Tuesday, August 23, 2016

Don’t Ask, Don’t Sell is the editorial decision that precedes most popular press stories concerning private equity. Editors do not ask if a statement is correct as clarifying details that dilute the headlines effect will hinder publications from selling. The NY Times ran a recent series covering over a dozen column inches; “What can go wrong when PE takes over a Public Service?” The story featured only two PE owned companies that privatized ambulance services. Yet, as a function of anecdotes from two stories, the Times felt comfortable concluding PE ownership results in poorer customer service, but had no data on any other PE owned service nor did it explore service levels in municipal owned ambulance services versus PE levels nor did it explore the question of why municipalities could not afford to provide the service. Each of these narratives would have sullied the author’s clear mission to pillory PE. Imagine “What can go wrong when government takes over a service?” (Health care, airport security, water in Flint) as a headline the NY Times will never run.

The most repeated, but least accurate description of the PE business is the mantra “2 and 20” as shorthand for its fee structure. Calpers has been fairly exposed for not reading the quarterly reports they receive to understand the amount they pay in fees, but far worse a sin is they do not know how they pay fees as indicated by the 2 and 20 cliché. At best, the fee structure is 2 or 20, not 2 and 20. That is a significant economic difference to investors. I do not mean to suggest PE is inexpensive, it is not. But the hierarchy of compensation is poorly understood as the media chooses not to ask or not to report the details. At the risk of getting wonky enough to get thrown off all backyard BBQ lists, here is the actual hierarchy: 20% net profits if all fees (2%) repaid and 8% preferred return earned or 20% net profit, if more than 10% earned. In other words if 2% fees and 8% preferred are earned and paid to the investor, then 20% of remaining net profits inure to the general partners.

Compare the PE arrangement to the hiring of a typical Public Equity Manager. Fees are 60 basis points or .60% times net asset value. Over ten years the public manager’s fees, which rise in dollars with any positive rate of return, more than double (1.4%), relative to the original investment, if a 10% rate of return is earned annually. None of this fee needs to be repaid to the investors. For the same result, a 10% ten year rate of return, the PE manager is not entitled to any profit interest, having repaid the 2% fee and the 8% preferred return. As imperfect as any compensation can be, it appears PE’s 2 or 20 is much better aligned with the investors’ results than other common market compensation schemes.

Influenced by the outrage created by the 2 and 20 headlines, the UK authorities decided to legislate a solution that is now in force. Remember the UK also invented the rules for golf and snooker. So to a crowd for whom a rule stating you can remove sand if it is on short grass, but not sand on long grass makes sense, the following is given. Two new categories, “good” and “bad” carried interest have been created. Whether or not a profit is good or bad will depend upon the weighted average life of a Fund’s investments at the time an investment is sold. The weighted average is weighted by value of the investments. For example, the average hold of a $10 investment held for one year and a new $20 investment is not six months, but slightly more than three months due to the weighting formula. Good carry arises at 40 months with a curve beginning at 36 months. The holding period has to be recalculated each time carry is paid. As you can see, a large investment made later in the fund’s life can wildly distort the average hold math, putting the general partners in conflict with investors who may wish for an early exit and liquidity on older investments. Carry is treated as conditionally exempt from the income based carried interest rules for up to ten years after the first investment. Clear as day now, isn’t it? These Brexits may prove to be knottier than the one with the EU.

I’m Rob Morris and I approved this blog.

Don't Ask, Don't Sell