Excess returns and performance fees: Interest Alignment in Private Equity Fund investments1 A case study modeled on CalPERS' Private Equity Program Oliver Gottschalg Department of Strategy and Business Policy HEC School of Management Paris Tel: +33 (0) 670017664 [email protected] 1 This paper has been written for a practitioner audience Executive Summary In late 2015, CalPERS released data on the carried interest payments made to their Private Equity (PE) GPs, disclosing fees of $3,441.8M as well as detailed information on the carry payments by fund since inception in 1990 to June 30 2015. The release indicated that the CalPERS (PE) Program has generated net profits totaling $34.1B over that same period. Intriguing as this information may be, the question to be asked is “How much of the $34.1B is true Alpha generated out of the PE Program?” In other words, what returns, in excess of the returns that the CalPERS plan would have generated had it invested in the other asset classes, did the private equity program generate? We answer this question through the following analysis. The exercise utilizes commercially available net cash flow (“CF”) data from Preqin on a sample of 635 ($ 52,741.0M in commitments) of the 848 PE funds (total commitments of $ 67,836.0M) listed on the CalPERS website. The total carry received by these 635 funds was $2,298.0M across 171 funds listed. While no “outsider” can guarantee the accuracy of this data and the data “only” covers roughly ¾ of the CalPERS track record, it enables us to derive directionally indicative results about the amount of Alpha generated, as well as about the relationship between Carry, Profit and Alpha. To help make comparisons, we constructed a “CalPERS Index,” based on the semi-annual returns of the entire plan derived from CalPERS publications since 1990. The performance of the “CalPERS Index” has been modeled to follow the evolution pattern of the S&P500 index since 1990. The “PERACS Alpha” methodology was then applied. PERACS Alpha quantifies CalPERS PE investment returns relative to the forgone opportunity of being able to invest the money elsewhere in the plan. Specifically, each of the PE cash flows were discounted back to 1990 with the appreciation of the “CalPERS Index” between the date of the CF and 19902. Doing so for the 635 funds (scaled by the commitment amounts listed on the CalPERS website) gives a total “CalPERS Alpha” of $13,012M. This clearly indicates that the CalPERS PE program has served CalPERS’ beneficiaries very well, as on the aggregate, the value created by the PE Program in excess of the CalPERS-specific “opportunity cost” of the capital devoted to the program, net of all fees paid to GPs, is $13.0B. In other words, CalPERS beneficiaries would have had $13.0B less in wealth had the PE Program not been created and run the way it has been since 1999. This is more than 5x the carried interest payments of $2.3B made and about 50% of the “absolute dollar value” created by these 635 funds, i.e. the un-discounted surplus (i.e. net distributions and NAV) of these funds. 2 As a simplified example, consider a fund with two cash flows only: If a fund calls capital in 2004 and returns it in 2008, then the capital call will be divided by the appreciation of the “CalPERS Index” between 1990 and 2004, while the distribution will be divided by the appreciation of the “CalPERS Index” between 1990 and 2008. The difference between the Present Value of the distribution and the Present Value of the drawdown is the “Alpha” of this fund, in terms of 1990 value. We then multiply this value with the appreciation of the “CalPERS Index” between 1990 and 2015 to get to the “Alpha” in 2015 value terms. Introduction Investors are attracted to Private Equity (PE) by the promise of attractive returns, while at the same time the asset class has a reputation of being “expensive” in terms of the fees payable to the PE fund managers. This is related to one of the distinguishing features of private equity, namely the particular governance structure through which these investments are made and managed. Capital for PE investments is typically raised through closed end funds with a limited time horizon for investments managed by specialized PE firms. These so-called sponsors serve as the ‘General Partners’ (GPs) in the funds that are structured as limited partnerships. They act as agents on behalf of the investors, known as ‘Limited Partners’ (LPs), and mange the fund by making investment and divestment decisions and acting as active owners of their portfolio companies. Detailed contractual agreements define the governance for each PE fund including a number of mechanisms through which the sponsors are compensated for their service. Two mechanisms are most frequently used and hence of particular importance. First the management fee, which is usually a percentage of the committed or invested capital3 that the GP receives as a fixed annual payment from the LPs to cover the cost of running the fund before any profits from realized investments are available. Second the carried interest (‘Carry’) is a profit sharing mechanism through which the GP receives a share of the capital gains of the fund’s investments. Frequently capital gains are only shared once a certain minimum annual percentage return, the so-called hurdle rate, has been achieved, as well as the original amount invested has been returned. The objective of these two instruments is to provide incentives for the GP to make and manage the fund’s investments in the best possible way – in other words to maximize the return to the LPs. At the same time, management fee and Carry are fundamental determinants of the cost of a given PE fund. After all, they determine what portion of the overall gains accrues to the LP and hence the net returns of the PE investments that can be captured by the investors4. Considering the large amounts of capital allocated to private equity by public pension schemes in the U.S., the questions of net returns and, as a related aspect, the amount of compensation paid to managers of the corresponding PE funds has been of great public interest for several years. Recently, the California Public Employees' Retirement System (CalPERS), the largest public pension plan of the U.S., released data around carried interest payments made to their private equity fund managers (Appendix A). According to the press release, a total $3,441.8M in performance fees had been paid out since inception in 1990 to June 30 2015 to GPs managing 269 funds they had invested in. It also included detailed information on the carry payment by fund. A related press release stated that the CalPERS Private Equity Program generated profits totaling $34.1 billion over that same period. A carry-to-profit ratio of about 10% seems surprising at first sight, given that the standard arrangement typically includes a 20% profit sharing mechanisms (Gottschalg and Kreuter, 2007). However, considering that carry is usually only paid out one a minimum return has been generated as well as the original investment having been returned, we can therefore assume that some of the 3 The management fee is typically paid as a percentage of committed capital for a set period, often 4-6 years. Afterwards it is paid as a percentage of invested capital and hence decreases as more and more investments are realized. 4 For further detail see Gottschalg and Kreuter, «Private Equity Fees More than meets the eye», Private Equity International, April 2007. funds CalPERS committed to have not (yet) reached the required levels of returns that would trigger carry payments due to the “J-Curve Effect” and/or due to under-performing investments, this number could be plausible. We take this information as a starting point to take a deeper look into the questions of how much true Alpha was generated out of the PE Program by CalPERS and how does this Alpha figure compare to the performance based fees? In other words, we first quantify what returns, in excess of the returns that the CalPERS plan would have generated had it invested in the other asset classes, did the private equity program generate and then compare this Alpha value to the carry paid – both overall and on a fund-by-fund basis. Data Starting point for the analysis is the information on the 848 PE funds that the CalPERS Private Equity Program historically invested in, totaling commitments of $ 67,836.0M, taken from data provider preqin (Appendix B). We then matched the names of these funds to a database commercialized by preqin which contains detailed information on the net cash flows (“CF”) for PE funds and most recent net-asset-values for the funds. We were able to obtain CF data on 635 of the 848 PE funds in the starting sample, which corresponds to $ 52,741.0M in commitments (See Appendix C for the list of excluded funds due to missing data). The total carry received by these 635 funds was $2,298M across 171 funds. While no “outsider” can guarantee the accuracy of this data and the data “only” covers roughly ¾ of the CalPERS track record, it enables us to approximate the cash flow and return pattern of the CalPERS Private Equity Program since its inception, using the information about the capital committed by CalPERS to each of these funds to scale the cash flows accordingly. This approach enables us to derive directionally indicative insights into the amount of Alpha generated, as well as about the relationship between Carry, Profit and Alpha.