Swedroe: A Close Look At Private Equity

November 17, 2014

Private equity has its allure, but it might not be the best place to reliably invest.

The private equity industry has changed substantially since the “Prudent Man” rule was modified in 1978 to give institutional investors the ability to allocate part of their portfolios to alternative assets.

The industry has grown tremendously over the past 30 years, thanks largely to high returns on early investments. Total fundraising by buyout and venture funds increased from approximately $7 billion in 1990 to more than $260 billion just before the financial crisis hit in 2008. The vast majority of assets have come from institutional investors searching for alternatives that will help them meet their return objectives.

Before evaluating the performance of limited partners (LPs), it’s important to understand that private equity, a term used to describe various types of privately placed investments, is riskier than investing in a publicly traded S&P 500 Index fund.

For example …

Assessing The Risks

  • Companies 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 tend to 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 arithmetic average, or mean, return. A relatively high average return, such as in the case of private equity, may reflect a small possibility of truly outstanding performance combined with the much larger probability of more modest or negative performance. In effect, private equity investments are like options (or 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 with a standard deviation of about 20 percent for the S&P 500 and about 35 percent for small value stocks.

Research On Returns

Berk A. Sensoy, Yingdi Wang and Michael S. Weisbach—authors of the November 2013 study, “Limited Partner Performance and the Maturing of the Private Equity Industry” —evaluated the performance of limited partners’ private equity investments over time.

Their data set included 14,380 investments by 1,852 LPs in 1,250 buyout and venture capital funds started between 1991 and 2006. They divided LPs into eight categories: public pension funds, corporate pension funds, endowments, advisors, insurance companies, banks/finance companies, investment firms and others.

Findings

Following is a summary of their findings:

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