The Open Book on Private Equity - TheStreet

One often hears of writers claiming that they felt "impelled" to write a book, and while I hesitate to use the expression, that was certainly the case with me when I wrote Private Equity as an Asset Class.

Private equity differs from just about every other asset class in just about every imaginable way. The most obvious are the ways in which returns are earned, calculated and stated (as compound returns over multiple periods rather than the periodic return of a single quarter or year), but the differences run much more widely and deeply than this.

Having been around the industry for 20 years, I have lost count of how many times I have attempted to explain these things to institutional investors only for them to be left, in many cases, still with a rather blank expression after the very limited time I usually had available. (Try explaining the difference between vintage year returns and annual returns in two minutes -- it isn't easy!).

This was not the fault of the investors concerned. They were intelligent, well-educated professionals, but private-equity theory made demands far beyond the range of their daily experience (bonds and quoted stocks), and they were completely unprepared for a world in which capital took years to put to work, annual returns had no relevance and their beloved risk model had no application. No, the fault lay rather with us in the private-equity industry.

It is a well-known psychological phenomenon that all humans are naturally location- and egocentric. That is, each of us sees the world with our self and our physical location at its center. This is brought home most powerfully when someone who has made their career in New York or London goes to some very small place elsewhere and finds local financial issues dominating the front pages. It is into exactly this trap that we in the industry fell, being given a helping push in many cases by complacency and arrogance.

It never occurred to us, as it should have, that the people to whom we needed to be talking were not those who attended private-equity conferences, but those who did not. We needed to address our message to the wider investment community, and we failed. The current unflattering press coverage of private equity in Europe is a direct consequence of this failure, particularly as it was well signaled in advance.

Ironically, it is the very ignorance, which could have and should have been addressed by the industry, that is now costing it dearly. Would things not be very different, for example, if every financial journalist knew that what they blithely refer to as "private equity" is in fact a very small number of large buyout firms representing only about 6% of the industry worldwide?

I had felt for years that what was needed was a definitive textbook on the asset class.

Not a case book. And not one of the several books that seem to appear every year based on interviews, anecdotes and such hoary old chestnuts as the LP/GP relationship and how to accommodate private-equity returns within a traditional risk model. (You can't!) What was needed was an honest-to-goodness old-fashioned textbook that would start with such basics as "What is private equity?" and proceed to explain how the different industry sectors operated, how their returns were generated and how these might be analyzed and evaluated. It may surprise many to know that no such book actually existed.

I set about researching the private-equity modules available in business schools (many in the U.S., almost none in Europe, though many did offer some sort of venture capital/entrepreneurship course) and aligned the chapters with the relevant course structure as best I could. I also thought long and hard about what I had found most striking about my own industry experience and how the industry could most usefully be analyzed.

The three ideal types of readers whom I had in mind were business school students; private-equity professionals, particularly those at entry level; and investors looking to enter the asset class for the first time. However, in practice, the book, which has already been available in the U.K. for some weeks, seems to have sold more widely than this.

Hopefully I have succeeded in my objective to demystify the asset class for business school students, investors and professionals alike, but there is also some new thinking that some may find controversial.

Guy Fraser-Sampson has 20 years' experience in the private equity industry. He set up and for several years ran the European operations of San-Francisco based Horsley Bridge, and previously lived and worked in the Middle East as investment controller with the Abu Dhabi Investment Authority. Guy is well known as a speaker and writer, and has written two books for the Wiley Finance series. He is also well known for his work on asset allocation and portfolio theory, in particular on the role of so-called "alternative" assets within a diversified portfolio.