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Private Equity: The New Hedge Fund?

Let’s face it. 2015 was a calamitous year all round. In the past year, we had experienced China’s black Wednesday, a near-capitulation of the Eurozone, and prices of crude oil so ridiculously low that ships are now sailing around the Cape of Good Hope once again rather than pass through the Suez Canal.

Alas, asset classes that produced net positive returns were few and far between. Although, ultimately in the world of finance, that’s not the thing that really matters. You only need to outperform the market. Or your peers. Or even better, a self-constructed index, to show investors that this fund manager “out-performed”, however way one wishes to interpret that word.

Amidst the relative chaos and talk of an impending recession, investors looking for protection against volatility have turned to Private Equity (PE) funds. Regarded by many as a bastion of stability and consistent “out-performance”, this alternative asset class has risen to the top of many an investor’s choice.

But is all in PE as promising as it seems?

Yes, PE investors and fund managers alike will point to PE funds consistently outperforming market indices. However, a paper titled “How to Private Equity Investments Perform Compared to Public Equity?” by Robert Harris, Tim Jenkinson and Steven Kaplan, suggests otherwise. Up to 2005, it is true that PE funds have indeed outperformed the market. Riding on the Dotcom bubble of the roaring 1990s in the United States, notwithstanding the eventual bursting, PE funds did manage to reward investors with an additional 15% return over the market (S&P 500) on average.

But move the needle back post-2005, and the scenery becomes a little less majestic. At best, PE funds have merely been tracking the market. What this suggests is that in the 10 year period that sandwiches the Great Recession of 2008, PE funds have not performed all that great. From reasons ranging from increasing financial regulations, growth of the secondary market or PE firms simply losing interest in the mega-buyouts of old, PE funds have in fact failed to distinguish themselves as the go-to place for investors to protect and more crucially, grow, their wealth.

Yet, money continues to pour into PE, probably at roughly the same rate as money is being sucked away from hedge funds. According to a report form Hedge Fund Research Inc., as at 30th September 2015, the hedge funds industry had their worst ever quarter since the 2008 crisis. The number of funds liquidated increased to 257, from 200 in the previous quarter; of course, few funds were spared. William Ackman’s Pershing Square Holdings portfolio, which reined in some 40% gains to make it one of the best performing funds in 2014, lost 12.6% in asset value, matching many other double-digit losses year-to-date in the hedge fund industry.

Hedge fund investors, acting on their ability to redeem their investments with relative ease, have driven the hedge fund industry south. In a bearish market, that means funds are losing a lot, very quickly. Having had barely enough time to catch their breath after the 2008 crisis, hedge funds struggled substantially when 2014-2015 came around, with the afore-mentioned record number of closures now painting a bleak outlook for the near future.

Could the same befall upon the mighty PE investor?

Wait a minute, PE fund and hedge funds have different redemption rules, some may say. While hedge funds investors may choose to cash out on relatively short notice, PE funds investors have their investments “locked-up” for a much longer time of (typically) at least five years. On the one hand, this may prevent sudden, short-term crippling of PE funds. On the other hand, the post-2008, or more recently, post-2015, risk-averse investors may find it too risky to park huge investments over such an extended time period, and now with a lower likelihood of substantial market-beating returns.

And yet, money continues to pour into PE. While the inflow of capital may seem like a windfall for PE funds, the alert investor must be cognizant that there are always two sides to a coin, no matter how adept your fund manager is at convincing you his tosses always land on heads.

With such an influx of capital, PE fund managers are under pressure to put this money to good use. After all, there is not much point in letting someone else manage your money by not doing anything with it. However, given the current economic climate, opportunities are harder to come by. Fund managers may tend to invest “for the sake of investing”, which means that some of these investments naturally would not necessarily provide the returns one would typically associate PE with. While investors scratch their heads at mediocre returns after five years, fund managers will be rubbing their hands together gleefully at the 2% management fee they typically charge.

To add fuel to the fire, given the scarcity of potential mega-deals, battles ensue amongst large PE firms that, ultimately, hurts investors the most. In leveraged buy-outs, a practice which PE firms are supposedly experts at, fierce competitions to seal the deal are driving prices up and forcing returns down. Overall, the accumulation of capital in the PE industry may spell its demise.

There are hardly any reassuring signs that 2016 is going to be a quick rebound from the tumultuous 2015 that we were all too happy to wave goodbye to. While it remains to be seen whether PE follows the path its older brother (hedge funds) took, I, for one, would not be willing to put my life savings into any PE fund just yet.