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.
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.