Swedroe: The Lies Of Private Equity

Peel back the hype and it seems that private equity, for most investors, isn’t worth the risk, Swedroe says.

While embarking on scenic tours can make life both interesting and exciting, they’re best avoided when it comes to the world of investing.

The reason is that most “interesting” investments fail to deliver on their promise of returns sufficient to compensate for their incremental risks. This has been especially true of hedge funds. And it has also been true of the particular type of hedge fund that was made popular by Kohlberg Kravis Roberts & Co. (KKR): the leveraged buyout fund (LBO).

LBOs are the purchase of corporations by private-equity funds, often 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, once the acquired company is sold, on the limited amount of equity used. Have investors been appropriately compensated for the risks of these illiquid investments?

Ludovic Phalippou sought the answer to that question with his November 2012 study “Performance of Buyout Funds Revisited?” His study covered funds with vintages from 1993 through 2010. The last recorded cash flow data was as of June 2011 for the majority of funds, and the most recent data was from September 2011. The following is a summary of his findings:

• The buyout funds outperformed the S&P 500 Index. However, that’s an inappropriate benchmark, as 95 percent of the buyout transactions listed in the Capital IQ data set have an enterprise value below $1.08 billion. The largest stock in the Fama-French small-cap index had a market capitalization of $1.1 billion.
• Benchmarking buyouts against either the Fama-French small-cap index or the DFA Microcap Fund, there was no statistically significant outperformance. The Fama-French index has no costs, while the DFA Microcap Fund (DFSCX) does incur costs, as it is a live fund. The Fama-French small-cap index currently has an average market cap of about $700 million.
• Since LBOs typically involve more value than growth stocks—the median book-to-market ratio for 537 U.S. buyout investments was above 2. A more appropriate benchmark would be the Fama-French small value index. The average book-to-market ratio in the Fama-French small value portfolio was about 1.2. Against that benchmark, there was a statistically significant negative alpha. The buyout funds produced virtually the same performance as the live DFA Small Value fund.
• Adjusting the results for the use of leverage, the average buyout fund underperforms small value stocks by 3.1 percent.

Phalippou’s results add to the body of research on buyout funds being inefficient investment vehicles that benefit the purveyors, not investors.

For example, a study by investment consultant Cambridge Associates examined the performance of more than 300 buyout funds. For the 20-year period ending June 2003, the average buyout fund produced a mean return of 11.5 percent. Unfortunately, in the same period, the S&P returned 12.2 percent.

While investors in LBOs were, on average, receiving below-market returns, they also were taking far greater risk—the greater balance-sheet risk created by leverage and the loss of liquidity; that is, the lack of daily access to funds that investors in mutual funds have. Even worse is that the return for more comparably risky U.S. small value stocks was 13.8 percent, as measured by the Fama-French small value index ex-utilities.

A study by the Yale Investments Office provides insight into how the use of a similar amount of leverage would have boosted the 12.2 percent return of the S&P 500 Index. The study examined 542 buyout deals initiated and concluded between 1987 and 1998, and found that the net returns were 36 percent per annum, well above the 17 percent return produced 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 percent per year, or 50 percent per annum greater than the return of the LBOs.Perhaps it was these results that led David Swensen, chief investment officer of the Yale Endowment, to draw the following conclusion:

“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 versus public—as well as the 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.”

But if you’re considering investing in a buyout fund, listen carefully to these words of caution from David 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.”

Individuals would be wise to accept that in order to have a good investment experience, they don’t need to purchase exotic instruments. The journey to one’s destination—the investment objective, is best accomplished without making scenic tours of interesting investments. If you’re seeking higher-than-market returns, the prudent way to try and achieve that objective is to increase your allocation to small value stocks.

Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.