets on a number of period after fees. The report was heavily disputed by the funds and Phalippou even included their objections in the paper.
An excerpt from the Financial Times:
The number of private equity barons with personal fortunes of more than $2bn has risen from three in 2005 to 22, according to a new analysis which estimates investors paid $230bn in performance fees over a 10-year period for returns that could have been matched by an inexpensive tracker fund costing just a few basis points.
“This wealth transfer from several hundred million pension scheme members to a few thousand people working in private equity might be one of the largest in the history of modern finance,” said Ludovic Phalippou, professor of finance at Oxford Saïd Business School.
The paper abstract:
Private Equity (PE) funds have returned about the same as public equity indices since at least 2006. Large public pension funds have received a net Multiple of Money (MoM) that sits within a narrow 1.51 to 1.54 range. The big four PE firms have also delivered estimated net MoMs within a narrow 1.54 to 1.67 range. Three large datasets show average net MoMs across all PE funds at 1.55, 1.57 and 1.63. These net MoMs imply an 11% p.a. return, which matches relevant public equity indices; a result confirmed by PME calculations. Yet, the estimated total performance fee (Carry) collected by these PE funds is estimated to be $230 billion, most of which goes to a relatively small number of individuals. If all vintage years are included to 2015, Carry collected is $370 billion, with a performance similar to that of small cap indices, but higher than that of large cap stock indices. The number of PE multibillionaires rose from 3 in 2005 to 22 in 2020. Rebuttals from the big four and the main industry lobby body are provided and discussed.
Phalippou, Ludovic, An Inconvenient Fact: Private Equity Returns & The Billionaire Factory (June 10, 2020). University of Oxford, Said Business School, Working Paper. Available at SSRN: https://ssrn.com/abstract=3623820 or http://dx.doi.org/10.2139/ssrn.3623820
The report can be found here.
The FT has a set of articles here