Swedroe: Private Equity Not Worth Fees

The headline of a December article in The New York Times declared: “Private Equity Fees Are Sky-High, Yes, but Look at Those Returns.” The author, Steven Davidoff Solomon, was making the case that while “critics love to complain about private equity and its exorbitant fees … as an asset class and with the right fund, private equity is nigh unbeatable” and “well worth the fees paid.”

He cites a recent disclosure by the California Public Employees’ Retirement System (CalPERS), the nation’s largest pension system, that despite paying billions in fees, its private equity investments had earned an annualized return of 12.3% per year over the 20 years ending June 2015.

Compared with the return of 8.9% provided by the S&P 500 Index, that may look like the fees were well spent. While that comparison is one private equity (PE) fund that sponsors would love you to make, unfortunately it’s also incredibly misleading.

Let’s see why comparing returns on PE to the S&P 500 Index isn’t appropriate.

Different Risks

For starters, they are very different investments in terms of risk. Companies in the S&P 500 are typically among the largest and strongest, while venture capital traditionally invests in smaller and early-stage companies with far less financial strength. Studies have estimated the betas for buyout funds at roughly 1.3, and for venture capital funds from about 1.6 to 2.5. Since the S&P 500 has a beta of 1, adjusting for the higher betas alone would have more than wiped out any evidence of outperformance.

In addition to the problem of adjusting for the higher betas (exposure to equity risk), investors in private equity forgo the benefits of daily liquidity provided by mutual funds. It’s been well documented in the literature that investors demand a premium for investing in illiquid assets, especially ones that perform poorly in bad times (as PE does). There is no adjustment in the returns data for the risk of illiquidity.

Moreover, relative to investments in mutual funds, PE investors forgo the benefits of transparency and broad diversification (and for individuals, the ability to harvest losses for tax purposes).

Another risk issue is that the median return of private equity is much lower than the mean (or arithmetic average) return. The relatively high average return reflects the small possibility of a truly outstanding return combined with the much greater probability of a more modest or even negative return.

In effect, PE investments are similar to options (or lottery tickets). They provide a small chance for a huge payout, but a much larger chance for a below-average return. And it’s difficult, especially for individual investors, to sufficiently diversify this risk.

It’s important to note as well that the standard deviation of PE returns is in excess of 100%. Compare that with a standard deviation of approximately 20% for the S&P 500 and about 35% for small value stocks.

A More Appropriate Benchmark

Given these greater risks, and the fact that PE investments are typically in smaller companies, a more appropriate benchmark than the S&P 500 Index would be publicly available small value stocks. At least then the individual stocks would be similarly risky to the investments made by PE funds.

However, we still would not be accounting for the incremental risks of illiquidity and the much higher skewness and kurtosis of PE, risks that investors should be compensated for taking in the form of higher returns. Over the 20-year period ending June 2015, the PE investments of CalPERS earned 12.3% per year. That was just 0.2 percentage points higher than the 12.1% return of the Dimensional Fund Advisors (DFA) U.S. Small Cap Value Fund (DFSVX).

And that’s with investors in DFSVX enjoying the benefits of daily liquidity, total transparency and broad diversification (for example, the fund currently holds more than 1,100 stocks). (Full disclosure: My firm, Buckingham, recommends Dimensional funds in constructing client portfolios.)

Let’s look at some additional evidence from a recent study on PE. The following is a summary of findings made by Steven Kaplan and Berk Sensoy in their October 2014 study, “Private Equity Performance: A Survey”:

• Buyout funds on average have outperformed the S&P 500 net of fees by about 20% over the life of the fund. (Of course, they were taking on much greater risk.)
• Venture capital funds raised in the 1990s outperformed the S&P 500, while those raised in the 2000s have not.
• Before the 2000s, buyout and venture capital fund performance showed strong evidence of persistence.
• Since 2000, there is little evidence of buyout fund persistence (with the exception of persistence among the worst performers, those in the bottom quartile), while venture capital fund persistence has remained strong.

PE For The Masses?

Returning to the article in The New York Times, the author writes that he believes “if all the barriers and regulations came down … hordes would flood the offices of these firms, racing to invest. It would make a Black Friday line at Target look Zen.”

Yet the relative performance of CalPERS’ PE investments compared with DFSVX certainly doesn’t justify that belief. And neither does the evidence on the historical performance of the PE industry, as demonstrated by Kaplan and Sensoy. What’s more, there’s another problem.

Given CalPERS’ size, they have access to the very best PE funds. This is an important issue because the research shows that the one type of investment where there is some evidence of persistence of outperformance is in PE. Considering that your average investor is never going to have access to the PE funds with the best historical performance, this creates a further hurdle for investing in PE.

In his book “Unconventional Success,” David Swensen, chief investment officer of the Yale Endowment, offered the following observation on buyout funds: “Investors in buyout partnerships received miserable risk-adjusted returns over the past two decades. Since the only material differences between privately owned buyouts and publicly traded companies lie in the nature of the ownership (private vs. public) and character of capital structure (highly leveraged vs. less highly leveraged), comparing buyout returns to public market returns makes sense as a starting point. But, because the riskier, more leveraged buyout positions ought to generate higher returns, sensible investors recoil at the buyout industry’s deficit relative to public market alternatives. On a risk-adjusted basis, market equities win in a landslide.”

He also cited a Yale Investments Office study that provides some insight into the additional return required to compensate for the risk in leveraged buyout transactions. Swensen writes: “Examination of 542 buyout deals initiated and concluded between 1987 and 1998 showed gross returns of 48% per annum, significantly above the 17% return that would have resulted from comparably timed and comparably sized investments in the S&P 500. On the surface, buyouts beat stocks by a wide margin. Adjustment for management fees and general partners’ profit participation bring the estimated buyout result to 36% per year, still comfortably ahead of the marketable security alternative … . Because buyout transactions by their very nature involve higher-than-market levels of leverage, the basic buyout-fund-to marketable-security comparison fails the apples-to-apples standard. To produce a risk-neutral comparison, consider the impact of applying leverage to public market investments. Comparably timed, comparably sized, and comparably leveraged investments in the S&P 500 produced an astonishing 86% annual return. The risk-adjusted marketable security result exceeded the buyout result of 36% per year by an astounding 50 percentage points per year.”

In a footnote, Swensen further observes that “the sample for the buyout study contains extraordinary survivorship bias. The data employed came from offering memoranda provided to the Yale Investments Office by firms hoping to attract Yale as an investor. Needless to say, only firms with successful track records came calling on the university, hoping to attract funds.”

Conclusion
The bottom line is that if you’re willing, able and have the need to take more risk in search of higher returns, the most likely place to find them is not in PE, but in publicly available small value stocks. And you can access their higher expected returns through low-cost, passively managed and tax-efficient funds. You can globally diversify their risks as well.

In addition, you will have all the benefits of daily liquidity and transparency. While there certainly have been some highly successful PE firms, in aggregate, any excess returns they have managed to generate have gone to the fund sponsors, not to investors.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.