Swedroe: Private Equity Not Worth The Risk

September 02, 2014

Some folks make out like bandits investing in private equity, but most don’t.

Last week, I wrote in-depth about some of the problems with hedge funds, especially in terms of how they’re viewed and how they affect financial markets as a whole. I thought I’d begin this week with a closer look at the performance of private equity, another nonpublicly traded investment.

The term “private equity” is used to describe various types of privately placed investments. This type of investment has grown tremendously over the past 30 years, thanks largely to increasing contributions from America’s pension funds as they search for alternatives to public equity markets in an effort to meet their return objectives.

The authors of the 2013 study “Private Equity Performance: What Do We Know?” provide some arguably unwarranted hope for venture capital investors. The authors employed a “research-quality” database from portfolio management software firm Burgiss to examine the performance of nearly 1,400 U.S. private equity (buyout and venture capital) investments. The data set was sourced from more than 200 institutional investors.

Using detailed cash-flow data covering the period from 1984 through March 2011, the study compared buyout and venture capital returns to the returns produced by public markets. The authors found that the median outperformance relative to the S&P 500 Index was 3 percent a year. That’s better than was previously documented, due perhaps to some problems with the data. The authors also state that the S&P 500 “is arguably an appropriate standard of comparison for institutional investors.”

Before you jump to any conclusions, consider the following: According to Venture Economics, a provider of information and analysis on the venture capital industry, private equity overall returned 13.8 percent on annualized basis for the 20-year period ending June 30, 2005, outperforming the S&P 500 by 2.6 percentage points. That’s somewhat less than the findings from the newer 2013 paper.

However, during the same period, small-cap value stocks returned an annualized 16.0 percent, outperforming venture capital by 2.2 percentage points. In my view, small-value stocks are a much more appropriate benchmark for venture capital than the S&P 500 Index. Let’s see why this is the case.