How big promises and big fees turned private equity into a lousy investment

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Private equity funds are the greatest wealth creators ever invented on Wall Street. So why have the retail versions of traders’ funds, peddled by Merrill Lynch and other brokers, performed so poorly?

by Antoine Gara and Jason bisnoff


Formate Merrill Lynch’s broker Kurt Stein vividly remembers the day in spring 2011 when the doors to the exclusive world of private equity seemed to open wide. Inside an ornate ballroom at the Waldorf Astoria Hotel in Manhattan, Stein and hundreds of his Merrill colleagues were tasted and dined by Blackstone, the world’s largest buyout company. The pitch: Blackstone’s much-vaunted dealing machine was invincible, producing net returns north of 15% per year with an uncanny ability to avoid losses.

Here’s how billionaire co-founder and CEO of Blackstone, Steven Schwarzman, explained his proposal to brokers in 2013: “We’re a safe pair of hands. . . . Why would you invest in the products you normally make if you can make two to three times your money and have happier customers if you make them part of our products? ”

Now Stein, who has since resigned from Merrill and submitted documents to the SEC as a whistleblower, wishes those doors remained firmly closed. Fast forward ten years, and most of the clients Stein has placed in private equity funds are showing annual returns after all fees of 10% or less, well below the annual 15% that the S&P 500 reported. Stein now believes these funds have been misrepresented by wealth management companies and their private equity partners. (The SEC declined to comment.)

In retrospect, it looks like Schwarzman was just breaking bread with the brokers because these sellers were the next big pot. Private equity had already tapped the largest pools of money – pensions, endowments and sovereign wealth funds. These institutions have more than 20% of their assets in alternatives, compared to less than 5% for individual investors. With the rapid growth of affluent households, financial advisers now control $ 8 trillion. Retail is the main driver of growth at $ 684 billion (assets) Blackstone today, attracting nearly $ 4 billion in new assets per month. This channel could almost triple by 2028.


Retail is Blackstone’s primary growth engine today, attracting nearly $ 4 billion in new assets per month. This channel could almost triple by 2028.


“You felt like you were talking to guys who were making a lot of money,” recalls Stein, 54, a then New Jersey-based advisor with a typical client account over $ 3 million. “I remember thinking ‘this will be a home run.’ ”

As soon as he was back in Jersey, Stein hit the phones. Initially, he mainly placed his clients in a flagship real estate fund, Blackstone Real Estate Partners, and a mezzanine credit fund. The first feedbacks were impressive and Stein was delighted. In three years, both funds have posted “internal rates of return” of around 20%. Stein quickly invested not only with Blackstone, but also with other PE stores including KKR, Carlyle Group and Lone Star.

He was not alone. A former Merrill heavyweight said he has invested more than $ 1 billion in client assets in PE funds. “It’s a scam,” he said. “I don’t buy any of these funds anymore.”

The feedback has been lousy. Take Stein’s experience with Blackstone’s diverse offering, Total Alternatives Solution, known as BTAS 2014. It started out respectably, generating a return of 10.82%, after all fees, at the end. from 2017; two years later, the returns were 6.78%. Today the net return is 5.18%, and the fund’s biggest holding is struggling group of doctors Team Health.

According to Stein, there are two big problems.

Start with the fees. Blackstone charges its usual management fee of 1.5% based on an investor’s total capital commitment and a 20% performance fee on returns above 6%. Then retail brokers like Stein can take an additional 1% per year on their committed capital, despite having nothing to do with trading. After that, there is a “placement fee” which can be as high as 2.5% of an investor’s investment.

According to a spokesperson for Merrill’s parent company, Bank of America, “We clearly detail the costs associated with such investments to ensure transparency.”

The second problem is the financial chemistry behind internal rates of return. During Stein’s indoctrination into the rarefied world of buyouts, he was introduced to a concept known as the “J-Curve.” This scholarly sounding theory postulates that the returns of PE funds are depressed in the early years because investors have to pay a fee on their capital commitment, which is normally not fully invested until the fourth year of a 10-year fund. . Then, like a J, the returns are supposed to go up like a phoenix. But Stein says his clients’ actual returns looked more like a J.

Take the example of the Blackstone BREP real estate fund, launched in 2012. It peaked at a net IRR of 20% in December 2015, including brokerage fees. In May 2021, the returns were only 10.3%. Or Blackstone’s GSO Mezzanine Trust 2012: the credit fund peaked in March 2015 at 23.3%, but in February 2021, its IRR was hovering around 6%. Carlyle’s US Equity Opportunity II has a net IRR of 2.62%. Other funds from Lone Star and KKR are worse. “There is no J-curve,” Stein growls.

A big reason for the inverted J? Leverage. These funds borrow in the early years, delaying capital calls and thus increasing rates of return, especially when an early investment pays off quickly. It’s like buying a house for 1% less and calculating the returns before paying the remaining 19%.

Win or lose, these first reported high IRRs are a great marketing tool. The strategy behind Blackstone’s Total Alternatives Solution VIII solution was touted in June as having a net IRR of 13.4%, far more than what Stein says its customers have earned. To arrive at this return, Blackstone refers to seven BTAS funds with total assets of $ 7.8 billion. Two of these funds date from 2019 and 2020, with net IRRs of 42% and 100%, respectively. None of the funds distributed any capital to investors.

“IRR is high at the start because they manipulate it to be high,” says Brad Case, an economist who studies private equity. “Why is it decreasing over time?” Because they lack the opportunities to continue to manipulate it.

In a statement noting its 35 years of experience of outperforming benchmarks, Blackstone insists: “Any suggestion that we have overestimated our performance or misled investors is totally false. Today, Blackstone and other buyout companies are looking for investors with less money. In mid-2020, after lobbying the Trump administration, Labor Secretary Eugene Scalia, son of the late Supreme Court Justice Antonin Scalia, approved the inclusion of private equity in defined contribution plans. In other words, Blackstone and his private equity friends are coming up with a 401 (k) plan near you.

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