I’ve admitted before that I am a Jeremy Grantham junky. He’s not ahead of Steve Nash or Lucinda Williams, but he’s in the running. He’s often accused of being perpetually bearish, as am I, but both of us are able to crank it up when opportunities arise. Certainly, his firm, GMO, has had spectacular returns over the years.

As part of his July letter, Grantham offers a buyer's guide, or perhaps it’s more of a reality check, for those looking to invest with a private equity firm. The piece is not aimed at the typical client of Steadyhand, but there are useful lessons that can be applied in a broader context and be useful for all buyers of investment management services.

So as a follow-up to my July 21st Globe & Mail column (Will Going Public Kill Private Equity?) here are a few things that I took away from Grantham’s commentary.

• He surmises that with the flood of people getting into the game, the exceptional private equity firms now make up at best 10% of the business. Ten years ago, it was 20-25%.
• Unfortunately, the average practitioners (and worse) have the same fee schedule as the elite 10%.
• If an investor hires a private equity manager, he/she is being forced to pay a steep fee on all elements of the fund’s return, each of which has a different amount of added value. For example, the 2 and 20% fee is applied to (1) the manager’s added value (great … send it in); (2) the normal market return during the term of the fund (which is available through an ETF at a fee of 0.25%); and (3) the leverage applied to the portfolio (for which you are taking the risk). TB: If we disaggregate the components of a balanced mutual fund, a mutual fund wrap (which are hugely popular right now) or principal-protected note, the same situation exists. Investors are paying a high fee on the whole product, despite the fact that only a small portion of it deserves that level of fee.
• The premium prices private equity firms are now paying to acquire assets offsets any added value the manager can provide from improving operating efficiency, focusing the company on its strengths and/or fixing the capital structure.
• Grantham notes that it is now assumed that increasing a company’s leverage increases its value. Disappeared is the ‘age old paradigm’ (my words) whereby the value of leverage is offset by increased risk. To quote Grantham - “[This] is a new idea in this cycle … [whereby] leverage is a free good not burdened by increased risk.”
• As opposed to a perfect storm, Grantham suggests that private equity has had the “perfect calm” as a result of easy credit, low risk premiums, rising profit margins and high price-earnings multiples. In the perfect calm, all funds do well (not just the best ones) and a lot of the industry’s sins are covered up. TB: I would add that this applies to all kinds of asset classes including hedge funds and good ole mutual funds.
• He thinks that few managers are assuming in their models that (1) profit margins will drop below the current record levels or (2) price-earning multiples might decline. TB: Profit growth and healthy valuations are taken for granted. But if both these factors reverse direction, look out.

Private equity provides the most illuminating canvas for Grantham’s comments, but when it comes to management dilution, fees, corporate profits and the perfect calm, they apply to all types of equity investing.