Con Keating

This blog was written in response to Henry Tapper’s blog of Monday 21^st March in which he raised the question: “I don’t understand why illiquids have to use performance fees.” As it happens, I had just written an opinion piece for Professional Pensions which touched on the use of illiquids. To quote from that:

“ The pensions minister, Guy Opperman, has been encouraging the wider use by pension funds of illiquid investments. This is a sound idea, but the timing is terrible.”

The cost of liquidity is currently close to its all-time lows, and it is liquidity which has a cost, not illiquidity which commands a premium. This point that it is liquidity which has a cost is most easily illustrated with the higher prices and lower yields of ‘on-the-run’ US Treasury securities relative to the older, seasoned, less liquid ‘off-the-run’ issues. It is also reflected in narrower bid-offer spreads for the highly traded ‘on-the-run’ issues than the ‘off-the-run’. The cost of liquidity experienced by an investor will result from the difference in the price of liquidity at acquisition and the price prevailing on sale.

This low cost of liquidity is a direct result of quantitative easing. It has also found expression in the unwillingness of the investment banks to run the huge bond trading inventories of former times. The current price of liquidity is insufficient reward for them. As investors, buying at today’s price may look very foolish at tomorrow’s, when we need to liquidate.

Traditionally, property was the home of illiquid investments, but pandemic, or more correctly the government response to pandemic, has torpedoed the commercial and industrial sectors there. The rents and income from these sectors have declined dramatically, but the debt service on them continues inexorably. Do we really know enough about the future state of our economy and the high street to make new commitments to property?

The Minister has added another dimension to support the promotion of illiquids, through variation of the ‘charge cap’ rules:

“That is why I am bringing forward draft regulations, building on the policy proposed previously by the government, which would allow schemes to smooth the incurrence of performance fees, which are often payable on illiquid investments, over five years.”

Make no mistake, this is a mistake.

Spreading any fee incurred over five years is a distortion of reality. It would not be feasible to spread it retroactively and spreading it over the coming five years would give current savers an incentive to take the money today and run to some other scheme.

The Minister also stated:

“The hope is that this will give trustees, especially those who might be unsure about investing in illiquid assets, greater confidence to make that leap, safe in the knowledge that they can deliver the best possible return for their members.”

To answer Henry’s question directly, illiquids do not need to be associated with performance fees. In fifty years of investing in property I have never been asked even to consider a performance fee. Performance fees are commonplace in hedge funds and private equity, and more recently, absolute return UCITs have borrowed this from them. Note that these absolute return UCITs follow the same liquidity regulation as other UCITs – twice a month, the saver can liquidate.

The illiquidity or lock-ups we see, as investors in hedge funds, have little to do with the nature of the assets in which they themselves are invested; these are predominantly listed and traded securities. By contrast, private equity funds do have portfolios of illiquid investments. It is interesting though, that PE investors often try to capture the cost of liquidity by listing the sale of companies in public markets.

The standard arrangement with hedge funds and private equity is often referred to as two and twenty, meaning a 2% ad valorem management fee and a twenty percent share in the fund returns. One recent academic study reported averages for the hedge fund industry of 1.54% management fee and 17.66% performance share.

A simple calculation shows the rapacious nature of these charges. Suppose you wanted to earn 7% net from your investment, then the fund would have to earn 10.35% to leave you with that 7% at these average costs rates. Maybe we should consider valuing our hedge fund and private equity assets as the impaired assets they are.

We should address the question as to whether these performance fee charging funds are likely to deliver “the best possible returns for members” that the Minister desires. These are many academic studies which examine the performance of hedge funds, private equity and absolute return UCITs.

To quote one recent study: “In the paper we show that the top UCITS (absolute return) fund portfolios deliver alphas that are negative across all rebalancing horizons no matter whether they measured net-of-fees or gross-of-fees. This implies that performance chasing by UCITS investors would result in significant negative risk-adjusted returns. For conventional hedge funds, the net-of-fee alphas are close to zero, whereas their gross-of-fee alphas are positive. This suggests that managers that run conventional top funds extract all the economic rents.”

And as Professor Phalippou of the Said Business School avers:

“Private Equity (PE) funds have returned about the same as public equity indices since at least 2006.”

Professor Phalippou asks a pertinent question:

“Why are non-PE people not objecting?”

and answers this.

“Those who know enough about PE are easily outnumbered, and even they may not know all the tricks (e.g., what is presented as a net return is not the rate of return earned by investors). But even when they understand the tricks, presenting a solid case against a myth perpetuated by thousands of clever people, who are well financed and in powerful positions … is still an uphill battle.”

He continues with:

“A tangible example of this appears in an anecdote told by one of the most renowned economists in this field, Brad Case: “I was asked to comment on a set of slides being developed to encourage defined contribution plans to include private equity investments. The “historical performance” was entirely gross of fees, meaning it didn’t come close to what “beneficiaries” would actually receive. When I pointed this out, the author explained that showing net returns would be false and misleading, because different investors pay different fees: only the gross returns are consistent across all investors. So instead of showing “historical performance” numbers that are accurate for some and somewhat accurate for all, the author said the only “honest” approach is to show numbers that are hugely wrong for everybody!”

The private equity industry is keen to promote the idea that this is a superior form of ownership. Morris and Phalippou address this in a short paper:

“Almost exactly 30 years ago, a famous article by Michael Jensen in the Harvard Business Review predicted that private equity (meaning leveraged buyouts, not venture capital and other private equity) would “eclipse” the public corporation because it was a superior form of corporate ownership.”

But they conclude, and this conclusion is based upon their enormous body of work on the subject:

“Thirty years after Jensen’s article, we believe the jury is still out. There is no proof yet that private equity in its current form is a superior form of ownership.”

These issues are hardly new, as this quotation from David Swensen, then CIO of Yale Endowment, in the year 2000 shows.

“Paying 20 percent of the profits to the general partner instead of 20 percent of the value-added drives a meaningful wedge between the result for the general partners and limited partners. Poor incentive schemes cause buyout fund managers to benefit by placing limited partner assets at risk, creating an extraordinarily valuable option for the general partner that comes at the expense of the providers of the funds(…) If private manager compensation depended on generating returns in excess of marketable investment opportunities, most would fail to receive a profits interest as results for the majority of private funds fall short of traditional equity alternatives (…) the investment management industry receives compensation far in excess of levels justified by the degree of value created”

The most succinct summary of the position is

“Today promises of high returns are mostly empty.”

“The hope that this will give trustees … greater confidence … safe in the knowledge that they can deliver the best possible return for their members” appears to be wishful thinking given these performance records.

To quote Applebaum and Batt:

“Unlike the shareholders of publicly traded PE firms, pension funds and other institutional investors continue to be lulled into thinking that these investments will provide strong returns. Despite poor performance and excessive fees, pension funds and other investors continue to pour money into private equity funds. … The stock market’s view of the future performance of publicly traded PE firms suggests these investors are likely to be disappointed.”

We should not forget that there is much academic and practitioner analysis which shows that the returns to conventional equity and bond portfolios are inversely related to the fees they incur. The charge cap has been a success story; the average fee paid is now just 41 basis points. Messing with that runs the risk of being a severely retrograde step for savers in DC schemes.