I N T E R E S T

Vol. 23, No. 12f

GRANTS
R A T E
Two Wall Street, New York, New York 10005 www.grantspub.com

O B S E R V E R
JUNE 17, 2005

Private inequity
Frederick E. (Shad) Rowe is chair of the Texas Pension Review Board. He writes from Dallas: I dont think my experience is too different from that of the thousands of people sitting in pension meetings a couple of hours a year who nod their heads and pretend to understand, and care, what is being said. A couple of years ago, emerging from my daze, it dawned on me that the problem of underfunded public defined-benefit plans is mushrooming, and that a favorite solution, private equity, is going to create more problems than it solves. Think about the deal politicians have made on behalf of the taxpayers who are obligated to fund definedbenefit plans. Employee and employer contribute investable money now that is to be returned to the employee much later as a stream of income, the promised magnitude of which assumes a compounded rate of return on the investment of, on average, 8.5% for public pensions. With long-term bond rates hovering around 4%, a stock market that has actually declined over the last six years and unfavorable demographics (people living longer), pension-plan administrators are facing a problem that can be expected to worsen substantially. In an effort to catch up, many are piling into alternative investments like private equity, often at the urging of pension consultants. The money invested in these funds, having been taken out of the hands of the individual plan administrators, is more difficult to account for. There is also a good deal of skepticism about the use of private equity because it takes a very long time to determine actual investment results. The investments are illiquid, and the timing of capital calls and the return of capital are not predictable, thus making it difficult to match assets with liabilities. In addition, the internal rate of return numbers thrown around by the private equity industry are sometimes misleading to managers familiar with the conventional performance measurements routinely used for stocks and bonds. The skeptics felt vindicated last fall when Ted Forstmann explained in an October 10 New York Times interview why he was getting out of the private equity business: Mr. Forstmann says he worries that more investors will bring cases against other private equity shops like the one that was brought against his firm. This is not the last of these things. Its going to be the first of many, he said. If you add up that there are no returns, that these people charge gigantic fees, that they get all their money from state pension funds, and that there is always someone running against someone who gave you the money, he said, as his voice trailed off. What do you expect? Mr. Forstmann says he thinks the entire industry has gone wrong, becoming too institutionalized and too big to make money, the Times went on. For much of my life, if I couldnt see making six or seven or eight times my money, we wouldnt do it, he said. Now what you have to look for is the opportunity to make, say, two or three times your money. Its fascinating to me. Much of what caused this idea to be such a great idea when there was only two of us and then four of us doesnt exist at all. And now theres 4,000! According to another private-equity professional who has abandoned the business out of sympathy for investors, and who doesnt want his name used: Here is the problem: Twenty years ago, EBITDA multiples were three or four. Now they are nine or 10. Do you think multiples are going to keep going up? I dont. On every deal, there are dozens of guys looking at it and the fee structures are so loaded that, to many of them, it doesnt matter what they pay. The investor has little chance without further multiple expansion, and the manager makes money no matter what. In a typical deal, he continued, there is a fee on committed capital, transaction fees when a company is acquired, annual management fees paid to the manager by the acquired company, exit fees, and success fees not offset by deals that dont work. A gross return of 12% before all fees, including those paid by the portfolio companies to the private equity manager, translates to less than 5% to the investor. When an investor buys a publicly traded stock or bond, there is a market price, and that is what the investment is worth. In private equity, an investor commits capital over a period of time, say five years. Capital is then called as the manager requires it, and capital is returned when a deal is sold. What is left to the investor is the value of unrealized interest, which is an estimate provided by the manager.

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Ive heard a number of investors joke good-naturedly about their returns: Im told weve made 21% on our money, but, so far, the last 15% is missing. One investor who is not smiling about his experience in private equity is Richard Gibson, with whom I recently attended the Berkshire Hathaway annual meeting in Omaha. Gibson makes his home in Longview, Texas, which sits atop what was once the biggest oil field in the world, the East Texas Field. He likes to portray himself as something of an investment bumbler, which those familiar with Gibsons reportedly stellar results find comical. After discussing investments with him for hours, I was impressed by his savvy and sophistication. What gripes me is that there is no connection between the money they brag about and the money Ive gotten back, Gibson told me of his plunge into private equity, which occurred from 1996 through 1998, leaving him ample time to determine how well he has done. Gibson showed me the promotional sales materials he received at the time of his investments. One firm described its annual 87.4% internal rate of return estimate as having been earned on all of its investments since 1985, and another major firm described its annual IRR as being in excess of 100% since 1974. Gibson then went on to describe his personal experience:

Beginning in February of 1996, and over the next couple of years, I invested $1,569,000 in a DLJ private equity fund of funds, which they touted as including the top managers in the world, the all starsThomas H. Lee, Hicks Muse, Abry Partners and Bruckman Rosser were the main ones. It was DLJ, but the fund was called WSW 1996 Buyout Fund (WSW is for Wood Struthers & Winthrop). I have continually gotten letters saying how well these funds have done. The reality is that, over a 15- to 20-year period after I invested my money, I will get back approximately $1.8 million. I do not call that hitting it out of the ballpark, which is what I read all of these guys do. Through WSW, I individually invested in Thomas Lee IV in November of 1997, Gibson said. What they say at year-end 2004 is that, ultimately, investors may get back 87% of the money they put up before fees. Or how about Hicks Muse IV in July of 1998, through Smith Barney? Of the money Ive put up, they are telling me I will get back 57%. Isnt that great? I told Gibson that, for people used to stocks and bonds and the returns they generate, the use of the internal rates of return favored by private equity investors can be deceiving. If you give me $100 today, and I give you back $99 tomorrow, and then I give you $2 a year from now, I can tell you that we gener-

ated a 100% IRR. Gibson replied, I dont care about internal rates of return, much less internal rates of return before fees. What I care about is what I put up and how much I am going to get back. While IRR numbers are easy to come by, the hard numbersthose involving individual investments and what individual investors put up, the total fees paid and what individual investors are getting backare difficult to come by. The industry regards this information as proprietary. As for Richard Gibson, he is a small investor in a big sector, but I suspect that his unlucky experience is not unique. Defined-benefit pension plan administrators, faced with actuarial deficits as far as the eye can see, have a range of options. They can do nothing (the problem will get worse), increase contributions (generally not affordable), decrease benefits (probably illegal), shoot for higher returns from higher-cost investments (private equity, etc.), or reduce their costs. Cutting costs is the option that, I believe, makes the most sense. As for trying to generate higher returns via private equity, to paraphrase Warren Buffett, if you are in a poker game and you dont know who the patsy is, the chances are, its you. I believe public pensions are going to learn the hard way who the patsy is in this very crowded game.

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