Report sparks debate over 'disappointing' returns

John Bakie
28 July 2010

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The debate over the ability of private equity funds to outperform public markets has been reignited, following claims by the Centre for the Study of Financial Innovation (CSFI) think tank. The CSFI says leverage buyouts produce тdisappointingт returns, a claim the private equity industry has challenged.

A CSFI report, published last week, suggested buyout funds underperform against public markets, take excessive risks and charge their investors excessively high fees. It believes the traditional 2% management fee with 20% carry model is outdated, and makes private equity highly risky by encouraging portfolio companies to take on ever higher amounts of debt.

Peter Morris, the report's author and former Morgan Stanley banker, stated: "Fee percentages have failed to adjust to the increasing absolute size of private equity funds. The result is large private equity managers can do extremely well, even if their investors are not making good returns on their investments."

In reply, US lobbying group Private Equity Council (PEC) alluded to contradictory research. It quoted analyses from a number of sources, including Cambridge Associates and State Street, that show private equity on average outperforms public markets by 7% over three years and 11% over five years.

PEC also hit back on fees, arguing that clawbacks from investors for fund losses were a sufficient deterrent to overleveraging investments to earn more carry. It further accused the CSFI report of ignoring the trade-off between risk and returns.

Recent research from the BVCA also suggests private equity funds produce real benefits for investors, including those above the effects of leverage. Its research suggests the average buyout fund generates an IRR of 19.61%, with alpha of around 4.47%.

The debate over whether private equity returns justify their fees will, no doubt, rage on. However, with several funds recently reporting successful closes, and a growing sense of confidence among GPs and LPs, investors seem to be confident that private equity can continue to deliver.