Earlier this month, a New York Times story discussed the costs associated with private equity investing at some length. “Private equity” is a broad term covering investments in companies in which there is no public trading. Typical investors are wealthy individuals and institutions (e.g., pension funds).
Why should anyone care about private equity? Harvard’s and Yale’s endowments (among others) have attributed a significant portion of their excellent investment returns to private equity investments. In addition, private equity has a certain mystique deriving at least in part from its inaccessibility.
Only accredited investors (meeting certain income and asset requirements) can participate. And, by its nature private equity trading is relatively illiquid (securities not SEC-registered, no public trading).
The article was interesting for at least two reasons:
- Rather than extol the purported return advantages of private equity as an asset class, it highlights some of the cost disadvantages (of course, a more complete analysis would attempt to net the costs against the benefits, but this is a newspaper article!)
- It casts some rarely discussed advantages of mutual funds into full relief.
So what about those costs?
|Cost Element||Private Equity||Mutual Funds|
|Management fees||1-2% of assets||1% (and often less) of assets for index and passive strategies.|
|Profit share||20% of gains||Relatively rare.
Must be symmetrical (positive for gains, negative for losses).
|Transaction fees||Charged Separately||Can be substantial (comparable to expense ratio) for actively managed mutual funds; limited for index and many other passive strategies. Returns are net of these expenses.|
|Legal costs||Charged Separately||Must be included in the expense ratio.|
|Monitoring or oversight fees|
|Expenses charged to portfolio companies||Charged Separately||Not feasible for mutual funds.|
Explicit private equity fees (1-2% per year of the amount invested plus 20% of any profit) are significantly higher than mutual fund fees (for index funds often less than .2%, managed funds often less than 1%, and rarely a percentage of the profit).
Then private equity fees pile on. First, there are operating expenses, including transaction fees, legal costs, taxes, and monitoring or oversight fees. To be fair, mutual fund shareholders also pay transaction costs (trading expenses that the expense ratio does not cover); both explicit – trading commissions – and implicit – spreads on traded securities. However, mutual fund investors do not pay separately for legal expenses, monitoring or oversight (read investment management) costs.
Finally, private equity firms charge fees to their portfolio companies. Mutual fund advisors can’t charge a fee to any company included in the fund portfolio.
Management fees, profit shares, monitoring or oversight fees and the expenses charged to portfolio companies all represent compensation to the private equity firm. If the deal does not specify these items in advance, the private equity firm can appropriate returns for itself before sharing them with its partners – a clear conflict of interest.
|Attribute||Private Equity||Mutual Funds|
|Transparency||“To outsiders, the lucrative business of borrowing money, buying companies and hoping to sell them later at a profit is as impenetrable as a lockbox. Rates of return and hidden costs are difficult to identify, even for investors in these deals.”||Mutual funds report results quarterly, and must report holdings at least semi-annually. Many funds publish updated results daily on their websites.|
|Consistency||“There is not a broad consensus within the industry on what is a cost.”||All mutual funds must publish prospectuses. The SEC prescribes the information they must contain, including investment strategy, prior performance history, risks and fees and expenses.|
|Comparability||If rates of return and hidden costs are difficult to identify for a particular fund, it must be nearly impossible to compare them across private equity deals.||Several services (including Lipper and Morningstar) compare performance among similar funds, and also to benchmarks.|
The larger advantages of mutual funds may be transparency, consistency and comparability.
Mutual funds must follow a strong set of rules, and must report their results (and their costs) in a standard format on a regular schedule. Mutual fund investors can put their analytical energy into choosing among the alternatives available to them.
In contrast, private equity investors must devote considerable effort to learning what historic costs and returns have been for any private equity deal they consider before they can even begin to analyze. The extra diligence required is very substantial, and even once completed is unlikely to provide private equity investors with the same degree of understanding and confidence that mutual fund investors enjoy.
Private equity can be mysterious. Investors may do better to enjoy playing detective in novels, movies and games, and keep the mystery out of their investments.