Private equity: True north

Private equity's most astounding success is not buying companies cheaply and revitalising them. Rather, it is coaxing institutions into repeatedly giving them billions of investment dollars despite massive fees. The unassuming and polite nation of Canada may be slowly undermining that achievement.

On Tuesday, Silicon Valley software company Informatica was acquired for $5bn in a leveraged buyout. The equity will be provided by traditional financial sponsor Permira and the Canadian Pension Plan Investment Board. This makes CPPIB a direct investor, rather than a traditional "limited partner". LPs give capital to firms such as Permira which then invest it; the groups then extract management fees and a fifth of the profits (the "carry") from the LPs.

That fee structure is steep, and a creeping scandal about how PE firms charge and disclose other fees to their investors may be making pensions and endowments more wary about becoming limited partners. The advantage of co-investing directly is in avoiding management and carry fees.

For the PE firm, the added firepower that a direct investor brings allows it to chase multibillion-dollar buyouts when leverage constraints pinch and partnering with rival firms has become verboten. CPPIB ($287bn in total investment assets) and another Canadian institution, Ontario Teachers' Pension Plan ($225bn), have participated with traditional firms in the large buyouts of companies including IMS Health, Neiman Marcus and 24 Hour Fitness.

This flurry of co-investments could die out. A seminal study recently showed that partnership deals lag the performance of standard private equity funds. The researchers, at Insead and Harvard, cite the "lemon" problem: the institutions only get to participate in less compelling deals where marginal equity was needed. Hefty management fees have always been a cushion for PE firms. No such backstop exists for capital providers.

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