The Myth That Drives Private Equity

The economy runs on narratives.

Those supportive of the status quo offer narratives – stories, essentially – about the benefits of existing arrangements. If those narratives are widely believed, the status quo typically endures. Changing the economy requires successfully changing the narrative.

Consider a narrative at the heart of one of the most striking economic developments of recent decades: the rise of “alternative” investment, an umbrella term for investments other than the traditional mainstream asset classes of cash and publicly-listed stocks and bonds. These alternative assets include private equity, hedge funds, venture capital, real estate, and infrastructure.

Through the 1970s, major U.S. investors such as pension plans held almost no investment in alternatives. Half a century later, the picture is radically different. The largest university endowments (those with over $1 billion under management), for example, now allocate 64 percent of capital to alternatives.

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Such a dramatic shift couldn’t have occurred and persisted without a strong supporting story. After all, the shift into alternative assets has at times faced considerable headwinds from critics: managers of private-equity funds, for example, have been widely attacked for themselves profiteering while asset-stripping the companies they take over. How then have those that have led the charge into alternatives fended off such criticisms and thereby legitimated what they do?

The pivotal narrative has been that investment in alternatives benefits ordinary, lower-to-middle class workers. The following statement is a prototypical example. “To the extent our funds perform well,” Blackstone, the world’s leading manager of alternative investment funds, explains each year in its annual report, “we can support a better retirement for tens of millions of pensioners, including teachers, nurses and firefighters.”

The narrative is not that alternatives always perform well, or indeed better than traditional asset classes. Nor is it that alternatives investment benefits only ordinary workers. Yet it is the latter that Blackstone and its peers invariably highlight. When, for example, skeptics question why the trustees of pension schemes persevere with high allocations of retirement savings to alternatives funds such as those managed by Blackstone, they are told that reducing such allocations will hurt ordinary workers most. And so the status quo persists.

This narrative is profoundly misleading, however. To say this is not to suggest that ordinary workers do not benefit when the funds in which their retirement savings are invested perform well. It is to argue rather that the benefits accruing to such workers are minor, both in relative terms (most benefits are captured elsewhere) and absolute terms. Thus, to center and highlight specifically ordinary workers among the cast of beneficiaries is to grossly distort reality. A consideration of three key aspects of the business of alternatives investment, which is dominated by asset managers like Carlyle, Apollo, Blackstone, and many others, clearly undermines this disingenuous narrative.

First and most importantly there is the question of how much of the capital invested by these funds actually represents the retirement savings of ordinary workers like teachers, nurses, and firefighters.

While pension plans are certainly the main institutional investors in alternative assets by number, they are much less dominant in terms of investment value. As at 2018, for example, just 14 sovereign wealth funds (SWFs), representing only 0.2 percent of all global institutional investors in private equity, accounted for as much as 7 percent of all private-equity investment ($215 billion out of $2.97 trillion). In the U.S. specifically, the share of capital invested in alternatives funds that constitutes retirement savings has been falling fast. Increasingly often, such savings account for just a small share of the capital that an alternatives fund invests, as other types of capital provider have come to the fore: for instance, fully half of the capital in Blackstone’s flagship $31 billion infrastructure fund is that of a single SWF (Saudi Arabia’s). In short, when the likes of Blackstone invest in alternatives, they invest in substantial measure for investors other than retirement savers.

Moreover, most of the capital invested in alternative assets which is that of retirement savers is not that of lower-to-middle class workers. As elsewhere in the world, there is vast inequality in holdings of retirement savings in the U.S. Around half is held by the top lifetime-earnings quintile among workers, while the bottom earnings quintile holds only around 1 percent. Most teachers, nurses and firefighters belong in the second and middle earnings quintiles, not in the top two, which is where retirement savings are concentrated. Thus, relatively little of the retirement savings available for investment–whether in alternatives or in other asset classes–is that of ordinary workers in the first place. It is principally that of elites, and, among savers, it is they who therefore benefit most when investments perform well simply because they have more investible capital.

Second, different types of institutional investor often earn different rates of return from their investments in alternative asset classes, and those institutions representing ordinary retirement savers – particularly public pension plans, which represent public-sector workers like teachers, nurses and firefighters–generally fare worst. Research has repeatedly found this to be the case, in contexts ranging from private equity to infrastructure. Consider the latter. After asset-manager fees, the average internal rate of return (IRR) on investments in unlisted infrastructure funds is around 8.5 percent, but public investors’ IRR on such investments is on average 1.8 percentage points lower than that of private investors.

The Myth That Drives Private Equity

What might account for such underperformance? Numerous explanations have been hypothesized, ranging from the negotiation of inferior fee terms to an inferior selection of asset managers and their investment funds, whether due to, say, politicized governance arrangements or constraints on the ability to recruit and remunerate talented staff members.

In any event, whatever the exact explanation, those whose putative gains Blackstone invokes in order to legitimate its business–such as teachers, nurses and firefighters–are those who actually tend to get the rawest deal.

Finally, to these two key foregoing points–namely, that the capital of ordinary workers that is invested in alternative assets is both relatively marginal and relatively poor-performing–we must add a third.

Consider what Blackstone and the like invest in when they invest in “alternatives.” Notably, one of the fastest-growing areas of this business is housing investment, specifically in the rental market. But if funds that invest in housing perform well, it is largely because they have been able to raise rents. And who lives in such rental housing? Generally, ordinary workers. Thus, where there is gain, there is also pain; the latter begets the former.

In 2018, Ro Khanna, a Democrat Representative in California who was evidently conversant with Blackstone’s rhetoric, spoke pointedly to the Faustian bargain that workers–usually unwittingly–often make with firms like Blackstone when their savings are invested by them. “In my district”, Khanna said, “teachers, firefighters, and nurses often can’t afford a place to live.” Blackstone happened at that time to be a major investor in Californian rental housing (where rents were rising fast), and a dogged opponent of efforts to strengthen the state’s rent controls.

In other words, the third critical point is that if a private equity firm does deliver strong investment returns to investors, ordinary workers themselves have often paid the price – if not in the form of higher housing rents, then for instance through higher usage charges on energy, transportation and water and sewage infrastructures, which like real estate have become an increasingly popular class of investment for asset managers’ alternatives funds in recent decades.

To sum up, the narrative of “supporting a better retirement for teachers, nurses and firefighters” plainly flatters to deceive. It is time, therefore, for a new narrative – one cleaving more closely to the realities of the alternatives investment business.

Not only do ordinary workers like teachers, nurses, and firefighters frequently suffer very real disbenefits as users of the real-estate and infrastructure assets held in the portfolios of alternatives investors, but the benefits they derive from such investments as investors are considerably smaller than those in the business suggest. On balance, those ordinary workers clearly lose.

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