For most of the middle class, the stock market is going to make the difference between retiring with dignity or not retiring at all.
We haven’t got gold-plated, “defined benefit” final salary schemes, we didn’t inherit trust funds, and we know that Social Security is there to provide a basic level of existence but little more.
So if we want to escape the rat race and kick back, sooner or later, it’s going to come down to what we manage to save in our 401(k)s, IRAs and other retirement accounts each year, and how much that money earns in annual returns.
But this week there dropped into my inbox a document which proved, once again, that you and I are getting shortchanged, every year. Big time. And that’s even if we do everything “right.”
The document? The latest annual Public Pension Study from the American Investment Council, the trade body that represents the private equity industry.
It demonstrates, once again, that private-equity funds continue to beat the “public” stock market funds available to everyone else, by a country mile too. It may sound innocuous, or technical, but it isn’t. It means quite simply that the stock market is failing to extract the full value out of companies. Vast amounts of money are being left on the table—for private-equity funds, and especially their managers, to gobble up.
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The great journalist Michael Kinsley used to point this out every time there was a big buyout deal and a company was taken private. We all know the story. Amalgamated Widgets is trading at $40 a share. Along comes a buyout fund offering $50 or $60 a share. Five years later the buyout fund sells Amalgamated Widgets (rebranded, probably) to someone else for $150 a share. Good for them, bad for us. But if the company was really worth $150 a share, or even just $60 a share, how come the public markets were only able to squeeze $40 in value out of it on their own?
We’re getting robbed. Incompetent managers and overstaffed bureaucracies are effectively stealing large sums of money from the stockholders, right under our noses.
The latest study gives an idea of the size of the offense. Private-equity funds owned by state pensions earned an average of 13.7% a year over the most recent 10-year period, a full percentage point a year ahead of their public stock market investments, according to the AIC.
That may not sound like much, but it’s huge, because these return figures are net of fees—and in private equity the fees are enormous. Typically they’re around 2% of the assets under management each year, plus 20% of the profits. Factor these in and the private-equity funds must have earned somewhere around 19% a year on their investments, gross.
So under hard-charging, value-oriented, incentivized management, companies could generate around 19% a year instead of 12.7%. Imagine what you could do with a 19% annual return on your investments. Imagine when you could retire.
So even if we kept all our money in low-cost index funds, we were missing out on maybe a third of the money we should have been making.
Yes, it’s tempting to be skeptical of the marketing claims put out by the private equity industry’s trade association, especially at a time when they are trying to get their hands on our 401(k) money. But these claims are not in isolation. Multiple studies have found over many decades that private equity has continued to outperform the public stock market, even after their epic fees.
If you want to see why, just take a walk around your office. If you work for any kind of public company, especially a big one, you can probably see the waste, incompetence and inefficiency everywhere you look. For me, a few years working as a management consultant were the equivalent of Keanu Reeves swallowing the red pill in the movie “The Matrix.” It’s revealed a shocking truth to me that I can never unsee: What consultants in cost-cutting mode typically call “quick wins” and “low hanging fruit” everywhere. Your typical big company is full of people who would be expensive even if they worked for free. It’s like a form of organizational isometrics, where you have different groups of managers balancing each other out.
And management rarely really cuts costs. The reason? Managers are almost the biggest waste. The longer the job title, the easier the decision.
Instead they cut front-line staff. And hire some assistant managers to help them.
What’s especially egregious is when you look at millions the CEOs are paid as “incentives.” And yet here they are, demonstrably wasting about a third of the potential annual returns every year.
No one gets to grips until some private equity company takes over the whole company, and goes through the organization like a dose of salts.
The problem with private equity isn’t that they squeeze real returns out of companies, but that the managers get to eat nearly all the upside. That may come to hundreds of billions—yes, indeed—of dollars. If only public mutual funds could put the same kind of pressure on managers.
Meanwhile the working stiff gets the short end of the stick in their 401(k)—before being laid off as a “cost cutting measure” by an expensive, yet exempt, “Quick Win” in a suit.
What can we do about it? Well, if you have a chance to get a job in private equity, take it! Otherwise, it’s another good argument for owning stocks, even if we’re stuck with public markets and regular mutual funds. There is still plenty of value to squeeze out of equities, even if someone else is going to get most of it.
This article originally appeared on MarketWatch.
