Hooke and Yook eliminated the possible bias of general partners in setting annual residual values for their funds by using a publicly traded replication index. In so doing, they showed the reported returns just aren’t believable, being in direct conflict with economic theory.
Issues with artificially smoothing returns are not unique to buyout funds. I was recently involved in reviewing the prospectus of a large, private fund in the middle-market lending business, providing financing for middle-market companies and their private equity sponsors. I noticed something similar to what Hooke and Yook found, in that 2008 losses just didn’t seem believable, given the losses experienced by publicly traded debt of comparable risk.
In addition, the fund’s incentive-fee structure led to the lender capturing the majority of returns on the leveraged portfolio of assets. The investor was taking all the downside risk of the leverage while earning less than half the returns generated by that leverage.
Given that second observation, I’ll now turn to how the use of leverage impacts the returns of buyout funds.
Impact Of Leverage
A study by the Yale Investments Office, cited by David Swensen in “Unconventional Success,” provides insight into how the use of a similar amount of leverage would have boosted the return of the S&P 500 Index. The study examined 542 buyout deals initiated and concluded between 1987 and 1998, finding that net returns were 36% per year, well above the 17% return earned by a comparably timed and sized investment in the S&P 500 Index.
However, a comparably timed and sized investment in the S&P 500 Index that also applied the same amount of leverage would have returned 86% per year, or 50 percentage points per year greater than the return of the leveraged buyout funds. Perhaps it was these results that led Swensen, the Yale endowment chief investment officer, to draw the following conclusion:
“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.”
If you’re considering investing in a buyout fund, listen carefully to these additional words of caution from Swensen:
“Buyout funds constitute a poor investment for casual investors. The higher debt and the lower liquidity of buyout deals demand higher compensation in the form of superior returns to investors. Unfortunately for private equity investors, in recent decades buyout funds delivered lower returns than comparable market securities positions, even before adjusting for risk. Fees create a hurdle that proves extremely difficult for buyout investors to clear. Aside from substantial year-to-year management fees, buyout funds command a significant share of deal profits, usually equal to one-fifth of the total. On top of the management fee and incentive compensation, buyout managers typically charge deal fees. The cornucopia of compensation ensures a feast for the buyout manager, while the buyout investor hopes at best for a hearty serving of leftovers.”
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 place to find them is not in private equity, but rather in similarly risky, publicly available small value stocks.
You can access these higher forward-looking return expectations through low-cost, passively managed and tax-efficient funds that provide daily liquidity, total transparency and the ability to rebalance and tax manage. You can globally diversify their risks as well.
Another alternative, as Swensen alluded to, is to simply employ leverage yourself, avoiding private equity’s excessive fees.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.