Swedroe: A Close Look At Private Equity

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:

• Endowments, on average, outperformed other LPs by 2.2 percentage points a year during the period studied. That outperformance was concentrated in the period from 1991 through 1998.
• The superior performance of endowment investors in the period from 1991 through 1998, which was 7 percentage points a year over other types of LPs, is due mostly to their greater access to the top-performing venture capital partnerships.
• In the subsequent period from 1999 through 2006, endowments no longer outperform, no longer have greater access to funds likely to restrict it, and do not make better investment selections than other types of institutional investors. There also was no significant outperformance, even for the leading endowments. And that’s whether measuring internal rates of return by the top 15 or the top two (Yale and Harvard) endowments.
• The performance gap is driven entirely by endowments’ investment in the venture industry, which benefited most from the technology boom of the 1990s. During this period, the main source of endowments’ unusually good performance was their superior access to the best venture funds.
• In the subsequent eight-year period, between 1999 and 2006, endowments no longer outperform other types of limited partners.
• The endowment advantage in skill or sophistication in selecting investments has declined over time.
• The private equity industry has matured and become more competitive, and the dispersion of outcomes has narrowed. As a result, the economic rents available to limited partners have declined—just as theory predicts it should. In other words, the huge inflows of capital and the commoditization of the industry have lowered the economic rents to general partners. The importance of limited access, which reflects the sharing of these rents in return for other benefits, has decreased as well.
• Private equity investments continue to outperform public markets, on average.

Analyzing The Data

Let’s now focus on this last point. While the authors did find that private equity outperformed public markets on average, looking at the results through the proper lens would provide a different perspective.

For example, the authors find that funds in which endowments invest have the highest performance of any LP type over the entire 1991-2006 sample period, averaging a 13.4 percent internal rate of return. While that is indeed higher than the 11.8 percent annualized return on the S&P 500 Index over that same time frame, it’s also much lower than the annualized return of 19.5 percent on publicly available and more similarly risky U.S. small value stocks (as represented by the Fama-French small value index).

And keep in mind that during this period, LP investments by endowments outperformed the average LP investment. This finding, that private equity outperforms the S&P 500 but underperforms more similarly risky small value stocks, is consistent with prior research.

For example, private equity overall returned 13.8 percent for the 20-year period ending June 30, 2005, outperforming the S&P 500 by 2.6 percentage points. That’s according to Venture Economics, a provider of information and analysis on the venture capital industry.

A Small-Cap Alternative

However, during the same period, small-cap value stocks returned 16.0 percent, outperforming venture capital by 2.2 percentage points.

The bottom line is this: The evidence clearly demonstrates that investors seeking higher returns than those provided by the S&P 500 Index, and considering investing in private equity, would, on average, 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.