A myth that has allowed private equity to persist in its predatory ways is that private equity delivers returns that investors can’t obtain through other investment strategies.
We’ve described the large body of research that demonstrates otherwise. Private equity has conditioned investors to use IRR, a return metric that exaggerates their performance. Average private equity industry performance does not beat the S&P 500, which is a much more flattering metric than smaller-cap indicies that would make for better comparables. Moreover, investors need to be compensated for the illiquidity of private equity and most investors use a rule of thumb of 300 to 400 additional basis points. Even the mighty CalPERS, which has better access to private equity funds than just about any market participant, has failed to meet its private equity performance benchmarks for the last 10, 5, 3, and one years. If CalPERS can’t eke out an adequate risk-adjusted return out of private equity, pray tell who can?
The justification for investing in private equity has rested almost entirely on the idea that investors could gain access to the best funds. If they could invest only in top quartile funds, private equity looks like a winner. But that notion has also been roundly debunked. It was once true that top quartile firms stayed in the top quartile, so investors could in theory target them. But top quartile outperistence no longer holds, so investors might as well throw darts at a list of private equity fund managers. Moreover, even in the days when top funds were able to maintain a performance lead over their peers, the also-rans were able to muddy the selection waters. One study found that 77% of the funds were able to claim top quartile status. Oops.
Rather than question the logic of investing in private equity at all, everyone in the industry has convinced themselves that it is reasonable to believe that they can be the Warren Buffett of private equity. The investment consultants go through the shooting-fish-in-a-barrel exercise of convincing their institutional clients that each of them is prettier, smarter, and more charming than average, and therefore capable of achieving sparking results. Needless to say, flattery is an easy sell….
Fundamentally, this is an intellectually dishonest exercise, and diametrically opposed to the way many public pension funds construct other parts of their investment portfolios. With public equity in particular, it’s almost certain that a significant majority of U.S. pension fund assets are invested in index funds. That’s because pension funds have recognized that, collectively, they cannot do better than average, and that after paying active management fees, actively managed public equity portfolios typically perform worse than the market average.
So it’s not as if these investors are so clueless that they can’t grasp the point that all of them cannot achieve above average results, let alone significantly above average results. Instead, with private equity, there is a desperate desire to be in the asset class for reasons that probably reflect a combination of intellectual capture by the PE managers, political corruption in legislatures that control public fund board appointees, and the need to have a strategy that could conceivably solve the pension underfunding problem over time.
In other words, the very long term, illiquid nature of private equity investments allows limited partners to fool themselves about how realistic it is for them to achieve their desired returns, and there’s a well-honed industry of private equity professionals and consultants who stoke those illusions.
But it’s going to be hard to keep those fantasies alive when academics show how to beat private equity returns with much cheaper public equity strategies. Matthew Klein of FT Alphaville summarizes a new paper by Brian Chingono and Dan Rasmussen that shows how to exceed the average private equity fund’s return by a solid margin. We’ve embedded the article at the end of the post. Klein does a fine job of recapping it, so we’ll quote liberally from his post.
The Chingono/Rasmussen strategy, in simple form, seeks to replicate what private equity funds do with a portfolio of public stocks by creating a portfolio of leveraged but low-priced yet solid cash flow generating firms. They focus on midsized stocks, in the 25th to 75th percentile of market capitalization, that are cheap (bottom 25% in enterprise value to EBITDA terms) and are leveraged more than average. The academics then tested several ways for selecting the best performers from this bunch. They found the best measures to be sales growth relative to assets and debt repayment ability (as in cash flow relative to debt levels). The only anomaly seems to be that rejiggering the portfolio annually in the 4th quarter produces sub-par returns; all the other variants produced impressive results of an average of 9.1% to 11.7% outperformance. That puts private equity to shame.
From Klein’s post:
It’s well known among finance academics that the performance of the average private equity fund is overwhelmingly determined by 1) junk bond spreads and 2) the amount of capital invested in PE funds. General partners overpay for their target companies when they have too much money to play with, which kills returns. But when credit is tight and few investors are willing to commit to private equity, general partners can get better deals and deliver the massive gains that underfunded pension plans salivate over.
In other words, returns are cyclical and can be predicted by the purchase multiples being paid, which in turn can be predicted by macro factors. (That’s not surprising, since basically all asset returns are inversely related to how much you pay.) You may want to have some exposure to this kind of thing, but you shouldn’t be paying pay 2 and 20 for it. Plus, there’s no telling that the particular funds you invest in generate returns representative of the strategy.
And get a load of the margin of outperformance over time:
Looking at US data going back to the early 1960s, they found that if you’d bought a portfolio consisting of companies in the top quartile according to each of these filters, you would have made around 23 per cent per year between 1965 and 2013. You would have done slightly better with an equal-weighted portfolio and slightly worse with a value-weighted portfolio.) Compare that to the roughly 10 per cent annual returns you would have gotten over the same period if you invested in the S&P 500 index and reinvested all dividends, or the long-run net of fees returns of the Cambridge Private Equity Index of around 13 per cent per year.
So what’s the fly in the ointment? Public stocks are more volatile than private equity funds. But that in large degree is a fallacy, by virtue of turning the defect of private equity, its illiquidity and infrequent valuations, into a trumped-up virtue. Moreover, PE firms flat out lie about what their portfolios would be worth in a bad market, like the fall of 2008. The authors mention the importance of this fibbing to private equity’s perceived superiority:
The key advantage of private ownership of leveraged businesses, however, is that the private equity investor can mask volatility because the equity securities are not publicly listed.
This truncating the bottoms of the worst of market cycles gives private equity the illusion of lower price volatility than it really has. Or put it another way, the valuation consultants haven’t adequately priced the fact that the investors have handed over the option as to when they get their money back to the general partners, which is not the same as “illiquidity”. That option is a very long-dated option, and long dated options are extremely expensive. It’s a virtual certainty that if this option were properly priced, limited partners would need to seek a far higher premium than the 300 to 400 basis point the industry has agreed upon as a heuristic.
But even handicapping the higher volatility using conventional metrics, this levered public equity strategy still beats private equity. As Klein sums up:
True, you would have endured extreme volatility to go along with your leverage-fueled returns, but the risk to return ratio would still have been somewhat better than the market as a whole…
But we can easily imagine investment committees lacking the stomach for this kind of strategy even if it is far more liquid than the private-market equivalent. Some may prefer to take comfort in the apparent stability of made-up numbers generated from appraisals of untraded assets even if that means leaving money on the table.
Yet we see CalPERS, which is better run than any other public pension fund, assuming more risks to eke out mere single-digit basis point improvements in performance, while ignoring what amounts to free money opportunities by getting out of the high-fee private equity regime, either by moving to cut out the middleman, as Canadian pension funds are doing, or by employing public market strategies to achieve equity like returns (Chingono/Rasmussen isn’t the only approach we’ve heard about, but it appears to be the most rigorously tested one). But until investors feel more pressure, either due to evidence of more private equity chicanery or faltering private equity returns, they aren’t likely to kick their private equity bad habit.