The term “private equity” is often used to describe various types of privately placed (as opposed to publicly traded) investments. Even the name of this alternative asset class is tantalizing, because of its allusion to privately available (read: exclusive) opportunities.
Individual investors may even yearn to be “players” in an arena dominated by institutional investors, such as the Yale endowment fund. This may explain why private equity is among the most popular alternative investments for individuals—commitments to private equity have grown more than tenfold over the past 25 years.
Leveraged buyouts—one form of private equity—are the purchase of corporations by private equity funds, which often involve 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 (when the acquired company is once again sold) on the limited amount of equity used. Have investors been appropriately compensated for the risks of these illiquid investments?
While a surface look at reported returns may look attractive, they may not include adjustments for risk or, importantly, they may reflect “smoothing,” which makes private equity appear less risky than it actually is. We’ll examine the evidence.
Buyout Funds’ Underperformance
In their study “Replicating Buyout Funds Through Indexing,” published in the November/December 2013 issue of the Journal of Indexes, Jeff Hooke and Ted Barnhill analyzed every public company taken private via leveraged buyout in the period 1984 through 2012.
The authors identified industry categories preferred by buyout funds and a number of financial and valuation ratios that typified those underlying companies. They used those industries and the firm-specific ratios to identify a replicating portfolio of publicly traded stocks each year. Subsequently, they compared the annual returns on the replicating portfolios to the S&P 500.
Hooke and Barnhill concluded that a public stock replication index (invested over the period 1991 through 2012) would rank in the highest-performing decile of buyout funds over a 21-year period. Their analysis did not make any adjustment for risks (such as volatility and liquidity).
As another example, Steven Kaplan and Berk Sensoy, authors of the August 2015 study “Private Equity Performance: A Survey,” found that buyout funds had outperformed the S&P 500 net of fees on average by about 20% over the life of the fund. However, studies have estimated betas for buyout funds at about 1.3. Thus, adjusting for the higher betas alone would have wiped out any evidence of outperformance.
In addition, in their survey, Kaplan and Sensoy observed that a 2013 NBER study, “Limited Partner Performance and the Maturing of the Private Equity Industry,” found that in the sample of private equity funds raised between 1999 and 2006, there was no evidence endowments outperform other limited partner types or display any superior skill at selecting general partners.
According to Kaplan and Sensoy, the aforementioned study (which Sensoy also co-authored) concluded that “the disappearing endowment advantage is consistent with other secular trends found in the industry, particularly the decline in [venture capital] performance since the late 1990s and the decline in performance persistence in [buyout] firms.”