Private Equity’s Returns Questioned, This Time by Buffett

Firms will include money that’s waiting to be deployed, such as funds sitting in Treasury bills, says Buffett.

Private Equity’s Returns Questioned, This Time by Buffett
Warren Buffet, chairman and chief executive officer of Berkshire Hathaway Inc., plays bridge at an event on the sidelines of the Berkshire Hathaway annual shareholders meeting meeting in Omaha, Nebraska, U.S. (Photographer: Houston Cofield/Bloomberg)

(Bloomberg) -- Private equity firms, which are attracting record amounts of investor funds, have for years faced criticisms that they game their returns. Over the weekend, billionaire Warren Buffett joined the chorus.

The Berkshire Hathaway Inc. chairman and chief executive officer said firms make their performance appear better than it is. Firms will include money that’s waiting to be deployed, such as funds sitting in Treasury bills, when charging management fees. But they’ll exclude those funds when calculating the internal rate of return -- the performance measure in which most funds are judged, Buffett said.

“We have seen a number of proposals from private equity funds where the returns are really not calculated in a manner that I would regard as honest,” Buffett, 88, said Saturday at Berkshire’s annual shareholder meeting in Omaha, Nebraska. “It’s not as good as it looks.”

Representatives for the largest private equity firms either didn’t immediately respond to a request for comment on Buffett’s allegations, or declined to comment by deferring to the American Investment Council lobbying group.

“Pension funds across America choose to invest in private equity because private equity investments historically outperform the public markets and deliver substantial benefits to public servants and retirees,” AIC President and CEO Drew Maloney said on May 5 in an email. The organization didn’t address the industry’s fees or the method of using IRR to determine performance.

“I agree 100 percent with what Buffett said, and that’s a big part of what we do for clients, is dig into the underlying numbers,” said Tony Tutrone, a Neuberger Berman Group LLC managing director who oversees about $70 billion of private equity investments for clients. Two issues he sees are that assets may be hard to value and that debt taken on at the fund level can sometimes inflate IRR, but not reflect the underlying performance of the investments. “I still believe private equity is a critical part of sophisticated investors’ portfolios, and overall it has performed very well.”

Verdad Advisers founder Dan Rasmussen, who runs a firm that can compete with the private equity model, said “there are tons of issues” with internal rate of return. “The fact that IRR math is easily gamed is extremely well-known,” he said.

Private equity firms are seeking to rush money out of deals quickly, and shorten the time during which they calculate the returns, Rasmussen said. If you take the same results over the decade of a private equity vehicle, returns would look a lot worse. The increased use of dividend recapitalization also is spurring more borrowing to boost stated returns of funds, he said.

“You didn’t sell the company, all you did was put on more debt and pay yourself a dividend,” Rasmussen said. He and Neuberger’s Tutrone separately said there’s also risk associated with the use of so-called subscription lines, where firms take on debt against their clients’ commitments, which can shorten investment horizons and change returns calculations.

Tracking Performance

The so-called public-market equivalent, or PME, is a better way to track performance, Rasmussen said. By that method, buyout firms are trailing stock markets, according to a study by Pitchbook published in September.

Jeff Zients, CEO of Cranemere Group Ltd., uses a similar approach to Berkshire’s at his firm by acquiring companies to hold for the longer term, and therefore uses multiple of invested capital -- or MOIC -- as a preferred performance metric.

It “reflects the power of compounding from buying, building and holding great companies for the longer term,” Zients said. “Too often in private equity, fixation on IRR leads to excessive focus on the short term and the overuse of debt.”

To Robert Semmens, a professor at New York University’s Leonard N. Stern School of Business, a combination of IRR, PME and MOIC is needed to track performance.

“IRR can be manipulated. The worst manipulation is investments made using the funds credit to make investments without actually calling the funds producing an infinite IRR,” he said in an email, adding that MOIC alone measures the overall profitability of investments, but not an annual return. “The IRR could be high but very short term such the profit might be small.”

Cambridge Associates has found that PE firms can inflate performance with their math. But the biggest investors are savvy enough to see through it, said Andrea Auerbach, global head of private investments at Cambridge Associates, which manages funds on behalf of endowment, foundation and pension clients.

Jedi Trick

“While PE funds are highly focused on fund-level performance and some may be pulling out all the stops and stopping at nothing to post strong returns, sophisticated investors cannot be ‘Jedi mind-tricked,’ and know to dig deeper,” Auerbach said in an email. Investors “need to ask questions beyond the fund-level IRR” to understand a PE firm’s capability.

Researchers at asset manager AQR Capital Management cited the “gameability” of the IRR method in a January report detailing private equity’s expected returns. They also preferred the public-market equivalent approach.

Rudy Sahay, who was previously at the principal investments group at Guggenheim Partners and now runs Aquarian Holdings, said that the IRR method can be a good way to figure out a return on one particular investment, but investors need to think about the opportunity cost as they wait for a private equity manager to use those funds toward deals. Usually, funds are kept in low-yielding cash or Treasuries.

And for firms that have poor performance, investors are paying almost 2 percent in management fees anyway.

“It’s a fair critique for one side of the equation,” Sahay said of Buffett’s argument. For pensions and insurers betting on private equity, the billionaire investor “is right in saying you need to think about what return I will generate on this investment, and what’s the opportunity cost as I wait for this investment to present itself.”

To contact the reporters on this story: Hema Parmar in New York at;Sonali Basak in New York at

To contact the editors responsible for this story: Michael J. Moore at, Daniel Taub, Josh Friedman

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