Buyout Firms Are Magically -- and Legally -- Pumping Up ReturnsBy
The practice can boost rate of return by 25 percent or more
‘It can make a mediocre fund look terrific,’ says consultant
The steroid era has arrived in private equity.
Much like a raft of baseball sluggers in recent decades, buyout shops have seized on a performance enhancer that artificially jacks up results, according to many industry executives.
The practice isn’t illegal, and is largely cosmetic, but it allows private equity firms to goose what’s known as their internal rate of return, or IRR. That’s the most important annual performance yardstick they trumpet to woo prospective investors. The strategy essentially uses short-term bank loans to shrink the time that investors’ money is deployed, thereby boosting annual results. It can make returns look better by 25 percent or more, a recent study shows.
“You want to hire a manager based on how fundamentally good they are at investing, and this obscures that,” said Andrea Auerbach, head of private equity research at Cambridge Associates LLC, a Boston-based investment firm.
Use of the strategy has spread rapidly across the industry in recent years, a reflection in part of firms’ angst about turning profits at a time of soaring acquisition prices. Near-zero benchmark interest rates, which make borrowing the money dirt cheap, have also been a catalyst.
No Big Deal
The pumped-up numbers aren’t a big deal for some pension plans, endowments and other sophisticated investors, known as limited partners. After all, the tactic makes their choices look smarter, too, and the impact on actual profits is often small. And some pension funds compensate their managers based on the IRRs they produce.
But others are troubled by the phenomenon. Not only is it misleading, they say, but it has real downsides. It can potentially lower actual cash returns in part by forcing investors to fork over incentive fees to otherwise underperforming managers. Concerned about the distortion, the Institutional Limited Partners Association trade group said it’s planning to issue guidelines soon to ensure that managers reveal more to investors about how they use the loans and the impact on returns.
“It can make a mediocre fund look terrific,” said David Fann, chief executive officer of pension consultant TorreyCove Capital Partners LLC.
Buyout houses started using short-term bank loans more than a decade ago in the ordinary course of business to fill temporary funding gaps. What’s changed is that in the last few years, as borrowing costs stayed low, firms saw their potential to amp returns, according to buyout firms and investors.
The strategy’s effectiveness is a matter of simple math. Investors in buyout funds typically are required to pony up at the time a deal is struck to buy a company. But now, private equity firms increasingly refrain from calling investors’ money for months at a stretch and instead tap credit lines to complete an acquisition.
Only later does the firm ask for investors’ money. That means the firm uses it for a shorter period -- inflating the fund’s annualized results. A 100 percent return looks better on an annual basis when divided by three years instead of five, for instance.
TorreyCove Capital offered this scenario: Using investors’ money, a buyout fund puts in $100 million of equity to acquire a company for, say, $400 million. It sells the company six years later, at a price that almost doubles the value of the equity. Employing credit to delay investing for two years produces an IRR of 13.9 percent, compared with only 10.6 percent if the money had been invested at the start, TorreyCove calculated.
The actual dollars that investors and buyout shops reap, assuming the deal is profitable, remain about the same in either case, reduced only slightly by the borrowing costs.
The impact on results can be even more eye-popping in the rare event when a company is bought and flipped without using any fund money. The resulting IRR is, in mathematical terms, infinite.
Use has gradually snowballed as firms seek to one-up rivals that employ the lines, said Auerbach of Cambridge Associates. “We’re seeing an arms race.”
Andrew Ahern, a lawyer at Debevoise & Plimpton LLP who represents private equity firms, said the controversy is overblown. “Folks in the industry may be putting too much weight on the IRR,” he said, rather than focusing on the actual cash-profit multiple.
Banks including Bank of America Corp., JPMorgan Chase & Co. and Wells Fargo & Co. offer the lines, which are secured by investors’ uncalled capital commitments to funds. Interest now runs less than 3 percent a year. Loans for specific deals typically fall due in six months or a year. But banks will often allow funds to keep loans in place for as many as two years, buyout executives say.
Buyout Who’s Who
The borrowers comprise a who’s who of private equity, from U.K. buyout titan CVC Capital Partners and Sweden’s EQT Partners AB to tech-buyout powers Vista Equity Partners and Thoma Bravo, along with distressed-asset specialists Lone Star Funds and Oaktree Capital Group LLC. Among publicly traded U.S. buyout sponsors, Apollo Global Management LLC, Blackstone Group LP and KKR & Co. LP have subscription credit lines, according to pension fund executives.
Less clear is which firms borrow more aggressively specifically to pump returns. That’s because most buyout sponsors don’t disclose when they take out loans, leaving investors to suss out what’s going on.
The firms cited above declined to comment, except for Thoma Bravo, which doesn’t use credit lines to enhance IRR, a spokesman said.
The head of private equity at a mid-sized state pension plan estimated that about 70 percent of the funds he invests in have credit lines. Of those, perhaps half borrow to boost returns, said the executive, who requested anonymity because he wasn’t authorized to speak to the media.
Jim Herrington, head of private and public equity investing at the West Virginia Investment Management Board, said he doesn’t see the practice as a big problem. He puts pension cash that hasn’t been invested yet into index funds, so it doesn’t sit idle.
“The opportunity cost isn’t great,” Herrington said.
Others say that not having to cough up cash every time a deal closes makes their lives easier as investors.
But critics view the strategy as a triumph of form over substance -- and one that can come at a cost. A particular magnet of criticism is that IRRs can be rigged to push subpar funds above the 8 percent return threshold that typically triggers sizable incentive-fee payments to their managers.
People on both sides believe use of credit lines is bound to grow until a spike in rates or market turbulence quells it. Private equity firms “don’t like to cede ground if they don’t have to,” and investor opposition isn’t strong enough to curb it, said Auerbach.
Resistance being futile, ILPA, the trade group, won’t seek to bury the trend but to bring it into the daylight.
The question is “the extent to which the numbers are being distorted,” said Jennifer Choi, head of industry affairs at ILPA. “That’s a big thing people need to know.”
— With assistance by Sabrina Willmer