Are private equity funds still worth it?

Private equity funds have produced an annualised return of around 17% over the past decade, making the asset class one of the best-performing in the world, according to the Cambridge Associates Private Equity Index. However, according to research by the Financial Times blog Alphaville, based on data from Prequin, over the past 13 years private equity funds have called $821bn more from their investors than they have returned. The figures are even worse over the past six years. Private equity funds have taken in a staggering $1.6trn more than they have returned to investors during this period.

Private equity funds drive healthy returns

For readers who don’t know the language of the private equity world, private equity funds will “call” on investors who have signed up to commit capital to a fund when they have found an investment they want to buy. After the fund has bought an investment (there can be tens or hundreds of investments per fund), it will typically hold onto it for three to five years and then try to sell it on, hopefully at a profit. All the money realised from the sale will then be returned to investors, minus any fees. As the Alphaville figures suggest, funds haven’t been selling their investments to repay their investors. They’ve been spending investors’ money but not selling holdings to realise profits. How have these funds produced such lofty returns if they haven’t been selling? Returns are based on net asset values, determined by estimated valuations for portfolio companies. Cold, hard cash does not lie, but estimated company valuations can only be confirmed when the underlying company is sold, which is why investors need to think carefully when buying into any private equity-focused vehicles.

The investment group 3i (LSE: III) bought a controlling stake in Dutch discount retailer Action in 2011 for €130m. Since then, its value has exploded, with 3i valuing its stake in the company last year at more than £14bn. Along the way, 3i has taken eight dividends, funded with debt. The latest will be worth €2bn, with €1.75bn in new leveraged loans and in €245m of surplus cash. Along with this payout, 3i will have earned around £4bn from the deal, but most of that has come from debt. What’s more, according to the FT’s analysis, the firm values Action at around double its peer-group average in terms of earnings before interest, tax, depreciation and amortisation (Ebitda).

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3i isn’t the only example of opaque trends in the private equity sector. HarbourVest Global Private Equity (HVPE), the UK’s largest listed private equity trust after 3i, announced in its report for the year to 31 January 2024 that it would seek to return 15% of cash realised from its portfolio to shareholders. Cash would be funded from a “distribution pool” to be continually topped up as sales progressed, and it was seed-funded with $75m. Management declared in the company’s annual report that up to $250m (including the seed amount) could go to shareholders by 2025.

That sounds good, but the company needs to find the money first. Last year, the company was a net investor to the tune of $283m, and it warned that the investments “place a demand on HVPE’s cash reserves in the short term”. It moved from a net cash position of $198m to a net debt position of $135m at the end of fiscal 2024. HVPE’s cash situation seems to have deteriorated since January. Cash calls have exceeded realisations by $100m, and projections suggest this will continue.

Pantheon International, another of the UK’s largest listed private-equity trusts, has a slightly better record, with distributions outpacing cash calls by around £50m over the past 12 months, but it has also spent £200m on share buybacks. Debt has filled the gap. If you are considering one of these funds it makes sense to think very carefully about how they’re earning money and where the cash is coming from. If private equity can’t sell its underlying investments to realise value and return cash to investors, its appeal is severely diminished.

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