At yesterday’s Berkshire Hathaway annual shareholders’ meeting, Warren Buffett took another swipe at private equity fund managers. “If I were running a pension fund,” he said, “I would be very careful about what was being offered to me.”
Buffett has taken shots at the private equity sector for many years, targeting the industry’s aggressive use of leverage, opaque reporting and questionable returns. As a former private equity fund manager, I don’t agree with everything Mr. Buffett says, but there have been times when his criticisms have been well-founded, particularly when the practices of some of the larger funds have been driven more by self-interest than maximising returns for their investors. Right now, I believe we are witnessing another such moment. In my view, the recent drift towards “super carry” is a step too far.
For decades, the industry ran on a “two and twenty” pricing model. Fund managers charged an annual management fee of 2% of committed capital plus 20% of profits made for investors (known as carried interest). However, over the last year or so, a handful of mega-fund managers have raised their carried interest to 30%, and there is talk of more to come.
It’s not difficult to see why. The last few years have seen record inflows of capital into the sector, with a disproportionate amount going into the coffers of the mega-funds. Pension funds and other institutional investors continue to see private equity as a route to out-performing the quoted markets and have voted with their feet, ploughing some $750 billion into the sector in 2017 alone. Faced with such massive demand for their product, who can blame some managers for raising prices? That’s capitalism at work, right?
The problem is the record returns reported over the last couple of years are not necessarily indicative of future results. You see, private equity is one of the most cyclical games in town. Recent realised profits reflect investments made in the early part of this decade, when acquisition multiples were low following the financial crisis. Right now, in my view, private company price multiples are at their peak. According to McKinsey, 2017 saw the global private equity average deal size rise by 25% and most of this was as a result of multiple increases. In other words, in order to deploy record amounts of dry powder, fund managers are having to pay handsomely for their targets. When recent investments are divested in five or six-years’ time, my worry is that we will be facing a completely different stage of the cycle.
If I’m right about prices having peaked, then future profits for investors will be considerably lower when current funds reach maturity. Worse still, investors in those mega-funds with 30% super carry will feel particularly aggrieved. Not only will their profits be lower, but they will also have paid their private equity managers much more for the privilege.
If more managers follow suit and introduce super carry into their funds, I believe institutional investors will look to do what some of their more forward-looking peers have done already. They will build their own in-house deal teams and start cutting out the expensive middle-men.
The rise of super carry means private equity managers run the risk of cutting their own throats.
