Investment

Gensler, greater private equity transparency, and why family enterprises should take note

The spirit of Gordon Gekko and his private equity deals still haunts family businesses, 35 years after director Oliver Stone brought him to life in the film Wall Street.

The general view is they cause too much pain, and charge too much money, to justify their aggregate performance.

Data from Bain & Co suggests buyout funds generated an annualised rate of return of 15.3%, net of fees over ten years, or slightly less than the S&P 500’s 15.5%.

In 2000, there were 22 multi-billionaires running private equity, against three in 2005

Buyouts were 1.2% ahead of the S&P over three and five years. But this was mainly achieved by rationalisation and leverage, providing quite a contrast to the patient approach of family businesses.

To be fair, top private equity managers, and some sectors, like venture capital, have lately performed better. But their clients still face a fee hurdle of 3-4% a year, plus hidden costs which could take the grand total to 7%, according to critics.

Is change on the way? Comments by Gary Gensler, the new chairman of the Securities & Exchange Commission, suggest it might just happen. 

Rather than mounting endless, and probably pointless, attacks on private equity managers like US Senator Elizabeth Warren, he is out for full disclosure of their costs and performance. Where their governance falls apart, he will tighten the screw harder. 

Family businesses may be forgiven for saying they have heard this kind of thing before. But Gensler is different from his peers. He is relentless. And he believes he has right on his side.

When he was a boy, he saw his father use a World War II payoff to develop a business fixing, and selling, vending machines to pubs. Young Gary used to count every nickel they produced. The business was only small, but his family depended on it. And this helped him to grasp the real value of capital. 

This summer, Gensler tweeted: “A critical part of our work at the SEC is helping small businesses to access the capital they need.” Clawing back unfair gains from private equity – and other intermediaries – can help to achieve this because straight dealing means fair markets. 

In 1979 Gensler joined Goldman Sachs, then a relatively conservative partnership, and graduated as one of its youngest partners, at the age of 30.  He became a top M&A banker after acting on deals such as the National Football League’s sale of television rights to broadcasters for a stunning $3.6 billion.

By inclination, Gensler is a Democrat. He left Goldman after 18 years to work for the US Treasury under Bill Clinton. In 2008, Barack Obama appointed him to work for a regulatory body for derivatives called the Commodity Future Trading Commission.

Few outside Wall Street knew about CFTC then viewed as a second-tier regulator. But Gensler earned respect from insiders by regulating swaps following the 2008 financial crisis, hoisting the value of derivatives within its remit to $400 trillion. Nothing second tier about that. 

For Gensler, futures markets can be better relied on than those which are private. The SEC has approved ETFs based on crypto futures, but refused to authorise ETFs in bitcoin itself, for fear this would further distort an unregulated market. 

Gensler wants more robust oversight of crypto. He wants to stop Robinhood using market makers to fund commission-free trade. He is doubtful on the lack of a common standard for ESG, which has proved to be better at marketing funds than saving the planet. 

In 2002, Gensler co-authored The Great Mutual Fund which showed that costs incurred by active mutual funds doomed them to lag the indices. The switch has saved investors $360 billion in fees, according to S&P Dow Jones. 

Few were surprised when Joe Biden appointed Gensler chairman of the SEC. And fewer still by news that his next probe will concern private assets whose $17 trillion is draining money out of regulated markets and making them less efficient.

On 10 November, Gensler made his views clear in a speech to the Institutional Limited Partners Association (ILPA) which lobbies private equity on behalf of its clients.

Gensler said that asset manager fees have fallen since he worked for Goldman Sachs. But private equity and hedge funds still charge a base 2% and 20% of performance leading to an annual fee of $250 billion on investors, who could do with the capital.

He argued private equity also levies hidden charges relating to the cost of managing businesses including legal advice, monitoring, servicing, transactions and directors expenses. According to clients, this often includes the use of private jets. 

Arch-critic Ludovic Phalippou says fees and expenses could take the total, including standard fees, to 7%. No one is exactly sure of the right figure. But private equity executives are certainly reaping the benefit. In 2000, there were 22 multi-billionaires running private equity, against three in 2005.

Back in 2014, the UK regulator moved against hidden broking costs, known as soft commissions, by making them transparent.  It’s not a bad model and Gensler says: “I have asked the staff to consider what recommendations they could make to bring greater transparency to fee arrangements.”

He takes the same view of private equity fees skewed by the use of side letters that can offer big clients beneficial fees or liquidity terms. Research published by Harvard Business School in 2020 looked into a sample of pension schemes and found they would have saved $8.50 per $100 invested if they had been offered the best terms available. 

On performance, Gensler notes that mutual fund performance analysis draws on information that is never available by private equity managers. Precise comparisons are impossible to achieve, making it easier for private equity to peddle softer marketing tools. So, again: “I have asked staff to consider what we can do to enhance transparency.” 

Gensler believes the industry should work harder to offer better reporting, and disclosure, to ensure it will remain resilient during a crisis.  He is particularly irked by evidence that general partners have lately modified, or reduced, their fiduciary duties. He says: “Make no mistake. An investment adviser to a private fund has a federal fiduciary duty to the fund. This federal duty may not be waived.”

Good stuff. But effective regulation of the private equity sector is likely to be a long-term project. Expect the industry to drag its heels, in the hope a less sympathetic Republican party can win the next election and chuck Gensler off the case.

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