Deals are on the increase but element of 'heads we win, tails you lose' remains an issue in this curious industry, writes TONY JACKSON

SOMETHING IS stirring in the world of private equity. Deals are on the increase – witness the $4.5 billion (€3.5 billion) bid for the UK engineer Tomkins last week – and Blackstone has just raised a new $13.5 billion buy-out fund. It is still a far cry from the bubble years; but it seems opportune to ask what is going on.

One obvious answer is that commitments made by investors to private equity groups in the boom times are starting to run out. So companies are under pressure to do deals, since only then can they collect the cash and start charging their 2 per cent handling fee.

The harder question is why investors are committing fresh money to new funds, and whether they are right to do so. To answer that, we must first remind ourselves how private equity makes its money.

Although the issue is familiar, fresh light has been thrown on it by several recent academic studies. These have been very usefully encapsulated in a paper called Private Equity, Public Lossby Peter Morris, a former Morgan Stanley banker.

One study he cites unpicked the returns on 110 completed deals in the UK and Europe between 1995 and 2005. The average internal rate of return was 39 per cent, of which debt accounted for 22 per cent and a rising stock market 9 per cent. That left just 8 per cent as the contribution of private equity managers.

Considering that Mr Morris puts the average annual fees in private equity at 8 per cent – some put it higher – this is thought-provoking. It means, in effect, that the pension funds which provide the bulk of the money would have been as well off investing in the market directly and borrowing the leverage from the bank.

Or rather, they would have been much better off. For by investing in private equity they lose liquidity – which, as long-term investors they ought not to care about, but do greatly in fact.

They also lose transparency. When they invest in the market, they know the value of their holdings from day to day. All they get from private equity is a periodic estimate of value, which in the case of unsold investments is based on the firm’s own calculations.

Furthermore, Mr Morris points out, they would not necessarily employ the same amount of leverage – even supposing they were allowed to, which in some jurisdictions they are not. This brings us to a wider point.

A central claim from the private equity industry is that it aligns the interests of investors and managers in a way that the public markets do not. If investors do not get a payday, neither do the managers.

That is not quite true. Besides their 2 per cent handling fee, private equity managers take 20 per cent of the fund’s profit above a certain level – say, 8 per cent. But their direct stake in the equity is typically very small – perhaps 2 per cent. It follows mathematically that they have a much stronger incentive to increase leverage – and risk – than their clients do.

As Mr Morris remarks, this “heads we win, tails you lose” element is familiar from the world of investment banking. But the misalignment of interests, he suggests, can be taken one step further.

It might naturally be supposed that fund managers work in the interests of their ultimate paymasters, the fund members. But in at least two respects, that is not quite clear either.

By investing in private equity, they relieve themselves of the immediate pressure to perform. As investors in the public markets, they are held to quarterly account. But private equity returns are only finally established on the sale of the businesses. And if their direct investment performance has been poor, they may feel tempted to rescue the position by gambling on leverage. In many cases, private equity is the only way they can do that.

It is worth pointing out, with Mr Morris, that all this undermines a further claim of the industry – that it does not need close regulation, since it deals exclusively with sophisticated investors. There are two aspects to this. First, if the industry structure tends to reward excessive leverage, it poses a risk to the banks. And that, as we have learnt the hard way, constitutes a risk to the general taxpaying public.

Second, if it provides an incentive to fund managers to make less liquid, riskier and less transparent investments, it poses a risk to the pensioner population. Whether the answer to this lies in the rather ham-fisted regulation now making its way through Brussels is debatable, but the case for regulation is clear.

So overall, I am not entirely sure why investors are still so keen on private equity. But I would rather those managing my pension stayed out of it. – (Copyright The Financial Times Limited 2010)