Are Intermediators Passé With Private Equity?

Two academic papers explore the value of private equity, claiming that high fees are spurring direct investment into the asset class.

(October 10, 2012) — Institutional investors are increasingly eschewing intermediaries in favor of direct investments in private equity, according to academic studies.

One piece of research–published by Lily Fang of INSEAD along with Victoria Ivashina and Josh Lerner of Harvard University–found that solo investments by institutions outperform co-investments and a wide range of benchmarks for traditional private equity partnership investments. “We also find that the outperformance is driven by deals where informational problems are not too great, such as more proximate transactions to the investor and later-stage deals, and by an ability to avoid the deleterious effects on returns often seen in periods with large inflows into the private equity market,” said the paper, titled “The Disintermediation of Financial Markets.”

The authors furthermore noted that their findings must be interpreted cautiously. “First, it is not clear whether this result is simply a consequence of the fact that our sample consists of large and sophisticated investors: it is unclear whether smaller investors will be able to replicate such an approach,” the paper explained. Additionally, the authors noted that it is not clear whether returns will continue to be as successful as these institutions expand their direct investment programs, or whether they will encounter diminishing returns as the set of investments where they have informational advantages are exhausted.

Read the full paper here.

Another recently published paper on the topic of how to value private equity explains that conventional interpretations of private equity performance measures may be overly optimistic, with intermediary fees cutting into the bottom line. Morten Sorensen, a professor at Columbia Business School and one of the paper’s authors told aiCIO that private equity outperformance is often not sufficient to compensate limited partners (LPs)–pensions and endowments, for example–for the risk of the investment. “I think there’s a consensus that the cost of the fees for private equity are high. We find that LPs are just breaking even, and on average, those that have smaller positions are better off,” he said, noting that the average private equity investor is just breaking even, largely as a result of intermediaries.

“The management of the PE fund is delegated to a general partner (GP), who receives both an annual management fee, typically 1.5%-2% of the committed capital, and a performance-based incentive fee (carried interest), typically 20% of profits,” Morten’s paper said.

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