Scandals, Bans Fail to Slow Placement Agent Boom

Despite bad publicity, official bans, and even criminal convictions, placement agents have become more rampant than ever in institutional investing, according to a new study.

From an examination of placement agent investments from 1991 to 2011—covering 32,526 investments in 4,335 private equity funds—the study found an overwhelming uptick in the use of intermediaries.

While placement agents were virtually absent in 1991, nearly 75% of private equity funds relied on them in 2011, wrote Matthew Cain of the US Securities and Exchange Commission, Stephen McKeon of the University of Oregon, and Steven Davidoff Solomon of the University of California, Berkeley.

While placement agents were virtually absent in 1991, nearly 75% of private equity funds relied on them in 2011, the study found.Specifically, investors in the Netherlands, Norway, and Denmark employed placement agents more than 50% of the time, while only 18% of US asset owners used them.

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But are these matchmakers truly helping limited partners (LPs), the authors questioned, or are they simply “influence peddlers” that attract investors through “personal relationships, aggressive marketing, or worse, kickbacks and ‘pay to play’ schemes”?

“Placement agents can create value for LPs if they are able to discern fund quality ex ante, thereby mitigating information asymmetries and reducing search costs for LPs by certifying high quality funds,” the authors said.

However, these potential benefits—in the form of strong fund performance—manifested in funds brought in by top tier agents and first time funds.

Generally, funds employing placement agents underperformed the market by 350 basis points, the authors found. Furthermore, 20 largest investors studied in the research reported 6.7% lower net internal rate of returns for investments in funds that used placement agents.

These low returns could be caused by agents working as “little more than hired guns acting out of self interest to market any fund willing to pay them,” Cain, McKeon, and Solomon said.

In addition, the study found a close relationship between an asset owner and agents could be particularly damaging for investors. When an LP invests with a single placement agent, the authors said, returns tended to suffer as the agent screens funds less strenuously.

In the 20-year period in the study, only three agents had exclusive relationships with a pension fund: Arvco Capital Research, Wetherly Capital, and Diamond Edge Capital Partners—all of which have been indicted on criminal charges of pay-to-play, according to the research.

Read the full paper here.

Focusing on the spread between government and corporate bonds disguises returns, according to AQR, and investors need to dig down deeper into what is producing the numbers.

“It is important to know if the credit risk premium is nothing more than the equity risk premium in disguise.” — AQRIn a paper entitled “Credit risk premium: its existence and implications for asset allocation”, AQR’s Attakrit Asvanunt and Scott Richardson highlighted the lack of investigation into what creates the return from bond portfolios—and why investors should be aware.

“We first confirm the existence of a positive premium for bearing exposure to default risk,” the authors said. “Using a combination of data sources, we compute returns for corporate bonds after first removing the influence of interest rates.”

They found this credit excess return, on an average monthly basis between 1936 and 2014, to be 11 basis points, with an annualized Sharpe ratio of 0.37. Between 1998 and 2014, the aggregate high yield corporate bond index number was 21 basis points a month, with an annualized Sharpe ratio of 0.26.

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These numbers, the authors said, stood as “robust evidence of a credit risk premium”.

“A skeptical investor will, and should, ask the question as to whether exposure to credit risk is beneficial in a broader portfolio context,” the paper said. “It is important to know if the credit risk premium is nothing more than the equity risk premium in disguise. You may be paying more for a well-known source of risk (credit indices are still more expensive to trade, and have less capacity, than equity indices).”

By examining three long-only portfolios allocated to treasury, equities, and credit, and credit default swap index data, the authors claimed there is a credit risk premium to be had—and it is “sufficiently different to the equity risk premium”.

The authors next looked at fluctuations in this risk premium, assessing timescales and macroeconomic events. They found them to be larger during periods of economic growth and when aggregate default rates were lower than expected.

“This suggests that investors interested in tactical variation in exposure to credit risk premium require good forecasts of (i) changing expectations of economic growth, and (ii) aggregate default rates,” the authors said. “Of course, to be useful for tactical allocations, these forecasts need to be superior to the anticipated growth and default rates that will already be incorporated into current spreads.”

To read the full paper, visit the AQR website.