Swedroe: A Private-Equity Puzzle

April 15, 2016

Capital committed to private equity (PE) funds worldwide has risen substantially in the last two decades, thanks largely to U.S. pension funds searching for alternatives to public equity markets that might help them meet their return objectives.

Endowments seeking to replicate the successes of the Yale Endowment have also contributed to the growth of PE funds, which obtained commitments for more than $460 billion in 2013, a twelvefold increase over the $38 billion committed in 1995.

The term “private equity” is used to describe various types (e.g., buyout funds and venture capital funds) of privately placed (nonpublicly traded) investments. Even though buyout (BO) funds and venture capital (VC) funds have a similar organizational form and compensation structure, they are distinguished by the types of investments they make and the way those investments are financed.

BO funds generally acquire 100% of the target firm (which can be public or private) and use leverage. VC funds take minority positions in private businesses and do not use debt financing.

Findings On PE Performance
Steven Kaplan and Berk Sensoy contribute to the literature on the performance of PE funds through an extensive survey of current research on the performance of private equity. Following is a summary of the findings from their October 2014 paper, “Private Equity Performance: A Survey”:

  • Buyout funds have outperformed the S&P 500 net of fees on average by about 20% over the life of the fund.
  • 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.

That’s the evidence presented by Kaplan and Sensoy. Unfortunately, the returns data presented isn’t risk-adjusted. Private equity is really much riskier than an investment in a publicly traded S&P 500 index fund, making it a wholly inappropriate benchmark. For example:

  • Companies 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. Studies have estimated betas for BO funds at about 1.3 and for VC funds from 1.6 to 2.5. Adjusting for the higher betas alone would have wiped out any evidence of outperformance.
  • Investors in private equity forgo the benefits of daily liquidity. It’s well-documented in the literature that investors will demand a premium for investing in illiquid assets, especially ones that perform poorly in bad times (like PE). There’s no adjustment in the returns data for the risk of illiquidity. In addition to the lack of liquidity, relative to investments in mutual funds, private equity investors also forgo the benefits of transparency and broad diversification (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. PE’s 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, PE investments are like options (or lottery tickets). They 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.
  • The standard deviation of private equity is in excess of 100%. Compare that with standard deviations of about 20% for the S&P 500, and about 35 for small value stocks.

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