Is Private Equity Really Safe From Disruption?

This is the ninth installment of an ongoing series on managed funds. Here are the previous articles:

• Part one: using the Sharpe ratio to assess fund performance.
• Part two: identifying appropriate benchmarks for private equity funds.
• Part three: evaluating common measures of private equity performance.
• Part four: understanding the negative impacts of pension fund complexity.
• Part five: revealing the perverse incentives of pension fund managers.
• Part six: demystifying co-investment.
• Part seven: fighting back against hedge fund fees.
• Part eight: pension funds’ hunt for yield.

Private equity is its own special beast, as we have discussed throughout this series on managed funds. Even as hedge funds and mutual funds face mounting pressure to cut fees from cost-conscious allocators, private equity managers have been comparatively immune. Yes, innovations such as co-investment have been tried to lower real fees for some large-scale allocators such as sovereign wealth funds and public pension funds, but their tangible impact on net fees has been minimal.

Private equity’s comfortable position has led some industry professionals to make a rather bold claim: Private equity is the least disruptable investment sector.

The performance justification

It is important to understand why private equity incumbents remain so confident in the security of their high-fee business model. Speaking in January at Private Equity International’s CFOs and COOs Forum, Blackstone’s Michael Chae gave a full-throated defense of the industry. The CFO of the world’s largest alternative investment manager argued that high fees can justified by performance:

“From a qualitative standpoint, I think many private equity firms are really well-constructed, have great value creation and management capabilities...I think LPs think the fees are justified relative to the active management and value creation and performance that has been delivered over a long period of time.”

That is the classic case made by private equity professionals when confronted about their extremely high fees. On its face, this is a fair point. LPs clearly do see value for money, or else they would not be allocating to private equity in ever-increasing amounts.

But customer satisfaction is not the same as actual performance, even in the investing world. As we have pointed out previously, private equity’s apparent outperformance tends to evaporate when set beside appropriate benchmarks. Limited partners were satisfied with hedge funds before the Great Recession hit, but that did not stop them from migrating en masse to lower-cost alternatives when the option arose.

The least “disruptable” investment business?

During his recent conference appearance, Blackstone’s Chae went much further than simply arguing the case for private equity’s performance. Indeed, he made the positive case that private equity was uniquely -- or at least comparatively -- insulated from the disruptive forces transforming public markets:

“I don’t see in the near term a wholesale dislocation or disruption to the business like it might the traditional investing world. I think in the continuum of asset management [control-oriented illiquid strategies like private equity are] probably the least ‘disruptable’.”

When asked about the prospect of new technologies to alter the landscape, Chae was quite emphatic that technology would not steal a march on the industry:

“There’s some talk about how artificial intelligence or technology writ large could disrupt the model, whether it’s around identifying investment opportunities or, on the other hand, raising capital [for investments], I think it will be evolutionary, not revolutionary, around tools like that. I think for the most part it might change or evolve how existing players do their business.”

The tools that have forced down the fees of mutual funds, ETFs and financial advisors would not do the same to Blackstone and its ilk, according to Chae. This makes some sense on its face, since the allocators to private equity are very different from those that allocate exclusively to the asset classes that have seen large-scale fee compression over the past decade.

Verdict

While Chae’s arguments are well made (and make sense in the context of what is undoubtedly a specially insulated segment of the investment industry), they seem stuck in an outmoded way of thinking. The firm protections that private equity has been able to exploit in order to maintain high fees are still there, but there are signs that these protections may be waning.

It is becoming easier for ordinary investors to allocate capital to alternative investments, whether directly, through fund allocations, or through institutionally-managed vehicles. These changes have impacted principally on real estate and startups, with little happening so far in the buyout space traditionally occupied by private equity fund managers. But, while confidence may be well deserved to a degree, complacency could prove fatal to the established private equity giants.

Disclosure: No positions.