Private equity funds are the greatest wealth builders ever invented on Wall Street. So why have the retail versions of the dealmakers’ funds, peddled by Merrill Lynch and other brokers, performed so poorly?
by Antoine Gara and Jason Bisnoff
Former Merrill Lynch broker Kurt Stein vividly remembers the day in the spring of 2011 when the doors to the exclusive world of private equity seemed to swing wide open. Inside an ornate ballroom at Manhattan’s Waldorf Astoria hotel, Stein and hundreds of his Merrill colleagues were wined and dined by Blackstone, the world’s preeminent buyout firm. The pitch: Blackstone’s vaunted deal machine was invincible, producing net returns north of 15% per year with an uncanny ability to avoid losses.
Here’s how Blackstone’s billionaire cofounder and CEO, Steven Schwarzman, explained his proposition to brokers in 2013: “We are a pair of safe hands. . . . Why would you invest in the products you normally do if you can make two to three times your money and have happier customers if you put them into our products?”
Now Stein, who has since resigned from Merrill and submitted documents to the SEC as a whistleblower, wishes those doors had remained firmly closed. Fast-forward ten years, and most of the clients Stein placed into private equity funds are sitting with annual returns after all fees of 10% or less, well below the 15% annually the S&P 500 has returned. Stein now believes these funds were misrepresented by wealth management firms and their private equity partners. (The SEC declined to comment.)
In retrospect it seems Schwarzman was only breaking bread with brokers because these salespeople represented the next big money pot. Private equity had already tapped the bigger money pools—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 affluent households growing rapidly, financial advisors now control $8 trillion. Retail is the biggest driver of growth at $684 billion (assets) Blackstone today, pulling in almost $4 billion in new assets a month. This channel could nearly triple by 2028.
Retail is the biggest driver of growth at Blackstone today, pulling in almost $4 billion in new assets a month. This channel could nearly triple by 2028.
“You felt you were talking to the guys making the big money,” recalls Stein, 54, an advisor, then based in New Jersey, whose typical client account is was over $3 million. “I remember thinking ‘this will be a home run.’ ”
As soon as he was back in Jersey, Stein hit the phones. At first, he mostly put clients in a flagship real estate fund, Blackstone Real Estate Partners, and a mezzanine credit fund. Early returns were impressive, and Stein was ecstatic. Within three years, both funds showed “internal rates of return” of roughly 20%. Stein was soon investing with not just Blackstone but other PE shops including KKR, Carlyle Group and Lone Star.
He was not alone. One former Merrill heavy hitter says he put more than $1 billion of client assets in PE funds. “It’s a scam,” he says. “I’m not buying any of these funds anymore.”
Returns have been lousy. Take Stein’s experience with Blackstone’s diversified offering, Total Alternatives Solution, known as BTAS 2014. It started out respectably, generating a return of 10.82%, after all fees, by the end of 2017; two years later, returns were 6.78%. Today, the net return is 5.18%, and the fund’s biggest holding is struggling physician group Team Health.
As Stein sees it, there are two big problems.
Start with fees. Blackstone takes its customary 1.5% management fee 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% annually on their committed capital, despite the fact that they have nothing to do with the dealmaking. After that, there are “placement fees” which run as high as 2.5% of an investor’s placement.
Says a spokesperson for Merrill’s parent, Bank of America, “We clearly detail the fees related to such investments to ensure transparency.”
The second problem is the financial alchemy 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 posits that PE fund returns are depressed in early years because investors are charged fees on their capital commitment, which normally isn’t fully invested until the fourth year of a 10-year fund. Then, like a J, returns are supposed to rise like a phoenix. But Stein says his clients’ actual returns were more like an upside-down J.
Consider Blackstone real estate fund BREP, launched in 2012. It peaked at a net IRR of 20% in December 2015, including brokerage fees. As of May 2021, returns were just 10.3%. Or Blackstone’s 2012 GSO Mezzanine Trust: The credit fund peaked in March 2015 at 23.3%, but as of February 2021 its IRR hovers around 6%. Carlyle’s U.S. 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 grunts.
A big reason for the inverted J? Leverage. These funds borrow in the early years, deferring capital calls and thus boosting rates of return, especially when an early investment is quickly flipped at a profit. It’s like buying a house for 1% down and calculating returns before shelling out the remaining 19%.
Win or lose, those high reported early IRRs are a great marketing tool. The strategy behind Blackstone’s Total Alternatives Solution VIII was pitched in June as having a 13.4% net IRR, far more than Stein says his clients have earned. To arrive at that return, Blackstone references seven BTAS funds with $7.8 billion in total assets. Two of those funds are from 2019 and 2020, carrying net IRRs of 42% and 100%, respectively. Neither fund has distributed capital to investors.
“The IRR is high in the beginning because they’re manipulating it to be high,” says Brad Case, an economist who studies private equity. “Why does it come down over time? Because they run out of opportunities to keep manipulating it.”
In a statement noting its 35-year track record of outperforming benchmarks, Blackstone insists, “Any suggestion that we overstated our performance or misled investors is completely false.” Now Blackstone and other buyout firms are eyeing investors with less money. In mid-2020, after lobbying the Trump administration, Labor Secretary Eugene Scalia, son of late Supreme Court Justice Antonin Scalia, approved private equity’s inclusion in defined contribution plans. In other words, Blackstone and its private equity pals are coming to a 401(k) plan near you.