Why Private Equity Does Not Outperform

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Investors in private equity and other “alternative” investments cling to the canard that they deliver superior returns. Mind you, in the case of private equity, that was true once upon a time. In the 1980s, making money busting up undervalued, overly diversified conglomerates was like shooting fish in a barrel. Even in the 1990s, private equity, which is at its core just a levered play on equity markets, rose on the surging tide of dis-inflation-goosed stock market valuations.

But institutional investors, particularly those with long-term time horizons like pension funds and life insurers, have been desperately chasing anything that even dimly offers the hope of outperformance as QE and ZIRP put real yields on safe investments in negative territory. Even so, they’ve come to recognize that some of their hoped-for salvations, like hedge funds, routinely failed to deliver.

Yet investors remain loyal to private equity, even though industry chieftans have warned that returns in the next few years will fall from current levels. And it’s not as though those results are as attractive as the PR would have you believe.

We’ve stressed that public pension funds have fallen short of their benchmarks for the last ten years, and in most cases, for the sub-periods in that time frame. That means investors are not being paid enough for the risks they are assuming.

We have given other, more detailed and technical critiques of over-hyped private equity performance. A new report by ValueWalk (hat tip DO) does a terrific job of putting the key issues together in a tidy package. I strongly urge you to read the entire article in full. It uses a 2014 overview of recent studies on private equity performance by Steven Kaplan and Berk Sensoy as its point of departure. Note that we’ve discussed the most important recent studies touted as favorable to private equity in earlier posts (see here, for example).

The recap of the Kaplan/Sensoy paper:


  • Buyout funds have outperformed the S&P 500 net of fees on average by about 20 percent over the life of the fund.

  • Venture capital funds raised in the 1990s outperformed the S&P 500 while those raised in the 2000s have not.

  • Before the 2000s, buyout and venture capital fund performance showed strong evidence of persistence.

  • Since 2000, there is little evidence of buyout fund persistence (with the exception of persistence among the worst performers, those in the bottom quartile) while venture capital fund persistence has remained strong.

  • Yves here. For those of you new to this topic, “persistence” is a big deal. In layerson terms, analysts want to know if an investor is likely to achieve the same sort of results relative to his peers over time. If he is a top performer one year, what are the odds he will do it again next year?

    As the summary indicates, the best private equity funds (typically the top quartile) in the past were likely to continue to outperform. But that’s no longer true. So an investor in private equity cannot identify funds that will do particularly well based on past performance. Yet even staunch industry defenders, like Harvard Business School Professor Josh Lerner, have conceded that it’s really not worth investing in private equity if you can’t attain those unachievable-in-practice top quartile performance, because average outperformance is so modest as to not be worth the bother.

    The ValueWalk article debunks the notion that private equity outperforms, when “performance” is properly adjusted for the idiosyncratic risks of private equity:

    Unfortunately, the returns data presented isn’t risk-adjusted. Private equity is much riskier than an investment in a publicly traded S&P 500 index fund, making it a wholly inappropriate benchmark. For example:

    • Companies in the S&P 500 are typically among the largest and strongest companies, while venture capital typically invests in smaller and early-stage companies with far less financial strength. Studies have estimated betas for BO funds at about 1.3 and for VC funds from 1.6 to 2.5. Adjusting for the higher betas alone would have wiped out any evidence of outperformance.
    • Investors in private equity forego the benefits of daily liquidity. It’s well-documented in the literature that investors will demand a premium for investing in illiquid assets, especially ones that perform poorly in bad times (like PE). There’s no adjustment in the returns data for the risk of illiquidity. In addition to the lack of liquidity, relative to investments in mutual funds, private equity investors also forego the benefits of transparency and broad diversification (and for individuals, the ability to harvest losses for tax purposes).
    • The median return of private equity is much lower than the mean (the arithmetic average) return. PE’s relatively high average return reflects the small possibility of a truly outstanding return, combined with the much larger probability of a more modest or negative return. In effect, PE investments are like options (or lottery tickets). They tend to provide a small chance of a huge payout, but a much larger chance of a below-average return. And it’s difficult, especially for individual investors, to diversify this risk.
    • The standard deviation of private equity returns is in excess of 100 percent. Compare that to standard deviations of about 20 percent for the S&P 500 and about 35 for small-value stocks.
    • Given the greater risks and the fact that PE investments are typically in smaller companies, a more appropriate benchmark than the S&P 500 Index is the Fama-French Small Value Index. Small-value stocks have outperformed the S&P 500 by about 3.5 percentage points a year over the last 88 years, and by even greater amounts over the past 35, 25 and 15 years. Once this adjustment in the benchmark is made, it’s clear that, overall, both BO funds and PE funds have performed poorly.

    Even adjusting the benchmark does not take into account the risk of liquidity. Clearly, whatever alpha there was being generated was going to the PE fund general partners, not the investors (the limited partners). And that leaves us with the puzzle of why PE continues to attract so much capital. My own view is that it reflects the triumph of hype, hope and marketing over evidence and wisdom.


    As we’ve said repeatedly, there is no justification for fund managers to continue to invest in private equity. Academic papers have modeled small-stock investment strategies that achieve comparable-to-better net returns. The general partners are syphoning off so much in fees that any value they do add goes entirely to them. The real lure for many investors is actually the bogus accounting: that in lousy stock markets, the general partners overstate how much the portfolio companies are worth, creating the illusion that private equity mitigates risk.

    If the bigger public pension funds believe that there aren’t enough small cap companies available for them to invest in if they and all their peers were to abandon private equity (hardly a risk now), the alternative for them is to build up a private equity operation in house, as some Canadian pension funds have done with considerable success.

    But limited partners, particularly public pension funds, have a bad case of Stockholm syndrome. Until the lousy returns that they’ve been warned about actually come to pass, they won’t consider abandoning their captors.

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    1. tony

      I wondered about public pension funds going for private equity, so I looked around a bit. Apparently, there is a quid pro quo relationship between the funds and the trustees. It’s looting as usual.

      As documented by Bloomberg News, placement agents often leverage political connections to convince public pension systems to invest in their clients’ funds. Because pension funds are barred from choosing investments based on such political considerations, the controversial placement business has periodically faced legal scrutiny, with some states and cities moving to crack down on placement agents. But, as evidenced by Kentucky and its relationship with Blackstone, many states still very much permit them. Indeed, according to Forbes, “Park Hill itself received $2.35 million for lining up business in Kentucky – for Blackstone funds.”

      Of course, what can supercharge the influence of lobbyists and placement agents is the campaign contributions of their clients. So, for instance, according to data from the Center for Responsive Politics, Blackstone employees are among the largest campaign contributors to Kentucky’s chief political powerbroker, U.S. Senator Mitch McConnell (R).


      1. Yves Smith Post author

        First, this is old news. Second, Kentucky is a real outlier in terms of its degree of corruption. Third, not all that many public pension trustees are elected officials. There are only 2 at the 13 member boards at CalPERS and CalSTRS, for instance.

        As difficult as it is to believe, the loyalty to PE really is about cognitive capture, and at least as important, fear of public pension fund staff of PE firms. It is the STAFF, the employees, who pick the investments, not the trustees. At CalPERS and CalSTRS, the board plays no role in reviewing individual investments.

        Even though it is urban legend, PE staff believe that private equity firms can get them fired. They also believe that PE firms can held them get a new job, not by hiring them (there is effectively no revolving door, the PE firm employees and partners have much tonier backgrounds) but by putting in a good word for them while they are looking.

        1. Anon

          Ah yes, the fear and loathing of public employees. The internal intrigue as to whom will be able to advance internally (or externally) makes public employment near Machiavellian.

        2. tony

          I apologize for coming off too certain. I just had a hard time understanding why normal, intelligent people had such a hard time understanding simple facts.

    2. fresno dan

      Wonderful article, wonderful analysis.
      It is an amazing thing – the analysis of equities and the associated costs, that should be the most cold hearted, dispassionate, take no prisoners analysis is so fraught with hype, wishful thinking, and susceptibility to the most swarmy snake oil salesmen.
      Almost makes one not believe in “homo economicus” i.e., that supremely rational utility maximizing dude who carriers an excel spread sheet and is always looking for another 1/100 of a risk adjusted basis point (Sarc).
      Really, like authors telling you how to get rich…who themselves have only prospered by writing books telling you how to get rich, the promise of someone sharing the secrets of wealth creation for a small fee is a never ending grift that never fails…

    3. TiPs

      I wonder how much of the early gains were due to the debt tax shield? With higher Corp leverage ratios, the only way to make gains today is ruthlessly cut costs or increased pricing power from merging competitors. The Heinz-Kraft merger by 3G comes to mind as an example using both strategies.

      1. Yves Smith Post author

        You have good instincts. One of my tax lawyer buddies says that private equity is a tax reduction scheme with an acquisition attached.

    4. MikeW

      The continued stream of commentary and insight matters, thanks. It strikes me that there are three important implications..

      Few if anyone, think about returns in the context of real interest rates. “Capital” as controlled by the elites and preferenced and subsidized by general society is seeking returns outsize what is possible in the current interest rate environment..

      This will almost certainly lead to increasingly risky decisions (more financialization/more leverage) that will create massively more instability in the overall economy. There is significant evidence of this already (e.g., non financial lenders replacing banks in private equity deals Koch is reported to be doing, per Bloomberg, peer-peer lending businesses, etc.)

      The repercussions will be an even more expensive bailout when the house of cards collapses and granting the elite their ultimate wish, the final dismantling of public and private social protection systems.

    5. matt

      Kind of off the wall, but sort of like why you have so many damn MLMs. Insane survivorship bias (aka a few mlms and a few leaders do greeat…) and the people who stand to make money have a HUGE bias to promote how good their system is, and there really is no natural adversary.

      I think almost all mlms are shit, but I don’t fight with those doing them because even if I “win” what do I get? Nothing economically. If they are good you ahve people who make 100-300k (1 out of every 500 people in it) as “leaders” in amway, herbalife, mary kay etc.

      Just like private equity, who really “wins” if they don’t invest with them? Probably pensioners by getting a few basis points of better returns.. 20-30 years later.. when they already have a defined benefit plan. Knowing both industries well I thought it was an interesting comparions Yves. Curious if you agree. Not usually comparison since such different industry but survivorship bias and misaligned incentives with no natural economic force on other side creates market failures / anomalies.

    6. David Yuguchi

      My message to Grant Boykin of CA Treasurer Chiang’s office regarding AN 2833:

      Mr. Boyken:

      Thank you for responding to me and my sister regarding AB 2833.

      We are independent thinkers and are not being led around by the nose by Ms. Smith or anyone else. I have no insight as to Ms. Smith’s motivations, intentions, or why she does, or doesn’t do, anything. We merely are impressed by Ms. Smith’s and Mr. Michael Flaherman’s concerns about the apparent capture of the pension market by private equity firms and their abuse of this system of investment which puts public employee pension investment funds at risk by egregious, unsubstantiated, and secret fees paid at CALSTRS and CALPERS’s expense, as well as by the less than impressive returns on investment that PE firms actually deliver. Tying all of this together is the fact that California’s investments portfolio which doesn’t even allow for a proper evaluation of the propriety of even using PE. Are we really getting our money’s worth?

      Your discussion of the definition of “related parties” misses the point that Ms. Smith raises: it is deficient in providing the protections need to insure the complete reporting of all payments to everybody involved. If you think that that is not the case, fine. But making the excuse that, well, everyone else does it this way, is not very reassuring.

      As for the specific recommendations which you kindly invited, I have one:

      (4) The public investment fund’s pro rata share of aggregate fees and expenses paid by all of the portfolio positions companies held within the alternative investment vehicle to the fund manager or related parties.

      The legislation would have a markedly positive impact if the text in red were stricken so that each investor would be given information about the total amount of related party transactions received by the fund manager from portfolio companies. An investor knowing its pro rata share does not allow it to impute the total related party transaction value, which is extremely troubling and easily correctable by a small change to the language. The whole point of this legislation is more transparency. My suggestion provides more transparency.

      Thank you for your attention to this very important matter.

      Best regards,

      David Yuguchi
      Santa Monica, CA 90403

      From: “Boyken, Grant”
      To: (redacted)
      Sent: Wednesday, June 29, 2016 8:32 PM
      Subject: RE: Oppose AB 2833

      Thanks for your input. I urge you to think for yourself and ask Ms. Smith why she falsely accuses those who are doing the most to shed light on private equity fees of “gamesmanship ” whIle she ignores all of those who are doing nothing to further the cause.

      The current language of AB 2833 is the result of hours of discussion and negotoation among the Treasurer’s office, legislative staffers and public sector labor representatives. The bill, if passed, will put California far in the lead of other states in terms of requiring greater transparency of alternative investment fees.

      The “related parties” definition is wordy and complex as Ms. Smith suggests. I agree. We gave this a great deal of thought, however, and discussed with stakeholders. In the end, we used the definition adopted by the International Limited Partners Association (ILPA). This made sense given that the definition is comprehensive and that the ILPA fee disclosure template is emerging as an industry standard. No one person gets to make law. It’s an open and public and iterative process. No one has unilateral authority to dictate the language of legislation.

      If you have specific recommendations regarding the language of the bill we would very much like to hear what those are.

      Fortunately, the bill passed through the Assembly and through its first senate committee hearing this week.

      John Chiang has worked tirelessly throughout his public career to shed light on government spending. AB 2833 is one more example of that track record. To oppose AB 2833 is to support the status quo of opacity with respect to private equity fees.

      Please share with your brother. And again, please share your specific concerms and recommendations with us.


      Deputy Treasurer

      1. flora

        Wow. Mr. Boyken’s letter sounds like the misinformed, important people circling the wagons to protect a system they truly do not understand. His letter sounds like he believes what he says and believes what he has been told, without further investigation. “International Limited Partners Association (ILPA)” That’s rather frightening. Yves leading anyone around by the nose is nonsense. Since it’s clear that the SEC and the state powers delegated to protect the public from unscrupulous actors are missing in action I take the info at NC as important for my own financial self defense.
        Bravo on your letter!

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