Swedroe: Private Equity Not Worth The Risk

Some folks make out like bandits investing in private equity, but most don’t.

Last week, I wrote in-depth about some of the problems with hedge funds, especially in terms of how they’re viewed and how they affect financial markets as a whole. I thought I’d begin this week with a closer look at the performance of private equity, another nonpublicly traded investment.

The term “private equity” is used to describe various types of privately placed investments. This type of investment has grown tremendously over the past 30 years, thanks largely to increasing contributions from America’s pension funds as they search for alternatives to public equity markets in an effort to meet their return objectives.

The authors of the 2013 study “Private Equity Performance: What Do We Know?” provide some arguably unwarranted hope for venture capital investors. The authors employed a “research-quality” database from portfolio management software firm Burgiss to examine the performance of nearly 1,400 U.S. private equity (buyout and venture capital) investments. The data set was sourced from more than 200 institutional investors.

Using detailed cash-flow data covering the period from 1984 through March 2011, the study compared buyout and venture capital returns to the returns produced by public markets. The authors found that the median outperformance relative to the S&P 500 Index was 3 percent a year. That’s better than was previously documented, due perhaps to some problems with the data. The authors also state that the S&P 500 “is arguably an appropriate standard of comparison for institutional investors.”

Before you jump to any conclusions, consider the following: According to Venture Economics, a provider of information and analysis on the venture capital industry, private equity overall returned 13.8 percent on annualized basis for the 20-year period ending June 30, 2005, outperforming the S&P 500 by 2.6 percentage points. That’s somewhat less than the findings from the newer 2013 paper.

However, during the same period, small-cap value stocks returned an annualized 16.0 percent, outperforming venture capital by 2.2 percentage points. In my view, small-value stocks are a much more appropriate benchmark for venture capital than the S&P 500 Index. Let’s see why this is the case.

Private equity is much riskier than an investment in a publicly traded S&P 500 Index fund:

• Firms in the S&P 500 are typically among the largest and strongest companies, while venture capital typically invests in smaller and early-stage companies with far less financial strength.
• Investors in private equity forgo the benefits of liquidity, transparency, broad diversification, daily pricing and, for individuals, the ability to harvest losses for tax purposes.
• The median return of private equity is much lower than the mean (the arithmetic average) return. The 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, private-equity investments are like options, or even lottery tickets. They 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.
• The standard deviation of private equity is in excess of 100 percent. Compare that to the standard deviations of about 20 percent for the S&P 500 and about 35 percent for small value stocks.

While private equity and venture capital investing is high risk and high expected return, the returns investors have actually realized don’t appear to have compensated them fully for their incremental risks. For example, the returns should reflect, at least to a significant degree, a premium for the extreme illiquidity of private equity investments.

But highlighting the investment’s lack of liquidity is the finding from one paper—“The Cash Flow, Return and Risk Characteristics of Private Equity”—that the internal rate of return for the average venture capital fund did not turn positive until the eighth year.

The bottom line is that, while this study does present private equity in a somewhat better light than did prior studies, the evidence still demonstrates that investors seeking higher returns than provided by the S&P 500 would be better served by looking to small value stocks (both domestically and internationally) in the public markets.

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