Hedge funds and Private Equity - PES

The manager insists on being close to the central, operational life of the companies. Management
companies in the LBO fund will often be represented on boards to take part in crafting
strategy to varying degrees. But there again, LBO funds generally insist on total control.
The manager’s ultimate objective is to maximise a return/cash flow – and develop revenue for
its investors. There are several ways to assure these returns and fees: Extraordinary shareholder
dividends, stepped increases in leverage, fees, cuts in jobs, sale or flotation. The LBO management
picks the time and the exit method that will maximize the cash flow.
Every three to five years, managers must raise capital on the market or at the time of cementing
an acquisition project. Faced with arbitrages between asset classes and competing projects,
they meet investors to propose new fund investment opportunities and try to convince them on
the basis of their past performance and their professional ability.
A distinguishing feature of LBO is that the financial reward of the investors, the investment
management team and the investee company’s management will largely come in stages. Firstly,
fees, shareholder dividends. Secondly, fees and value creation realised when exiting (by sale or
flotation). An important part of the investment management team’s/private equity manager’s
strategy is therefore the early identification of alternative routes for exiting their investments.
2.12 The returns to investors – better than others?
The supporters of LBOs constantly look for some kind of positive, general effect on financial
returns or employment. They only differ from critics of LBOs as to whether it is positive or negative.
The gains from operating and selling on an individual company within three to five years
come, as we have seen, from several sources. And various events and decisions at the macro
and company level will influence the net result. When there are so many factors and changing
elements influencing the result, it seems quite unlikely that LBO funds will have any general positive
effect regardless of sector, time period or the volume of the LBO activity.
There are only a limited number of academic studies. Studies on US LBO are especially interesting
because they suggest that there are important differences of return within and between
funds, with overall average levels of return which are far from decreasing. Like the recent study
from CRESC – Centre, The University of Manchester, February 2007, Caplan and Schors US
study found that average buyout returns over the period 1980-2001, after large fees have been
deducted, are approximately equal to those of the big stock market companies from the S&P500
but with large “heterogeneity” in returns across funds and times. Or put another way: some funds
produce high returns, but many others perform worse than publicly traded equity and even with
successful funds, the overall performance will often depend on a small number of successful
investments with losses on others.
In another CRECS Centre study from the University of Manchester Swenson finds that for funds
formed between 1980 and 1997 both LBOs and venture capital in the US produce lower
returns than public equity. These studies suggest that LBOs have not so far generated superior,
average returns. These studies also show that these returns come with important warnings about
variability and risks.
Part I – Hedge funds and private equity funds – how they work
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