Analysis Of Private Equity Business

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More recently, a pair of European academics, Ludovic Phalippou and Oliver Gottschlag, demonstrated in a paper that the poor performance of private equity firms could be understated. When private equity firms report the value of their funds, they include estimated values of deals before the investments are actually realized through a sale or share offering. Surprise, surprise: Those estimates tend to be biased upward. When the data is cleaned up, Phalippou and Gottschlag found, it becomes clear that the private equity industry tended to underperform the S&P 500 by three percentage points a year after fees.

In the end, the data is all largely irrelevant. Private equity thrived—and will continue to thrive—because its execs have excelled at finding believers. Private equity firms long ago persuaded pension funds and endowments to commit to their funds; by 2006 and 2007, they were snowing the banks, which fell over themselves to lend money on questionable terms. Much of this was known at the time and reported in broad strokes. But it’s only now becoming clear how masterfully the private equity firms handled those negotiations. Investors poring over beaten-up bonds of private-equity-owned companies currently in trouble are now discovering trip wires galore.

Private equity execs were adept at more than just relaxing the covenants of their companies; they also were brilliantly elastic in defining how profitable their companies were. Take Apollo and its absurd investment in Realogy, which Apollo acquired in December 2006, for a fat premium over the stock price. In a standard loan agreement, the lender gains power and might even assume control if the borrower triggers certain clauses of the contract. Typically, the borrower is required to keep up a certain level of cash flow.

The Realogy credit agreement is a cunning thing of beauty to behold. For one, it has an “equity cure” provision, which stipulates that if Realogy starts running into problems, it can raise money from investors, including Apollo, and then count that money as cash flow for the purposes of its loan covenants. Neat trick No. 2 is that the agreement allows Realogy to take its trailing cash-flow figure and adjust it for the cost savings the company intends to reap if it has merely identified them. That’s sort of like asking your mother for your allowance today based on all the chores you plan to finish over the next year.

Such slick terms won’t be enough to save Realogy, whose bond prices now reflect the expectation that it is headed toward bankruptcy. The terms were primarily for the benefit of Apollo, which will be able to retain control of its investments much longer than it would have under normal lending conditions.

Siren SongThe other major factor working in private equity’s favor is that many of the biggest firms have raised money for their follow-on funds—often before the current fund results that contain the 2006-07 time bombs are fully known. Throughout last year, private equity firms asked their investors to make good on those commitments. Many universities and pension funds began to redeem from hedge funds to fulfill their obligations.

Even though these limited-partner investors in private equity firms are generally sour about the funds’ current terrible performance, they don’t ­really have anywhere to go. Pension funds, in particular, overpromised to their pensioners and are now so desperate for returns, they are going to buy into the private equity story. The academic research shows that the top-­performing funds are more likely to continue to perform well. Therefore, if you can somehow get into a great fund, the thinking is that over time, you’ll be in good shape.

“Anyone who goes into private equity thinking the average of private equity will beat the average of the public markets is misguided,” says Britt Harris, chief investment officer of the Teacher Retirement System of Texas. “It’s well-known that as a whole, it’s not a value-added operation.” But he latches onto the academic research that finds that the top funds will most likely remain the best performers. “If in first quartile,” he says, “outperformance is likely to be very high.”

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