- Private equity (PE) has grown tremendously over the past 30 years.
- Growth is a result of American pension funds searching for alternatives to public equity markets.
- Private equity doesn’t provide risk adjusted returns.
The term private equity - PE - is used to describe various types of privately placed (non-publicly traded) investments. It has grown tremendously over the past 30 years - thanks largely to America's pension funds as they search for alternatives to public equity markets that might help them meet their return objectives.
Frank Jian Fan, Grant Fleming, and Geoffrey J. Warren, authors of the study "The Alpha, Beta, and Consistency of Private Equity Reported Returns," which appears in the Fall 2013 issue of the Journal of Private Equity, examined the performance of both buyout and venture capital - VC - funds through 2011. Their study adds to the literature on private equity by incorporating the factors of size and value - instead of benchmarking returns to a single broad market index. They also benchmarked returns against investable index funds, rather than just the index itself (which doesn't have costs). In addition, they considered whether the reported returns of these funds lag market returns. The following is a summary of their findings:
- Buyout funds have an estimated beta (market risk) of around 0.85-0.90, and they tend to invest in small growth companies. Relative to index funds the small-cap beta is 0.28 and the value beta is -0.18. In addition, they lag public markets by about four months.
- Relative to index funds, buyout funds generated alpha of 5.6 percent.
- VC funds have market beta of about 0.75, with no significant exposure to size or value.
- Relative to index funds, VC funds delivered negative alpha of -3.2 percent.
- The R-squared of PE funds ranged from 70 percent to 79 percent, indicating that PE is closely related to public equity markets. This suggests that any diversification benefits of PE are modest at best.
This last point is an important one because it refutes the argument that PE is a good diversifier of public equity risks. In fact, it was once the conventional wisdom that PE is an alternative asset class characterized by its low correlation to public equities. The problem was that the reported low correlations were simply a result of poor accounting practices. Prior to 2006, PE investments were generally held at cost until an actual realization event - their valuations weren't adjusted to reflect changing valuations in public equities. The fair market accounting rule changed all that.
The authors also found that PE exposure to beta varies substantially over time. For example, for the period 2000-2008, the market beta of buyout funds was above 2. For VC funds it was 1.2. Before and after that period, the betas were often below 1. Similarly, the exposures to size and value factors varied substantially over time. One explanation offered for the variance, as mentioned above, is that accounting rules were quite different before 2006 when fair value accounting became the standard. The problem of lagging valuations prior to this period also brings into question the alpha estimates - if beta exposures are underestimated, alpha will be overestimated. The authors noted that the 10-year rolling alpha estimates for buyout funds fluctuates around zero after 2005 (raising questions about the validity of the prior data).
The evidence from this study adds to an already considerable body of evidence which has found that venture capital has failed to deliver risk-adjusted alpha - especially after considering the lack of liquidity inherent in such investments (investors should receive a liquidity premium for taking that risk).
Given the findings on buyout funds, I thought it worthwhile to review some of the literature on their performance. We'll begin with a study by investment consultant Cambridge Associates. They studied the performance of more than 300 buyout funds. For the 20-year period ending June 2003, the average fund produced a mean return of 11.5 percent, and underperformed the S&P 500 by 0.7 percent.
A study by the Yale Investments Office provides insight into how the use of a similar amount of leverage would have boosted the 12.2 percent return of the S&P 500 Index. The study examined 542 buyout deals initiated and concluded between 1987 and 1998. It found that the net returns were 36 percent per year, well above the 17 percent return produced by a comparably timed and sized investment in the S&P 500 Index. However, a comparably timed and sized investment in the S&P 500 Index that also applied the same amount of leverage would have returned 86 percent per year, or 50 percent per year greater than the return of the leveraged buyouts. Perhaps it was these results that led David Swensen, chief investment officer of the Yale Endowment to draw the following conclusion:
"Investors in buyout partnerships received miserable risk-adjusted returns over the past two decades. Since the only material differences between privately owned buyouts and publicly traded companies lie in the nature of the ownership (private vs. public) and character of capital structure (highly leveraged vs. less highly leveraged), comparing buyout returns to public market returns makes sense as a starting point. But, because the riskier, more leveraged buyout positions ought to generate higher returns, sensible investor recoil at the buyout industry's deficit relative to public market alternatives. On a risk-adjusted basis, market equities win in a landslide."
The bottom line is that investors are best served by avoiding scenic tours into the land of alternative investments. The public equity markets have provided superior returns with all the benefits of daily pricing and liquidity and total transparency. In addition, for taxable investors public equities allow for tax loss harvesting and the subsequent benefits it can provide.