Swedroe: Private Equity Not Worth The Risk

September 02, 2014

Private equity is much riskier than an investment in a publicly traded S&P 500 Index fund:

  • Firms in the S&P 500 are typically among the largest and strongest companies, while venture capital typically invests in smaller and early-stage companies with far less financial strength.
  • Investors in private equity forgo the benefits of liquidity, transparency, broad diversification, daily pricing and, for individuals, the ability to harvest losses for tax purposes.
  • The median return of private equity is much lower than the mean (the arithmetic average) return. The 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, private-equity investments are like options, or even lottery tickets. They 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 is in excess of 100 percent. Compare that to the standard deviations of about 20 percent for the S&P 500 and about 35 percent for small value stocks.

While private equity and venture capital investing is high risk and high expected return, the returns investors have actually realized don’t appear to have compensated them fully for their incremental risks. For example, the returns should reflect, at least to a significant degree, a premium for the extreme illiquidity of private equity investments.

But highlighting the investment’s lack of liquidity is the finding from one paper—“The Cash Flow, Return and Risk Characteristics of Private Equity”—that the internal rate of return for the average venture capital fund did not turn positive until the eighth year.

The bottom line is that, while this study does present private equity in a somewhat better light than did prior studies, the evidence still demonstrates that investors seeking higher returns than provided by the S&P 500 would be better served by looking to small value stocks (both domestically and internationally) in the public markets.


Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

 

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