Private equity firms have only so much capacity — and elite institutions have the upper hand in getting access to it, according to a new paper by professors at Harvard and MIT and two researchers from State Street Corp.
In response to both fee pressure and a desire for access from smaller and less-gold plated institutions, private equity firms have been increasingly launching strategies that are offshoots of their main funds and co-investment opportunities. But even after accounting for fee discounts, the new vehicles don’t perform better than the firm’s top-shelf funds and, in many cases, deliver lower returns.
“It’s the supply and demand effect,” said Josh Lerner, professor of investment banking at the Harvard Business School and one of the authors of the study,Investing Outside the Box: Evidence from Alternative Vehicles in Private Capital, in an interview with Institutional Investor.
Returns may be lower because managers only have so many good investment ideas. As a result, the top firms won’t budge on fees.
“The best groups may not be willing to offer discounted separate accounts or co-investments at all,” write the authors in the report. “However, they might be willing to set up alternative vehicles with lower deal quality to target less premier LPs.”
[II Deep Dive: Private Equity Firms Get Creative with Fees]
Capacity has become an issue as institutional investors have steadily increased their allocations to private equity. In the 1980s, 93 percent of investors’ capital commitments went to private equity firms’ main funds. That fell to 76 percent in the 2000s. The rest of the money went into so-called alternative vehicles, or funds other than the firms' main funds, according to the study.
The average performance of the top private equity firms' alternative funds “lagged that of the GPs’ corresponding main funds,” according to the study.
Although private equity firms’ flagship funds are tracked by consultants such as Cambridge Associates, there is little transparency into the so-called alternative vehicles, also called offshoot funds. Using almost 40 years of data from custodian State Street Corp., the study is the first large-scale look at the performance of offshoot funds and co-investments. The study looks at 20,000 private investments for 112 asset owners between 1980 and mid-2017.
“Limited partners have been pushing hard for more transparency on this,” said Will Kinlaw, head of research and advisory at State Street Global Exchange. “One of the big problems is that there are no good benchmarks for alternative vehicles,” he added. State Street is considering launching benchmarks based on co-investments and alternative vehicles, Kinlaw said.
Lerner and his co-authors undertook the study because they wanted to provide data on an opaque sector of the industry and to analyze the lack of price competition in private equity markets, despite the high-profile debate over fees. They also set out to address the power of elite investors to get better terms and performance.
“You’re paying lower fees and carry on these alternative vehicles, so you’d think you would be ahead of the game,” said Lerner. “The average investor doesn’t get much of a free lunch in terms of added returns.”
Lerner added that investor may want to think about their battles for fee reductions, as that might not always be the best tactic.
The results of the study are significant, as they underscore and partly explain why there is such a huge divide between the size of endowments like Yale University’s and those of second-tier colleges, as well as insurance companies and pensions.