Mariana Mazzucato - The Value of Everything - Making and Taking in the Global Economy

This same ‘2 and 20’ model is also used in venture capital. Like hedge funds, VC claims special skill in picking profitable opportunities in young businesses and technologies. In practice, VC usually enters the fray after others, notably taxpayer-funded basic research, have taken the biggest risks and the technology is already proven.

Private equity firms provide a case study of how fund managers increase their likelihood of making a profit. PE firms also charge annual management fees of the order of 2 per cent. Over the, say, ten-year lifetime of a fund, this fee represents a commitment of 20 per cent, leaving only 80 per cent which is actually free to earn a return. So limited partners, rather like investors in mutual funds or hedge funds, start out with an embedded cost to catch up on – which is hard to do. What’s more, as the New York Times revealed in 2015, some companies in which PE firms invest end up paying fees to the PE firms for years after they have been taken public again. 43

In addition to the management fees, PE funds have found many other ways to get paid in order to avoid relying on their portfolios’ actual performance. These include paying themselves fees (on top of fees paid to consultants, investment bankers, lawyers, accountants and the like) for any transactions undertaken (the acquisition itself, acquisitions of other companies, the sale of divisions and so on), paying themselves monitoring fees as part of their role on the boards of these companies, and other service fees. All in all, this results in a fixed component for them of about two-thirds of the general partners’ compensation. 44

The final element of the PE firm’s compensation is carried interest – the investment manager’s share of the profits of an investment above the amount the manager committed to the partnership. For many years now, market practice has been that carried interest is 20 per cent of the profits generated over and above an agreed hurdle rate – i.e. a return on an investment below which a company will not pursue an investment opportunity or project. This element of the compensation is specifically meant to motivate general partners to perform, and PE capital gains are taxed at a favourable rate. But in practice, fees are so high that carried interest amounts to only about a third of general partners’ compensation.

PE firms also protect themselves by loading down the companies they acquire with debt, typically 60–80 per cent of the cost of an acquisition. Consider this: if an asset worth 100 is bought with 30 put in as equity by the investment manager and 70 from debt, the investment manager can make a 100 per cent return if the debt is paid off and the equity value goes up to 60. And yet PE firms hold on average only 2 per cent of the value of the funds they manage.

What do PE investors get for their money? When PE firms present their results to investors, they usually highlight their internal rates of return – the rate of return on capital invested (technically, the discount rate which makes the net present value of all cash flows [positive and negative] from an investment equal to zero). One may well argue that all the charges and compensation could be justified if they resulted in outsized returns. And in fact, there are many studies that claim superior returns for PE firms compared to other investment vehicles. Figure 20, from one highly cited work, appears to show that in recent years PE has outperformed by 27 per cent (average and median for the 2000s). But that performance should be viewed over the ten-year lifetime of a fund, so it actually represents an outperformance of just 2.4 per cent per year.

To be fair, this is still outperformance in absolute terms. But several factors effectively negate it. The performance has been achieved through highly indebted investments that are relatively illiquid (hard to sell). In fact, limited partners often require extra outperformance to take account of this additional risk – a premium of the order of 3 per cent – in recognition that PE’s superior performance is otherwise offset by its increased risk-taking. Furthermore, the basis for comparison in the table below, the Standard & Poor’s (S&P) 500 index, is less relevant than an index of small- and medium-sized companies in the US such as the Russell 2000 or 3000. Relative to these indices, the outperformance is significantly lower, about 1–1.5 per cent. In short, once the returns reported by private equity are adjusted for risk and compared to appropriate benchmarks, it becomes much harder to justify their high charges.

Figure 20.Buyout funds performance vs S&P 500 45

The fund management industry naturally argues that the returns it can make – seeking ‘alpha’ – for clients justify the fees it charges. In an influential article, 46Joanne Hill, a Goldman Sachs partner, identifies conditions in which trying to achieve alpha need not be a zero-sum game – conveniently showing that investment banks’ proprietary trading might have some social and economic value. But these conditions include an assumption that the market is divided into traders with short- or long-term horizons, who are pursuing alpha over different time periods and measuring it against different benchmarks. Without this artificial separation, alpha is indeed zero-sum – and turns into a negative-sum game once active managers deduct the extra fees they must charge for selecting stocks rather than just buying them in proportion to the relevant index.

CONCLUSION

Asset management has grown into one of modern capitalism’s defining characteristics. If nothing else, its sheer scale and central importance to the financial security of many millions of men and women have given financial management its influence. But at least as significant is that many of its activities extract value rather than create it. Financial markets merely distribute income generated by activity elsewhere and do not add to that income. Chasing alpha – selecting and over- or under-weighting stocks so as to outperform an index – is essentially a game that will produce as many losers as winners. This is why actively managed funds frequently fail to beat the performance of passive funds. Much of fund management is a massive exercise in rent-seeking of a sort that would have caused raised eyebrows among the classical economists.

Reform is not impossible. Financial regulation can be used to reward long-termism and also help to direct finance towards the real economy, as opposed to feeding on itself. Indeed, the point of the financial transaction tax – which has yet to be implemented – is precisely to reward long-term investments over quick millisecond trades.

Furthermore, the fees being earned by asset managers should reflect real value creation, not the ‘buy, strip and flip’ strategy common in PE, or the ‘2 and 20’ fee model common to PE, VC and hedge funds. Were the fees more accurately to reflect risks run (or not run – such as the large taxpayer-funded investments that often precede the entrance of VCs), the percentage of realized and unrealized profits retained would be lower than the customary 20 per cent. It is not that financial actors should not make money, or that they do not create value; but that the collective effort involved in the value-creation mechanism should be reflected in a more equitable share of the rewards. This is tied to Keynes’s notion of ‘socialization of investment’. He argued that the economy could grow and be better stabilized, and hence guarantee full employment, if the quantity and quality of public investment was increased. By this he meant that funding investment in infrastructure and innovation (capital development) ought to be done by public utilities, public banks or co-operatives which direct public funds towards medium- and long-term growth rather than short-term returns.