A new paper by Antoinette Schoar, the chair of the finance department at MIT’s Sloan School and one of the scholars whose studies helped provide the intellectual underpinnings justifying the inclusion of private equity in institutional portfolios, has released a new study that knocks the legs out from under some of her widely-cited earlier work on the persistence of the out-performance of top private equity funds. It also shows that private equity funds have not delivered the performance needed to justify investing in them. From Top 1000 Funds:
Persistence of returns in private equity is diminishing. Further, the returns themselves are not what they used to be. And in even further bad news, new research from a leading Massachusetts Institute of Technology academic shows that co-investment vehicles may not be a panacea for these problems…
New research by Antoinette Schoar, chair of the finance department and the Michael M Koerner Professor of Entrepreneurship at MIT Sloan School of Management, shows that persistence of returns from private-equity funds in the last decade has gone down, undoing the seminal research she co-authored with Steve Kaplan, from the University of Chicago, that showed “returns persist strongly across funds raised by individual private equity partnerships”. See Private-Equity-Performance-Returns-Persistence-and-Capital-Flows
As we’ll discuss later in this post, one supposedly well regarded Chief Investment Officer, John Skjervem, reacted by saying it he could still justify investing in private equity even if it fell well short of delivering the needed risk premium. Why? Private equity lies about its results in a way he finds useful. I kid you not. In any other realm of investing, lying about your results is a reason to run for the hills. Skjervem has apparently managed to forget that even the toothless SEC managed to rouse itself and work with the DoJ to indict public company executives in the early 2000s for accounting fraud. But despite considerable evidence to the contrary, the SEC regards the likes of public pension funds as “accredited investors,” meaning sophisticated enough to take care of themselves. That means the onus is on them to do their own policing.
The new Schoar paper also explains why CalPERS has been doing so poorly in private equity. In 2015, it decided to reduce the its number of private equity investments by 2/3. CalPERS intended to concentrate on making larger sized fund investments in order to reduce fees. Mega-funds typically have lower fees, plus medium sized and large funds often have tiered pricing, charing lower fees for larger commitments.
CalPERS was pursuing this idea in such an aggressive way that it was limiting itself to investing in large funds. It turns out that was not such a hot idea. From the Top 1000 Funds story:
There is more competition, but the concentration of [assets] in the hands of the biggest and best-performing funds is also growing more quickly than we saw in the 2000s,” Schoar explains. “You could say it is efficient that this happens, because we want capital to be with the best performers. But it also means the top funds have to expand their investment portfolios.”
The very nature of venture capital and private equity, where illiquidity is greater and opportunities are tougher to scale, means the marginal returns to capital go down, even at the top performers, when funds become larger.
“This is a very strong relationship – when the fund size increases, the marginal return on the funds goes down. Research suggests this is something that has accelerated in the last decade,” Schoar says.
But let’s return to Schoar’s main finding, that persistence has fallen, and explain why this is so devastating to the efforts to justify investing in private equity.
The Importance of the “Persistence” Myth
We’ve been writing since 2014 that private equity does not produce superior returns. That should not be a controversial idea except that so many people are deeply invested in private equity, pun intended, that the response has been to come up with more and more creative rationalizations.
Since then, more and more investors, in particular public pension funds, have reported results that fall short of their own benchmarks for the preceding ten years and shorter sub-periods. This should come as no surprise. Private equity’s share of global equity has more than doubled since 2004. More money chasing deals means lower returns.
One of the justifications that investors have relied more and more upon is the idea that they can somehow do better than the typical investor by identifying and investing in top funds, which translates into the search for the mythical top quartile fund. Never mind that 77% of funds can present themselves as top quartile or that the idea of being the Warren Buffett of private equity and somehow out-selecting other investors is folly. The basis for this hope has been that historically, private equity funds demonstrated “persistence,” in that a top quartile performer for one fund would have a much-better-than-the-odds chance of being a top quartile performer in its next offering.
As we indicated, there is ample reason to doubt that theory could be translated into practice. Investors commit to a new fund typically four years after a fund manager’s last launch, which is too soon to be certain of its results (and that’s before the fact that academics have ascertained that fund managers exaggerate their funds’ performance around the time they are raising new money). For instance, one fund manager had a fund that showed an over 70% IRR at the time it raised its next fund. The final result for that fund? An IRR of 11%.
But the theory of persistence is breaking down too. In 2015 in a private equity workshop at CalPERS, Harvard professor Josh Lerner discussed some of the recent studies on private equity performance persistence. In public comments, Rosemary Batt, co-author of the landmark book Private Equity at Work, linked the issue of average fund performance with the persistence data:
And so I want to talk a little more about the performance data and just expand on Professor Lerner’s excellent presentation.
The findings from that core Harris article that he mentioned are very important. He reported a 27% out-performance for private equity vintage funds in 2000s, which equals an annual excess return of about 2.4% if you assume a 10 year lifespan. To clarify, this finding is based almost entirely on estimates, if you look at the paper, so it’s not based on actual returns. The paper also reports returns on funds over three decades, and there the average annual excess drops to about about 2%, and the median is about 1.2%. So that’s in the Harris paper.
When the private equity funds are compared to the Russell 3000 and 2000, which cover the mid-sized companies that are comparable to private-equity-owned companies, private equity performance is worse, beating these indexes by between 1% and 1.5%.
So moreover, the pension funds, they generally require a premium of about 3% over the stock index in order to adjust for greater risk or illiquidity. None of the estimates in this important paper, porbably the most important paper recently, would warrant investment in private equity.
Two more points. Professor Lerner then refers to another really important paper by Robinson and Sensoy who report, they actually report performance based on real returns, so liquidated funds. And here they find that the average fund does outperform the stock market by 1 to 1.5%, depending upon the index.
The median fund, however, just matches the stock market, which means that 50% of the funds do not perform as well as the stock market. It is the top quartile funds that outperform both indexes by 3 or 4%.
So, if we put this together, then, Professor Lerner also points out this problem of persistence of performance. And the studies he refers to show that prior to 2000, the private equity firm with a top performing fund had about that 50% chance of being in the top performing funds in the follow-on fund. But since 2000, that probability has dropped to 22%, and that is less than would be expected if the distribution were random.
And so, in sum, I worry based on our review in which we’ve kind of turned the kind of technical papers into lay language, and that’s what we’ve tried to do in this book, um, you look across the studies and they really do not provide the kind of evidence to suggest that private equity beats the market in general, and especially if you take a risk-adjusted return into account. While the top quartile do beat the market, then the question is this persistence problem: it is no longer possible to use a private equity firm’s track records to predict funds that have the best chance of being top performers.
As the Top 1000 Funds article indicated, the 2003 Kaplan/Schoar paper was one of the foundations to the argument that top private equity funds showed persistent outperformance.1 With that now gone, private equity loyalists are even more on the defensive
Oregon CIO Says He Still Likes Private Equity for Its Phony Valuations
If public pension funds want to know why they are seen as dumb money, they need look no further than remarks like those of John Skjervem, Chief Investment Officer for Oregon. Keep in mind that John Skjervem is considered to be one of the better public pension fund CIOs. He spoke at the same conference where Schoar discussed her new paper.
On the one hand, Skjervem is to be given credit for reducing his allocation to private equity in light of its falling performance and persistence. From a second Top 1000 Funds story:
For Oregon’s Skjervem the structural changes have put the asset class under more scrutiny, and he is getting questioned by his board about the continued validity of private equity. Where it was formerly the star performer in the portfolio, more recently it hasn’t met its benchmark, which is the Russell 3000 plus 300 basis points, he says.
“We haven’t met our benchmark in at least five years, so we are starting to get questions about performance,” he says. “Is this a realistic benchmark? I would argue no, so then you get into the discussion about what the benchmark should be.
“I could argue Russell 3000 plus 10 basis points is worthwhile because 10 basis points on a $16 billion portfolio is real money. But plenty of people want a more significant figure over public markets to justify the illiquidity you are taking on.
“For a public plan, I could make a philosophical argument that even if we do nothing but match public market returns, there’s a place for private equity because of the appraisal-based accounting, which artificially smooths our total fund volatility, and there’s a genuine benefit to that.”
So see what is going on. First, even though none of the risks of private equity have changed, Skjervem is unwilling to admit that a protracted period of central banks having negative real policy rates has resulted in investors not being paid enough for taking on risk, particularly long-term risks. But he’d rather fudge his metrics, which will lead to poor decisions, rather than keep that basic problem front and center.
Second, he openly voted for even more bad metrics by saying that he know that private equity’s valuation methods “artificially lower” fund volatility. This is in part due to the perverse fact that any investment that is marked only quarterly will show lower volatility than one that is marked intra-day or even just daily. But that “appraisal-based” accounting represents what are real negatives for private equity:
The investments are highly illiquid
The LPs have zero influence on when they get their money back
Private equity investors have been found to exaggerate their valuations in bad markets, when raising a new fund, and late in a fund’s life
In that same 2015 CalPERS private equity workshop, Idaho CIO Bob Maynard stated up front that the only reason he invested in private equity was for its dishonest reporting:
Bob Maynard, Chief Investment Officer, Public Employees Retirement System of Idaho: We’re I think more skeptical of private equity than many and actually I’ve been quite surprised at the experience we’ve had, which has been dead solid on the average. Our time-weighted returns are almost exactly yours [turning to CalPERS’ head of private equity Réal Desrochers], that 1.34 above what you could put in the public markets is exactly our experience, so we’ve actually gotten average institutional experience, so it’s worked out better than we were expecting.
We knew we were entering an area where we would not have much influence over what we could do.
Ah, in fact, ah, we recognized however that we were going to get some pressure to look at local investments in private side, we did know that our actuaries and accountants would accept the smoothing that the accounting would do. It may be phony happiness, but we just want to think we are happy and they actually do have consequences for ah, ah, actual contribution rates we are going to be able to put in place. So we’re looking for it even if it just gave public market returns, we’d be in favor of it because it has some smoothing effects on both reported and actual risks, as seen that way.
Once you get into the area, this is kind of a like a rental car return type investing. Once your front wheels are over the spikes, you can’t back up. You’ve got to keep kind of going forward. If we’re going to have a little bit, we’ve got to at least have enough to have a difference in the portfolio, which means get to at least 5 to 10%. And by the time we got to the 2000s, we had gotten to that point, so it did make an appropriate difference. So we’re there, it’s demonstrated benefits in the portfolio, we’re happy if it gives public market returns, anything extra, because of its effect having some smoothing of the risk as seen by the accountants and actuaries and, um, just don’t, you’ve got to keep going once you are there.
We were astonished when the SEC revealed in 2014 that over half the private equity firms they’d examined so far had stolen from investors or engaged in other serious abuses. Given what Maynard and Skjervem have said about clearly bogus private equity reporting which would have most investors running for the hills, we should not have been surprised. Private equity investors see its chicanery as a feature, not a bug.
1 Another wee fact not often enough discussed is that even the persistence they found back then was not overwhelming. If you managed to identify a top quartile fund correctly, it had 33% odds of being top quartile in its next fund. That means that if you performed the miraculous task of guesstimating (because the lack of final results means there is a guesstimation factor) so that 100% of your investment was in top quartile funds, you’d expect only 1/3 to wind up being top quartile performers. Is the increase from dart-throwing (25% top quartile) to 33% enough to enable a public pension fund to beat a 300 basis point benchmark?