The term “private equity” is often used to describe various types of privately placed (as opposed to publicly traded) investments. Even the name of this alternative asset class is tantalizing, because of its allusion to privately available (read: exclusive) opportunities.
Individual investors may even yearn to be “players” in an arena dominated by institutional investors, such as the Yale endowment fund. This may explain why private equity is among the most popular alternative investments for individuals—commitments to private equity have grown more than tenfold over the past 25 years.
Leveraged buyouts—one form of private equity—are the purchase of corporations by private equity funds, which often involve taking a public company private. When making acquisitions, the private equity fund will typically use minimal amounts of equity and large levels of debt (hence the term leveraged buyout).
The high leverage creates the opportunity for incremental returns (when the acquired company is once again sold) on the limited amount of equity used. Have investors been appropriately compensated for the risks of these illiquid investments?
While a surface look at reported returns may look attractive, they may not include adjustments for risk or, importantly, they may reflect “smoothing,” which makes private equity appear less risky than it actually is. We’ll examine the evidence.
Buyout Funds’ Underperformance
In their study “Replicating Buyout Funds Through Indexing,” published in the November/December 2013 issue of the Journal of Indexes, Jeff Hooke and Ted Barnhill analyzed every public company taken private via leveraged buyout in the period 1984 through 2012.
The authors identified industry categories preferred by buyout funds and a number of financial and valuation ratios that typified those underlying companies. They used those industries and the firm-specific ratios to identify a replicating portfolio of publicly traded stocks each year. Subsequently, they compared the annual returns on the replicating portfolios to the S&P 500.
Hooke and Barnhill concluded that a public stock replication index (invested over the period 1991 through 2012) would rank in the highest-performing decile of buyout funds over a 21-year period. Their analysis did not make any adjustment for risks (such as volatility and liquidity).
As another example, Steven Kaplan and Berk Sensoy, authors of the August 2015 study “Private Equity Performance: A Survey,” found that buyout funds had outperformed the S&P 500 net of fees on average by about 20% over the life of the fund. However, studies have estimated betas for buyout funds at about 1.3. Thus, adjusting for the higher betas alone would have wiped out any evidence of outperformance.
In addition, in their survey, Kaplan and Sensoy observed that a 2013 NBER study, “Limited Partner Performance and the Maturing of the Private Equity Industry,” found that in the sample of private equity funds raised between 1999 and 2006, there was no evidence endowments outperform other limited partner types or display any superior skill at selecting general partners.
According to Kaplan and Sensoy, the aforementioned study (which Sensoy also co-authored) concluded that “the disappearing endowment advantage is consistent with other secular trends found in the industry, particularly the decline in [venture capital] performance since the late 1990s and the decline in performance persistence in [buyout] firms.”
Investors should consider other factors than returns when evaluating the performance of private equity. For instance, private equity investors forgo the benefits of daily liquidity. It’s well-documented in the literature that investors demand a premium for investing in illiquid assets, especially ones that perform poorly in bad times (like private equity). There’s generally no adjustment in the returns data for illiquidity risk.
In addition to the lack of liquidity, relative to mutual fund investments, private equity investors forgo the benefits of transparency and broad diversification (and for individuals, the ability to harvest losses for tax purposes).
Another factor to consider is that buyout funds tend to invest in much smaller and more “valuey” companies than are represented in the S&P 500, making it an inappropriate benchmark. A more appropriate benchmark would be small value stocks, which have provided a significantly higher return over the long term than the S&P 500.
Investors in buyout funds should also consider that the median return is much lower than the mean (the arithmetic average) return. Their 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, buyout investments are like options (or lottery tickets)—which perhaps explains their attraction, given the well-documented preference individual investors have for “lotterylike” investments.
Said another way, buyout funds 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.
Smoothing Of Returns
Jeff Hooke and Ken Yook highlight another problem with buyout funds in the study “The Curious Year-to-Year Performance of Buyout Fund Returns: Another Mark-to-Market Problem?”, which appears in the Winter 2017 issue of The Journal of Private Equity.
Their study was motivated by the fact that the general partners of buyout funds have great flexibility, often with little-to-no oversight, to estimate the value of their investments, which results in a smoothing of returns compared to public equities.
To demonstrate this, Hooke and Yook compared year-to-year buyout fund returns and volatility to a public-market proxy. They constructed a public-index proxy for buyout fund investments, and adjusted the index for buyout-type leverage. They then compared (1) the leverage-enhanced public index’s year-to-year returns to the buyout industry’s year-to-year returns; and (2) the resultant volatilities of these returns.
Based on their findings, they concluded that “buyouts’ year-to-year performance results have a higher volatility than previously reported, either by the industry or academic research.” This is despite the fact that Financial Accounting Standards Board has required mark-to-market accounting for residual investment since at least 2006. There is still a significant element of subjectivity, as the following example illustrates.
Hooke and Yook write: “In 2008 … U.S. stocks had a negative 38% return and our proxy index (before added leverage) had a negative 37% return. In contrast, the buyout industry, as recorded by Cambridge Associates, indicated a less negative 26% return (net of fixed fees and performance carry) despite its much higher leverage. The industry’s smaller annual loss makes little sense and defies financial theory regarding leverage and volatility, unless one argues that, among other matters, (1) private firm equity values deviate sharply from corresponding public stocks or (2) our proxy is an inaccurate representation of underlying buyout portfolio companies. Indeed, adjusting for buyout leverage, our proxy-index return was negative 75% in 2008.”
Hooke and Yook found that, while their replication index had a roughly 24% annual standard deviation of returns, adjusted for leverage, that figure rose to 46%. On the other hand, the reported returns of buyout funds showed an annual standard deviation of just 16%, compared to about 20% for the CRSP index of U.S. stocks.
It’s clearly not credible to believe that buyout funds actually experienced less volatility than the market. The reality is that private equity returns are much more correlated with public equity returns than their reported results would lead one to conclude.
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.