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 ...
- Companies in the S&P 500 are typically among the largest and strongest companies, while VC 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 at 1.6 to 2.5. Adjusting for the higher betas alone would have erased any evidence of outperformance. Similarly risky but also publicly available small value stocks have also outperformed the S&P 500 by a wide margin—from 1927 through 2016, the S&P 500 returned 10.0%, while the Fama-French Small Value Index (ex utilities) returned 13.6%.
- Investors in private equity forgo the benefits of daily liquidity. It’s well-documented in the literature that investors will demand a premium for investing in illiquid assets, especially those 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 forgo the benefits of transparency and broad diversification (and for individuals, the ability to harvest losses for tax purposes).
- The median return of PE 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 exceeds 100%, in comparison to standard deviations of about 20% for the S&P 500 and about 35% for small value stocks.
In their survey, Kaplan and Sensoy observed that the authors of the 2013 study, “Limited Partner Performance and the Maturing of the Private Equity Industry,” found that, in the more recent sample of PE funds raised between 1999 and 2006, there was no evidence that endowments outperform other limited partner types or display any superior skill at selecting general partners.
According to Kaplan and Sensoy, this study (which Sensoy also co-authored) concluded that “the disappearing endowment advantage is consistent with other secular trends in the industry, particularly the decline in VC performance since the late 1990s and the decline in performance persistence in BO firms.”
Reiner Braun, Tim Jenkinson and Ingo Stoff contribute to the literature on private equity performance and its persistence with their study, “How Persistent is Private Equity Performance? Evidence from Deal-Level Data,” which was published in the February 2017 issue of the Journal of Financial Economics.
Their findings were consistent with those of Kaplan and Sensoy. Their study covered timed cash-flow data at the deal level for 13,523 investments made by 865 buyout funds (not VC funds) run by 269 general partners (GPs). The investments were split roughly equally between the U.S. and Europe, with a few in other regions, and span the period 1974 to 2012. This is important, as most other studies examined only U.S. data.
The authors noted: “As well as being extensive and detailed, for the vast majority of the GPs in our sample we have their complete investment history. This is clearly critical when analysing performance persistence, and lack of completeness is a problem that has plagued earlier analyses. We source the data from three fund-of-fund managers who required all GPs who sought capital to provide this detailed deal-level information in a standardized format. Importantly, the sample includes all the GPs upon which the fund-of-fund managers performed due diligence, whether or not they actually chose to invest.” They also partitioned the data sample into an early period up to the end of 2000 and a later period from 2001 onward.
Following is a summary of their findings ...
- While there was evidence of performance persistence in the early period, it was weaker than performance persistence found in previous studies and has largely disappeared in recent years. The authors stated: “This is consistent with the PE sector maturing, with financial engineering and valuation techniques becoming commoditized, professionals moving between or forming new GPs, and the ways to create operational improvements to portfolio companies becoming assimilated across firms.”
- Competition has clearly increased in recent years, but not evenly over time or by region. When a large amount of capital chases deals, persistence tends to be lower.
- There is significant evidence of top-quartile performance persistence but only in low competition states. On the other hand, GPs who make bad deals tend to repeat, irrespective of the state of competition.
Braun, Jenkinson and Stoff concluded: “Overall, the evidence we present suggests that performance persistence has largely disappeared as the PE market has matured and become more competitive.”
They add: “Those Limited Partners (LPs) who were early investors in PE—such as endowments—established relationships with successful GPs which were valuable when the market was developing. However, those relationships, and access to funds—at least on the buyout side—are now much less valuable and are no longer a source of LP out-performance.”
For investors, the research has an important implication: If past performance provides little guidance on the choice of GPs, how can one identify the future top performers?
Swensen On Private Equity
If you’re considering investing in PE or sit on the board of a committee that is doing so, be sure to consider these sage words of advice from David Swensen, chief investment officer of the Yale Endowment: “Understanding the difficulty of identifying superior hedge fund, venture capital, and leverage buyout investments leads to the conclusion that hurdles for casual investors stand insurmountably high. Even many well-equipped investors fail to clear the hurdles necessary to achieve consistent success in producing market-beating active management results.”
In his book, “Unconventional Success: A Fundamental Approach to Personal Investment,” Swensen offered the following observation on BO funds: “Investors in buyout partnerships received miserable risk-adjusted returns over the past two decades. Since the only material differences between privately owned buyouts and publicly traded companies lie in the nature of the ownership (private vs. public) and character of capital structure (highly leveraged vs. less highly leveraged), comparing buyout returns to public market returns makes sense as a starting point. But because the riskier, more leveraged buyout positions ought to generate higher returns, sensible investors recoil at the buyout industry’s deficit relative to public market alternatives. On a risk-adjusted basis, market equities win in a landslide.”
Swensen also cited a Yale Investments Office study that provides some insight into the additional return required to compensate for the risk in leveraged buyout transactions. He writes: “Examination of 542 buyout deals initiated and concluded between 1987 and 1998 showed gross returns of 48% per annum, significantly above the 17% return that would have resulted from comparably timed and comparably sized investments in the S&P 500. On the surface, buyouts beat stocks by a wide margin. Adjustment for management fees and general partners’ profit participation bring the estimated buyout result to 36% per year, still comfortably ahead of the marketable security alternative…. Because buyout transactions by their very nature involve higher-than-market levels of leverage, the basic buyout-fund-to marketable-security comparison fails the apples-to-apples standard. To produce a risk-neutral comparison, consider the impact of applying leverage to public market investments. Comparably timed, comparably sized, and comparably leveraged investments in the S&P 500 produced an astonishing 86% annual return. The risk-adjusted marketable security result exceeded the buyout result of 36% per year by an astounding 50%age points per year.”
The bottom line is that if you’re willing, able and have the need to take more risk in search of higher returns, the most likely to place to find that is not in PE, but rather in publicly available small value stocks. And you can access these higher expected returns through low-cost, passively managed and tax-efficient funds. You can globally diversify their risks as well. In addition, you’ll have all the benefits of daily liquidity and transparency.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.