As we have discussed, the investment success of the Yale Endowment led many endowments, foundations and even high-net-worth individuals to consider adopting the strategies utilized in the so-called “Yale Model.” This included a focus on alternative investments and attempts to capture the liquidity premium available in illiquid investments, such as private equity and hedge funds.
In his new book, Asset Management: A Systematic Approach to Factor Investing, author Andrew Ang includes a chapter that takes an in-depth look at private equity (PE). Because I highly recommend the book, I thought it worthwhile to review some of his thoughts on the subject.
Ang begins by explaining, as he did with hedge funds, that PE isn’t an asset class. He notes that PE returns are highly correlated with the returns on public equities, though there are major differences. Among them are that public equity investment enjoys the benefits of being highly liquid, with low transaction costs and daily valuation. On the other hand, PE is illiquid, has high transaction costs and is difficult to value. In fact, valuations are available infrequently, and the contracts are often complex. These risks should be accounted for when evaluating returns. In other words, returns must be appropriately risk-adjusted.
While there are three main performance measures used with PE—internal rate of return (IRR), total value to paid-in-capital multiples, public market equivalents—all three have problems that can result in measures of performance misleading to investors.
For instance, paid-in-capital multiples don’t take into account either risk or the time value of money. And the IRR measure assumes that cash flows can be reinvested at the IRR. Making matters worse, the IRR is often manipulated, with gaming sometimes taking place.
Ang provided the following example of how this can occur. He explains that IRRs can be computed at the vintage level—which pools all funds within a given vintage, thus hiding the performance of a poorly performing fund—rather than computing the IRR of each fund separately. If a PE firm has great successes in only some of its funds, and those come in the funds’ early years, aggregating funds produces a high IRR and masks other bad investments. One study that Ang cites found that about half of PE funds pool their investments and then compute IRR rather than first computing IRR for each fund and taking a weighted average across funds.
Ang also refers to a 2012 study, “Valuing Private Equity,” in which the authors developed a model that takes into account the issues of illiquidity, high fees and agency risks (misalignment of interests). The result is that the estimated break-even IRR figure for general partners is between 13 percent and 17 percent if the portfolio assets have a market beta of 0.5, and 17 percent to 19 percent if the portfolio assets have a market beta of 1. The authors of the study discovered that the average buyout fund had an IRR of 16 percent. Thus, risk-averse investors were just breaking even. And since 2004, buyout funds have not generated value.
Other studies that looked at risk-adjusted returns also found that PE didn’t deliver outperformance. For example, a 2009 study, “The Performance of Private Equity,” found that, using fund-level cash flows, PE funds have underperformed the market by 3 percent, and by 6 percent on a risk-adjusted basis. Ang also mentions studies concluding that any outperformance of PE is well-explained by exposure to some common risk factors, such as small and value, and that there was no outperformance on a risk-adjusted basis. These factors can easily be accessed via low-cost mutual funds and ETFs, which provide daily liquidity and much broader diversification. Ang determined that despite PE’s reputation, his reading of the literature found no compelling evidence the average fund outperforms public equities on a risk-adjusted basis. He writes: “In fact, the evidence is precisely the opposite.” Citing researcher Antoinette Schoar, Ang continues: “This industry has had very poor performance over the last 25 years.”
Most investors, who lack the skills to invest in PE directly and have insufficient assets to diversify the idiosyncratic risks effectively, hire outside managers to invest for them. Ang then asks the question: Would you sign a contract where you:
- Have no right to examine the underlying assets?
- Don’t receive return numbers, but only complicated, nonlinear functions of subjective “values” (called IRRs and multiples)?
- Receive opaque, sometimes meaningless status reports?
- Can’t withdraw money on demand?
- Are charged fees for investments not yet made?
- Allow managers to hold onto worthless investments so they can milk fees from investors as long as possible?
Ang then goes on to state: “This is the current state of PE contracts.”
David Swensen, who as the manager of the Yale Endowment fund certainly has plenty of experience with PE, concluded: “The large majority of buyout funds fail to add sufficient value to overcome a grossly unreasonable fee structure.” Ang cited a 2010 study, “The Economics of Private Equity,” which found that of every $100 dollars invested in PE, an average of $18 was paid by the limited partners in carry and management fees.
Ang did note that some investors in PE, such as Yale and Harvard, have done well. And the evidence indicates that private equity is the one investment category in which there’s some evidence of persistence in performance.
Here’s what Swensen, from his book Unconventional Success, had to say on the subject: “Understanding the difficulty of identifying superior hedge fund, venture capital, and leverage buyout investments leads to the conclusion that hurdles for casual investors stand insurmountably high. Even many well-equipped investors fail to clear the hurdles necessary to achieve consistent success in producing market-beating active management results. When operating in arenas that depend fundamentally on active management for success, ill-informed manager selection posses grave risks to portfolio assets.”
In a 2012 interview in The Economist, Swensen warned: “In the absence of truly superior fund-selection skills (or extraordinary luck), investors should stay far, far away from private equity investments.” Unfortunately, as Ang notes, investors haven’t heeded Swensen’s advice. I would add that the same counsel holds even for most endowments, because the evidence shows they don’t all happen to live in Lake Wobegon, where as we know everyone is above average. The 2012 study “Assessing Endowment Performance,” Vanguard’s research team found that “while the top 9 percent of endowments performed well, the average performance of the remaining 91 percent has been modest in comparison to low-cost mutual funds.”
What’s The Appeal?
Before concluding, Ang asks the question: Why does PE keep drawing so many investment dollars? He hypothesizes that:
· It may be the triumph of hope and dreams over wisdom, experience and the evidence. Investors hope for that one big home run, the next Google.
· PE contracts are opaque and incomprehensible to the average investor.
· Information is poor and contains hard-to-understand fees.
· Selective reporting presents investors with misleading return information.
· Investors don’t learn from their mistakes.
· Investors are duped by industry propaganda.
Ang concludes with a citation from the Marion Kauffman Foundation’s 2012 report. The foundation is dedicated to promoting entrepreneurship and education. It had almost $2 billion at the end of 2011, of which 45 percent was invested in PE. That’s an amazing figure given the conclusion of the report, which is entitled “We Have Met the Enemy…And He Is Us: Lessons from Twenty Years of the Kauffman Foundation’s Investments in Venture Capital Funds and the Triumph of Hope over Experience.”
The reports lays out the foundation’s failures, finding that despite all the risks of such investments, their average venture capital investment failed to return investor capital after fees.
The bottom line is that private equity investments are fraught with opportunity. If you are interested in learning more about private equity and its performance, my books, The Quest for Alpha and The Only Guide to Alternative Investments You’ll Ever Need, each contain a chapter that discusses the issues related to investing in it, as well as the findings from academic research on how it has performed.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.