Private Equity: Who Gets Rich?

Private equity (venture capital) excites many investors, offering the opportunity for spectacular returns (though, like with most investments, we generally hear only the stories with happy endings). And it is reasonable to assume that high-risk, illiquid investments are priced by investors to deliver higher expected returns than publicly traded securities as compensation for the greater risk. The question is: Has private equity actually delivered high returns, especially after adjusting for the incremental risks?

Oliver Gottschlag, assistant professor of strategy at the HEC business school in Paris, and Ludovice Phalippou, assistant professor at the business school of the University of Amsterdam, researched the performance of 6,000 private equity deals and about 1,000 buy-out funds.(¹⁾ Their research was based on data collected from investors in 852 private equity funds raised before 1993—to be sure they had sold all their assets. Their findings are quite interesting.

Gottschlag and Phalippou found that before accounting for fees and carried interest (profit sharing) the average private equity fund outperformed the S&P 500 Index by 3 percent per annum. However, after accounting for fees the average private equity fund underperformed the S&P 500 Index by 3 percent per annum. Investors took all the risks (including owning illiquid assets) and received returns well below those available on publicly traded securities. The fund sponsors, on the other hand, were rewarded quite handsomely (explaining why private equity is so popular among the sponsors)—while delivering poor results.

The Private Equity Puzzle

Clearly, the stunning growth in assets committed to private equity— capital committed increased from $5 billion in 1980 to $300 billion in 2004, for a total of $1 trillion—cannot be explained by historical performance.(²⁾ Instead, it is the hype surrounding the industry and a desire to be “a player” that explains the flow of dollars into private equity funds.

Unfortunately, there is yet a third explanation. The industry presents misleading data—data that contains biases that overstate performance. The first bias results from the fact that private equity typically employs leverage, increasing risks. Returns should be adjusted for risk—doing so would reduce returns substantially.

A second bias results from how private equity accounts for residual values. Despite funds having reached their normal liquidation time, half of mature funds still report substantial residual values. Gottschlag and Phalippou argue that such residual values should be written off based on the following observations: “i) All base-sample funds have reached the typical liquidation age and, in addition, are either officially liquidated or have had no cash flows over the last six quarters. These funds can be considered ‘effectively’ liquidated given their age and lack of activity; ii) 71 percent of the residual values are reported by funds with neither cash-flow activities for more than three years nor revision in residual values for more than three years.”(³⁾ Writing-off residual values would have a significant negative impact on returns.

Gottschlag and Phalippou also showed that a third bias exists because of the way internal rates of return are calculated by the industry—again overstating returns.

The three biases in the reported data may help explain why funds flow into private equity despite the lack of performance that would justify such risky investments. Another possible explanation is that the performance of the asset class is highly skewed by the outstanding returns of a few funds. Investors are likely placing too much weight on the few success stories.

Summary

The findings of the study by Gottschlag and Phalippou are consistent with the findings of other studies on private equity—once adjusted for risks and the biases in the data, private equity returns have not exceeded the returns of publicly available securities. Thus, for those investors considering private equity investments, the more prudent strategy appears to be to take equity risks in the public markets using passively managed funds that deliver the returns of their respective asset classes in a low-cost and tax-efficient manner.

1. Oliver Gottschlag and Ludovice Phalippou, “Performance of Private Equity Funds,” April 2007.

2. Ibid.

3. Ibid.

_{Larry Swedroe is the author of Wise Investing Made Simple (2007), The Only Guide To A Winning Investment Strategy You Will Ever Need (2005), What Wall Street Doesn’t Want You to Know (2000), Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today (2002), and The Successful Investor Today: 14 Simple Truths You Must Know When You Invest (2003), and co-author of The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006). He is also a Principal and Director of both Research of Buckingham Asset Management and BAM Advisor Services — a Turnkey Asset Management Provider serving CPA-based Registered Investment Advisor (RIA) practices — in Clayton, Missouri (www.bamservices.com).}

_{His opinions and comments expressed within this column are his own, and may not accurately reflect those of the firm.}