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.