Filling the basket

I didn’t mean to turn this week into a week criticising private assets, but this is the third day in a row when I will be discussing private equity or private debt. To be clear: I am not against these investments, it just so happens that I was inundated by a series of papers that showed how general partners try to tilt the playing field in their favour. As with all unregulated or weakly regulated investments, the maxim for investors should be ‘buyer beware’. Do your due diligence and this mini-series of articles is intended to help investors with that.

Private equity managers are usually compensated through fees generated during the lifetime of a fund. But the nature of these fees changes. In the first four to five years, general partners typically are paid as a percentage of committed capital, whether that capital is invested or not. Sometime around year 5, the fee structure changes, and general partners are paid as a share of invested capital.

This creates an incentive for general partners to invest as much money before the switch in fees. However, what is a fund manager to do when after three years or so, a large part of the committed capital is not invested yet? The incentive then changes to invest as much money into any project, whether it is viable or not. They have to fill their basket as fast as possible to maximise their fee income. The result is that one would expect that investments made in years four or five of the life of a fund are worse than investments made earlier.

In essence, general partners increase their fee income by diluting the quality of the investment portfolio and the future return for investors.

Hyeik Kim examined more than 5,000 deals by more than 1,800 European private equity funds made between 1984 and 2018. As expected, he found that investments made in years four or five of a fund’s life perform materially worse than investments made earlier. The chart below uses EBITDA margin growth as a measure that is difficult to manipulate (remember what I wrote two days ago?). Later investments have substantially lower margin growth.

Margin growth of fund investments by investment year

Source: Kim (2024)

Further analysis in the paper shows that investments made at a later stage in the fund’s life have a higher likelihood of being unprofitable and create a drag on fund IRR and money multiples.

Ironically, the more experienced a general partner is, the more pronounced this effect is. It’s almost as if experienced private equity managers have learned that fee income is more valuable than performance. And, possibly not surprising, the larger the share of investment held by pension funds, the more pronounced this effect is as well, indicating that a lack of oversight of fund managers by investors allows the managers to get away with it.

What are investors to do then? If a fund hasn’t made a lot of investments in the first two to three years of its life, investors should increase oversight and (if possible) reduce capital commitments. At the very least they should think long and hard before increasing their commitments to such funds. It might amount to throwing good money after bad.

And with that, I will stop writing about private equity and private debt for a while. Time to move on to greener pastures. And since tomorrow is Friday, I promise you, I will not write about anything as depressing as today. Instead, I will return to a very important topic for investors I wrote about before. But since it is of such vital importance, I must revisit the issue. I am talking, of course, about Mercury retrograde.