Swedroe: Why Small Value Stocks Top VC Funds

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

In addition, endowments seeking to replicate the successes of the Yale Endowment have also contributed to the growth of PE funds.

The term “private equity” is used to describe various types (for instance, 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.

Fund-Of-Funds Returns

Robert Harris, Tim Jenkinson, Steven Kaplan and Ruediger Stucke contribute to the literature on the performance of PE with their May 2017 paper, “Financial Intermediation in Private Equity: How Well Do Funds of Funds Perform?”

They note that funds of funds (FOFs) potentially provide specialized investment skills, diversification and lower cost services (for example, due to economies of scale) for investors wanting exposure to private equity. Against these advantages must be weighed the additional fees charged by the FOF manager.

The authors benchmarked FOF performance, net of fees, against public equity markets as well as strategies of direct fund investment. Their study covered FOF performance over the period 1987 through 2012 and FOFs raised from 1987 through 2007. Following is a summary of their findings:

• FOFs, both in buyout and venture capital, have generated returns equal to or above those from investing in public equities.
• Comparing FOFs to direct fund investing, FOFs that focus on buyouts or are generalist funds had significantly lower returns compared with portfolios formed by “random” direct fund investing in similar direct funds.
• FOFs in venture capital perform roughly on par with portfolios of direct funds, even after the additional fees.

Specifically, the authors found that relative to the performance of the S&P 500 from 1987 through 2007, FOF buyout funds provided a mean PME (the ratio of total return relative to the benchmark) of 1.14 and a median PME of 1.11. For venture capital FOFs, the mean PME was 1.16 and the median PME was 1.01. For all private equity FOFs, the mean PME was 1.13 and the median PME was 1.08.

They concluded: “Our results suggest that FOFs focusing on VC provide more advantages than those investing in buyout funds.”

Fly In The Ointment

That’s the evidence presented by Harris, Jenkinson, Kaplan and Stucke. Unfortunately, the returns data they present isn’t risk-adjusted. Private equity is actually 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 more than 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 demand a premium for investing in illiquid assets, especially ones that perform poorly in bad times (like private equity). 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 individual PE investors, 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 a negative return. In effect, PE investments are like options (or lottery tickets). They tend to offer a small chance of a huge payout, but a much larger chance of a below-average return. In addition, it can be difficult, especially for individual investors (at least without paying the fees of a FOF), to diversify this risk.
• The standard deviation of private equity is in excess of 100%. Compare that to standard deviations of about 20% for the S&P 500 and about 35% for small value stocks.

More Appropriate Index

From my perspective, given PE’s greater risks and the fact that PE investments are typically in smaller companies, a more appropriate benchmark than the S&P 500 Index is the Fama-French Small Value Research Index. Once this adjustment in the benchmark is made, you would likely reach very different conclusions than those drawn by Harris, Jenkinson, Kaplan and Stucke.

It is important to point out that the authors did also provide comparisons to the Russell 2000 Index. When comparing returns to the Russell 2000, all FOFs produced a mean PME of 1.04 and a median PME of 1.0. Thus, the average FOF just matched the returns of the Russell 2000, and investors were not rewarded for the much greater risks and the sacrifice of liquidity.

However, in my view, that is a very poor choice of benchmark as well, biasing the data favorably toward private equity.

Russell 2000 Index Issues

First, there are many well-known problems with the Russell 2000 Index. As evidence, over the period 1987 through 2012, while the Russell 2000 returned 9.0%, the similar CRSP 6-10 Index returned 10.6.

I would also argue that an even better benchmark in terms of more comparable risk—and one that avoids the small-cap growth stock anomaly problem (poor returns)—would be either the Russell 2000 Value Index, which returned 10.5%, or, again, the Fama-French Small Value Research Index, which returned 13.5%. Had either of those benchmarks been used, FOF performance would have to be viewed in a much different, and harsher, light.

Given that investors in private equity and private equity FOFs have performed poorly after making appropriate adjustments for their incremental risks, we have a puzzle: Why does private equity continue to attract so much capital? My own view is that this puzzle reflects the triumph of hype, hope and marketing over evidence and wisdom.

VC Funds That Need Don’t Money

The one ray of sunshine in the data is that, at least with VC funds, there is evidence of persistence of performance among the winners. Unfortunately, it’s likely that funds showing persistence in performance don’t need your money. They can get all they need from the largest endowments (such as Yale and Harvard).

And there’s another problem. Berk Sensoy, Yingdi Wang and Michael Weisbach, authors of the 2013 study “Limited Partner Performance and the Maturing of the Private Equity Industry,” found that in their most recent sample of PE funds raised between 1999 and 2006, there was no evidence that endowments outperform other limited partner types or display any superior skill at selecting general partners.

They concluded: “The disappearing endowment advantage is consistent with other secular trends in the industry, particularly the decline in VC performance since the late 1990s and the decline in performance persistence in BO firms.”

Small Value Stocks Over VC Funds

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 rather in publicly available small value stocks. And you can access these higher forward-looking return expectations through low-cost, passively managed and tax-efficient funds. You can globally diversify their risks as well. Additionally, you’ll have all the benefits of daily liquidity and transparency.

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