Swedroe: Private Equity No Bargain

April 13, 2018

Other Considerations

Investors should consider other factors than returns when evaluating the performance of private equity. For instance, private equity investors forgo the benefits of daily liquidity. It’s well-documented in the literature that investors demand a premium for investing in illiquid assets, especially ones that perform poorly in bad times (like private equity). There’s generally no adjustment in the returns data for illiquidity risk.

In addition to the lack of liquidity, relative to mutual fund investments, private equity investors forgo the benefits of transparency and broad diversification (and for individuals, the ability to harvest losses for tax purposes).

Another factor to consider is that buyout funds tend to invest in much smaller and more “valuey” companies than are represented in the S&P 500, making it an inappropriate benchmark. A more appropriate benchmark would be small value stocks, which have provided a significantly higher return over the long term than the S&P 500.

Investors in buyout funds should also consider that the median return is much lower than the mean (the arithmetic average) return. Their 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, buyout investments are like options (or lottery tickets)—which perhaps explains their attraction, given the well-documented preference individual investors have for “lotterylike” investments.

Said another way, buyout funds tend to 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.

Smoothing Of Returns

Jeff Hooke and Ken Yook highlight another problem with buyout funds in the study “The Curious Year-to-Year Performance of Buyout Fund Returns: Another Mark-to-Market Problem?”, which appears in the Winter 2017 issue of The Journal of Private Equity.

Their study was motivated by the fact that the general partners of buyout funds have great flexibility, often with little-to-no oversight, to estimate the value of their investments, which results in a smoothing of returns compared to public equities.

To demonstrate this, Hooke and Yook compared year-to-year buyout fund returns and volatility to a public-market proxy. They constructed a public-index proxy for buyout fund investments, and adjusted the index for buyout-type leverage. They then compared (1) the leverage-enhanced public index’s year-to-year returns to the buyout industry’s year-to-year returns; and (2) the resultant volatilities of these returns.

Based on their findings, they concluded that “buyouts’ year-to-year performance results have a higher volatility than previously reported, either by the industry or academic research.” This is despite the fact that Financial Accounting Standards Board has required mark-to-market accounting for residual investment since at least 2006. There is still a significant element of subjectivity, as the following example illustrates.

Hooke and Yook write: “In 2008 … U.S. stocks had a negative 38% return and our proxy index (before added leverage) had a negative 37% return. In contrast, the buyout industry, as recorded by Cambridge Associates, indicated a less negative 26% return (net of fixed fees and performance carry) despite its much higher leverage. The industry’s smaller annual loss makes little sense and defies financial theory regarding leverage and volatility, unless one argues that, among other matters, (1) private firm equity values deviate sharply from corresponding public stocks or (2) our proxy is an inaccurate representation of underlying buyout portfolio companies. Indeed, adjusting for buyout leverage, our proxy-index return was negative 75% in 2008.”

Hooke and Yook found that, while their replication index had a roughly 24% annual standard deviation of returns, adjusted for leverage, that figure rose to 46%. On the other hand, the reported returns of buyout funds showed an annual standard deviation of just 16%, compared to about 20% for the CRSP index of U.S. stocks.

It’s clearly not credible to believe that buyout funds actually experienced less volatility than the market. The reality is that private equity returns are much more correlated with public equity returns than their reported results would lead one to conclude.


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