Private equity firms can take a “surprisingly long time” to fully exit companies they own after taking them public — costing investors in their funds billions of dollars in fees, according to finance professors at University of Oxford and American University of Sharjah.
Many private equity managers sell down their holdings slowly following an initial public offering, in extreme cases holding stakes in companies a decade after the IPO, Oxford’s Tim Jenkinson and Howard Jones and American University of Sharjah’s Christian Rauch said in a recent paper. It takes buyout firms an average three years to fully exit their post-IPO holdings, including an initial six-month lockup period, according to their study.
“Faster sell-down strategies could have saved investors” around $3.5 billion in management fees, the researchers said in the paper. “It is, perhaps, surprising that GPs can continue to charge management fees on public holdings, and this creates an incentive to sell slowly.”
General partners, or GPs, are the mangers of private equity funds. GPs typically charge investors in their buyout funds annual management fees of 1 percent to 2 percent, and take a 20 percent cut of profits reaped from investments they make on their behalf.
While the performance of private equity-backed IPOs is initially strong, particularly during the lock-up period, the study found it doesn’t last long.
“This outperformance remains significant over the first year, and then declines in magnitude and significance,” the researchers said. “Three years after the IPO mean and median alphas are not significantly different from zero.”
Their work identified a potential conflict of interest between private equity managers and the investors in their funds: While buyout firms continue to be compensated as they wait to cash out from their deals, their investors, known as limited partners, would have seen bigger net — and gross — returns in a faster sell-down strategy, according to the paper.
“The discretion to sell-down the stakes in public companies generates significant additional fees for GPs that are not offset by higher (gross) returns from continued ownership of these public companies,” the researchers wrote. “LPs would have been better off, in terms of gross returns, had GPs adopted a quick-sale approach after the end of the lock up period.”
The study focused on the IPOs of companies that had been purchased in leveraged buyouts, a segment that represents about a quarter of the market for initial public offerings in the U.S., according to the paper. The researchers observed a significant range of post-IPO-holding periods behind the three-year average they calculated.
Their evaluation of private equity-backed IPOs from 1995 to 2014 found that in about a quarter of deals, GPs still retained around half of their holdings after five years. And some private equity managers still held stakes more than a decade after taking companies public.
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Private equity firms tend to avoid selling down shares below the IPO price. The study found clear evidence that share sales are more likely when the trading level of private equity-backed companies is above the original IPO issue price.
Buyout firms also pay attention to the internal rate of returns of their funds, as in most cases, their 20 percent cut of gains depends on clearing an IRR hurdle that is normally 8 percent, according to the paper. But the researchers found “very limited evidence that fund performance impacts on the speed of sell-downs.”
Their study showed that private equity-backed IPOs performed in line with public equity, producing significant absolute returns that resulted in increased carried interest payments. Yet investors could have achieved similar gains by holding the shares directly or investing in a market index fund, the researchers said. That raises the question whether GPs should continue to earn carried interest and management fees on their public equity holdings.
“After all, mutual fund managers that include the same companies in their portfolios do not take home 20 percent of any absolute returns, and generally earn far lower management fees,” the authors of the paper wrote. They also suggested direct listings may be a preferable avenue for private equity managers to cash out from their deals — at least for the investors in their funds.
Taking companies public through direct listings rather than an IPO could have saved investors around $9 billion of fees and carried interest, the researcher estimated. “In this way, LPs could achieve immediate separation rather than a long goodbye and save significant sums,” they said.