Private equity investing has created enormous wealth for those fortunate to be the general partners of a fund. But for regular investors – the limited partners – recent studies show that when properly adjusted for risks, PE returns lag those of the less risky public markets. Moreover, there is little evidence that investors can identify, in advance, the very few PE funds that will outperform.
Q2 hedge fund letters, conference, scoops etc
The collapse in interest rates, combined with historically high valuations (at least for U.S. stocks), have led many endowments and pension plans (especially those with large unfunded liabilities) to seek alternative investments that might offer more attractive returns. For example, over the 20-year period 1996 to 2016, pension plan allocations to private equity (PE) increased from just 3% to 11%, with the increase mostly coming at the expense of allocations to fixed income.
PE excites many investors, offering the opportunity for spectacular returns (although, as with most investments, we generally hear only the stories with happy endings). Even the term conveys an exclusive nature, especially for investors who yearn to be “players.” The question is: Is the hype supported by the results?
Washington University’s recent Wealth and Asset Management Research Conference included a panel on private equity with representatives from Washington University, Ascension Investments, Warburg Pincus and Harvard’s Erik Stafford. Unfortunately, I was unable to attend. However, a good friend related that Stafford challenged those promoting PE and their investment assumptions. My friend’s conclusion was that the three PE proponents were unable to adequately defend against Stafford’s data, which, as you will see, showed there was nothing special about private equity returns (except for the huge fees earned by the sponsors).
This outcome did not surprise me, as we have a substantial body of academic research on private equity. As you will see, the studies came to the same conclusion – private equity has not outperformed publicly available mutual funds on a risk-adjusted basis. And that does not even account for the liquidity that private equity investors forfeit.
We’ll examine the evidence, beginning with a review of Stafford’s September 2017 paper “Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting.” Using a database that covers the period 1984 through 2014, Stafford investigated whether an outside investor could replicate the risks and returns of a diversified private equity allocation with passive investments in public equities using similar investment selection, holding periods, leverage and the calculation of portfolio net asset value under a hold-to-maturity accounting scheme. He began by noting that “the pre-fee private equity return series [Cambridge Associates Private Equity Index] represents highly attractive investments compared to a portfolio that is invested in the aggregate U.S. stock market and levered two times to mimic the typical leverage of private equity investments.” However, net-of-fee returns were comparable. In other words, just as economic theory suggests, the “alpha” went to the scarce resource – the fund sponsors, not the investors.
Making matters worse, however, is that sophisticated investors understand that the U.S. aggregate market is an inappropriate benchmark, as it is an unlevered investment, which offers daily liquidity, and is dominated by less risky large companies. Returns should be adjusted for incremental risks. The following is a summary of Stafford’s findings:
- Private equity funds tend to select small firms with low EBITDA multiples (value stocks) and low equity issuance (repurchasers as opposed to issuers).
- Public equities with those characteristics have high risk-adjusted returns after controlling for common factors. For example, a portfolio comprised of stocks most similar to PE-selected stocks have high excess returns, averaging 18% per year for the equal-weight portfolio and 14% for the value-weight portfolio, while portfolios comprised of the high multiple stocks have average excess returns of 7.1% and 7.6% for equal and value weight, respectively.
- The equal-weighted portfolio of stocks most similar to the PE-selected stocks has a Sharpe ratio of 0.90.
- A passive portfolio of small, low EBITDA multiple stocks with modest leverage and hold-to-maturity accounting produces an unconditional return distribution that is highly consistent with that of the pre-fee aggregate private equity index.
- The passive replicating strategy represents an economically large improvement in risk- and liquidity-adjusted returns over direct allocations to private equity funds, which charge estimated fees of 3.5% to 5% annually.
Read the full article by Larry Swedroe, Advisor Perspectives
