Rob Bauer Rob Bauer Foto: Sacha Ruland

Who becomes rich from Private Equity Funds?

In Money
Written by  Femke Kools Thursday, 23 February 2012 09:13

The standards of professional conduct within the Private Equity sector are currently under discussion in the US, following the presidential candidacy of Republican Mitt Romney, who was the head of Private Equity Funds for fifteen years. According to the research conducted at Maastricht University and Yale School of Management, up to 70% of the profit goes to these types of managers.  As a result, institutional investors who finance these funds do not get proper returns. Prof. Dr Rob Bauer, one of the UM researchers in this particular research, tells us more about it.

Private Equity funds are unlisted investment funds. With the help of big co-investors such as large pension funds, they provide capital to starting-up innovative companies (venture capital) or they refinance and restructure troubled companies or divisions of large conglomerates. The ultimate goal is to eventually resell and make big profits. This often occurs at the expense of employment or even survival of the company in question. Unions are not happy, and neither are the employees in some cases. “But on the long term it could be better for a company branch”, says Bauer. “Restructure could lead to a more efficient conduct of business or the rejection of long term unprofitable activities. It can also lead to innovation. In principle, I believe in the purifying effect of stopping things that are not profitable. But of course there are excesses, and then financiers tend to go for short-term profit.”

Morally acceptable
On 27 January, the Financial Times published the article ‘Private Equity profits called into question’ about the professional conduct of the republican presidential candidate Mitt Romney. In his fifteen years as top executive of Bain Capital, of the 77 companies he invested in, 17 went bankrupt; on just one transaction, for instance, he earned 2.5 million dollars. Is this morally acceptable? Professor of Institutional Investors, Dr Rob Bauer, definitely criticises the reward construction within the Private Equity sector. “Fund managers usually get 2% of the assets as management fees plus 20% of the profit as performance fees. When you take over and restructure (a leveraged buyout) a large company, the private equity fund will make huge profits. This incentive structure can lead to very risky investment behaviour: clearly these are wrong incentives. Moreover, 2.5 million dollars in that world is not even such a huge amount.  These managers and their employees earn millions of Euros per year, which is not surprising with such a cost structure. I would prefer a reward system in which clients get a bigger share from profits, and costs are kept as low as possible. This requires good monitoring by knowledgeable investors. But I do not think that you can blame Romney for that. It is simply a legal industry that requires institutional investors to know how the game works. And that is primarily what our research is about.”

Conclusion of the research
The publication entitled ‘Can Large Pension Funds Beat the Market? Asset Allocation, Market Timing, Security Selection and the Limits of Liquidity’, maps out which investment strategy is most profitable for pension funds. “Our main conclusion is that only the larger pension funds reap the benefits of investing in private equity or in so-called Private Investments like infrastructure, real estate and so on. Large funds have sufficient mass, manpower and knowledge to monitor, select and influence the market. Larger funds can spend a lot more time selecting good private equity providers and because of their impact and size, they are more capable of reducing costs. Our research also shows that there’s almost no room for smaller funds in this segment, especially if they hire an additional intermediate party. Fund-of-funds in Private Equity often require a high fixed reward and a substantial variable reward as well, for example, ‘1 and 10’. After cost accumulation, what is then left for the end investor, the pension fund?”
Smaller funds should focus on public markets, researchers say. “They are less affected by the disturbances in market prices (market impact) resulting from large transactions. They are much more flexible and can pick up on a new trend more easily. According to our research, large funds perform significantly worse in those markets.”
To sum up, the message of Rob Bauer and colleagues is: Know what you’re getting yourself into when you invest in Private Equity or similar non-listed investments. As a pension fund, you are only capable of achieving a decent return if you can gather enough knowledge and manpower in your organisation. And that is often only reserved for large pension funds.
The article ‘Can Large Pension Funds Beat the Market? Asset Allocation, Market Timing, Security Selection and the Limits of Liquidity’ was published in September 2011 on the website Social Science Research Network. Besides Rob Bauer, Alexander Andonov from UM and Martijn Cremers from the Yale School of Management also participated in this research.

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