The premise that private equity delivers returns better than that of public stocks has fallen apart as more and more money has chased a not-comparably-expanding universe of deals. Private equity as a share of the global equity markets has more than doubled since the early 2000s. Despite private equity funds having record levels of “dry powder,” meaning committed but unspent cash, more and more investors are throwing money at the strategy out of desperation to achieve higher returns.
We’ve also pointed out that fiduciaries like CalPERS have continued to be fanatically loyal to private equity even when its own metrics have said private equity isn’t earning enough in the way of returns over the last ten years to justify its extra risks.
Recent work by Oxford professor Ludovic Phalippou, one on the few academics not beholden to the private equity, paints an even grimmer picture of how the private equity industry has performed since 2006. As described in the Financial Times, Phalippou ascertained, using what he describes as conservative (meaning private equity industry favoring) assumptions, that the private equity industry only matched the S&P 500 benchmark. This is particularly damning, since as we have described repeatedly in past posts, the use of the S&P 500 is flattering to private equity by virtue of its average company size being much larger than typical private equity portfolio company sizes, hence you’d expect a higher growth rate. And for newbies, do not forget that the rule of thumb is that private equity should outperform the relevant public equity benchmark by 300 basis points (3%).
US private equity managers have extracted $400bn in fees and expenses from investors since 2006 but on average they failed to beat the returns from an S&P 500 tracker fund, according to a new analysis.
The findings are an analysis by Oxford Saïd Business School based on the Burgiss database…
Ludovic Phalippou, a Saïd finance professor, said the funds launched in those 10 years have, on average, performed in line with the S&P 500, the main US equity benchmark. This delivered annualised returns, including dividends, of 8.6 per cent between January 2006 and the end of March 2018.
Nine out of 10 of these private equity funds also beat the 8 per cent annual return “hurdle” that allows their managers to claim performance fees, which amounted to an estimated $200bn.
A further $200bn was paid in management and other expenses, but there was less certainty over this data. The estimate could be conservative…
In fact, if you read Phalippou’s blog post, which gives a more detailed description of his analysis, he did indeed bend over backwards to be fair, and arguably more than fair to private equity managers. However, part of being “fair” meant using PME, which means “public market equivalent,” which is widely acknowledged to be the most accurate way to compare private equity returns to public market returns. It’s no accident that the private equity industry on a widespread basis instead uses IRR, or “internal rate of return” which is flattering. From his site:
Burgiss is perceived as one of the most comprehensive and accurate database of private equity fund cash flows….
Fact and matter is that for many years, people kept on saying that PE funds outperformed the S&P 500 by 3-4% p.a. and that was great (see a related blog). Over the last 10-12 years the S&P 500 has been doing well and now people tend to use other indices as benchmarks (e.g. MSCI world); this still has little to do with the type of companies helped by PE funds but MSCI world has the advantage of having low returns over the last decade.
To keep it simple and focused, let’s keep it to the tradition and compute PMEs with the S&P 500.
Next, let’s go on the positive side: eliminate vintage years 2016-2018 because these funds are young and as of now have a PME below 1 (i.e. underperform the S&P 500 index), eliminate debt funds, and keep only equity and real asset funds. These funds basically do either LBOs (be it applied to real estate, infra…) or venture capital no matter how they call it. We would think any of these investments has a beta above one hence the benchmark needs to be higher than the stock-market but we are on the positive side… hence ignore all that (just like liquidity issues etc.)… and select only western Europe and north America (they have the best performance)
Take ten vintage years, this brings us: vintage 2006 to 2015 and performance is as of March 2018. Total fund size $2.2 trillion, 2424 funds, average PME 0.97 (median is 0.98), TVPI (total value and distributed compared to invested) of 1.46.
You probably missed the key point in this somewhat technical discussion. Even after playing with the sample to make it more favorable to the private equity industry, both the average and median PME were below 1. Lower than one means they did less well that the stock market.
Now of course, industry stalwarts will then say, “You just need to pick the best managers!” We’ve been debunking that idea for years and we will spare you extended quotes from our archives to show that. Private equity funds do not show persistence of outperformance (as in top quartile performers don’t reliably outperform on their next fund). And on top of that, one study found that 77% of the funds can cut the numbers to make themselves look like top quartile funds!
Let’s return to Phalippou:
You can change sample construction, assumptions etc. this estimate is quite stable. For example, you could select only US LBO funds. PME for this subsample is better: 1.04 (i.e. about 1% outperformance p.a.), total size is $773 billion. Funds in the money have a total size of $567 billion and a TVPI of 1.67. Total carry would then be $76 billion.
In both cases (and in many others) the situation is the same: carry is about 10% of the amount of money raised and performance is about that of the S&P 500 index. And the absolute amount of money we are talking about is large.
For other fees (management fees, portfolio company fees, expenses) it is a lot more difficult to have an estimate. But a management fee of 1.5% of fund size for five years is a lower bound, which means 5*.015*2.2T = $165 billion. The next five years, make if one third of that amount (very much a lower bound) and you are above $200 billion. And then you would need to add all the other fees and expenses.
If the PE industry finds the above unfair despite my best effort, it is welcome to make data on fees and expenses available to a group of diversified academics and I am sure we will manage to count and end up with a precise estimate.
Now industry boosters might again say: “Ooh, a PME of above 1! See, private equity is not so bad.” Folks, a supposed outperformance of a mere 1% per year over what ought to be a flattering index is insufficient. Remember, the bogey is 3% outperformance of stocks.
Consider one risk of private equity: the need to stay liquid enough to meet capital calls, which come, depending on the fund, on a five or ten business day notice. Missing a capital call has draconian consequences, typically having your entire past investment divvied up among the rest of the fund investors. And this risk is real. During the financial crisis, CalPERS had to dump stocks at the bottom of the market to raise money to meet private equity capital calls.
There is a cost to keeping funds in lower-returning investments, often a chunk in cash equivalents, to have the funds on hand to meet those capital calls. Phalippou and I have estimated it separately at 100 basis points over a fund’s life.1
Here is the fun part: So far, the industry does not dispute Phalippou’s finding, that private equity firms earned 8.6% over the last decade plus, which is on par with S&P 500 returns. Again from the Financial Times:
The American Investment Council, a lobby group for the private equity industry, disputed the data…
The AIC’s analysis found the median annualised return over the past 10 years from private equity was 8.6 per cent (net of fees), based on data from 163 US public pensions schemes. This was higher than the median 6.1 per cent return earned from public equity by the same pension schemes.
Did you catch the sleight of hand? We don’t know how AIC chose those 163 funds. Pension & Investments surveys the largest 1000 retirement plans every year, so AIC has a lot of room for artful sample selection.
But AIC came up with exactly the same private equity returns that Phalippou did. They misleadingly to throw cold water on his findings by showing that their chosen group fell way short of the S&P 500 in their public stock investing. In other words, all of these pension funds should fire their entire public equities investment teams and dump the money in Vanguard’s S&P 500 fund.
Indeed, we’ve pointed out from time to time that CalPERS, despite running a big S&P index fund in house, is one of those big laggards. In CalPERS’s case, the causes for big-time underperformance have included:
Making an anti-dollar bet by putting half the public equity portfolio into foreign stocks at the start of a strong-dollar market. This alone appears to have had a large negative impact on returns
Getting out of tobacco stocks at the worst possible time
It’s distressing to see CalPERS and other investors who ought to know better act like private equity cult members. If Financial Times columnist John Dizard is right, that the sharp drop in copper prices is a warning that markets are “not far from a more general sell-off in risk assets,” it would really be a good idea for them to wean themselves of that Kool-Aid.
1 Banks developed a product called “subscription line financing” that would have allowed the fund itself to meet capital calls in the early years, begging the question of what investing in private equity actually meant. The objective was to goose the IRRs, since in the first year or so of a fund, cash goes out, the purchased companies are valued only at par, and the investors also have to pay fund fees and expenses, so the returns are negative. If you borrow to invest, then the returns are infinite!