Swedroe: Private Equity Adds Risk, Little Return

March 27, 2017

The term “private equity” is used to describe various types (e.g., buyout funds and venture capital funds) of privately placed (nonpublicly traded) investments. Even though buyout (BO) funds and venture capital (VC) funds have similar organizational and compensation structures, they are distinguished by the types of investments they make and the way those investments are financed.

BO funds generally acquire 100% of the target firm (which can be public or private) and use leverage. VC funds take minority positions in private businesses and do not use debt financing. Today BO funds account for about three-fourths of private equity deals.

Private equity (PE) excites many investors, offering the opportunity for spectacular returns (although, as with most investments, we generally hear only the stories with happy endings). Even the term conveys an exclusive nature, especially for investors who yearn to be “players.”

Capital committed to PE funds worldwide has risen substantially in the past two decades, thanks largely to U.S. pension funds searching for alternatives to public equity markets that might help them meet their return objectives. Endowments seeking to replicate the successes of the Yale Endowment have also contributed to the growth of PE funds. And it is reasonable to assume that high-risk, illiquid investments are priced by investors to deliver higher expected returns than publicly traded securities to compensate for the greater risk.

The Historical Evidence
Steven Kaplan and Berk Sensoy contributed to the literature on the performance of PE funds through an extensive survey of current research on the performance of private equity. Following is a summary of the findings from their October 2014 paper, “Private Equity Performance: A Survey”:

  • BO funds have outperformed the S&P 500 net of fees by about 20%, on average, over the life of the fund.
  • VC funds raised in the 1990s outperformed the S&P 500, while those raised in the 2000s have not.
  • Before the 2000s, buyout and VC fund performance showed strong evidence of persistence.
  • Since 2000, there is little evidence of BO fund persistence (with the exception of persistence among those in the bottom quartile, the worst performers), while VC fund persistence has remained strong.

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

 

Find your next ETF

CLEAR FILTER