Are the benefits of private equity a mirage?

Wealthy and institutional investors have poured trillions of dollars into private equities over the past half century in the belief they provide higher and less volatile returns than public equities on stock exchanges – while enhancing diversification because of low correlation to other assets.

But recent research finds that the touted benefits of private equity fall short of their billing.

One key development is that returns on U.S. private equities have trended down relative to public equities. In the ten years to 2010, the U.S. Private Equity Index had a wide margin of outperformance over the S&P 500 Index, but this margin deteriorated over the next ten years: the average annual return on the S&P 500 came in at 14.0 per cent versus 13.8 per cent for the U.S. Private Equity Index. Comparisons of the latter index with other benchmarks, such as the Russell 2000 Index, show a similar shrinkage in alpha.

“As the 50-year-old industry matures, investment returns are falling,” noted Karim Khairallah and François Mann Quirici in the June 9, 2021, edition of the Harvard Business Review. “As the number of active private-equity firms reaches record levels, returns … are largely competed away. And with private-equity firms paying more for businesses than ever …. return potential is meaningfully reduced.”

Such an outcome is consistent with the Efficient Markets Hypothesis, which postulates that returns above the norm tend to attract investment flows that bid up the price of the asset until the excess returns are arbitraged away. Countries with mature private-equity industries, such as the United States, may have reached this saturation stage. Markets with lower penetration rates, such China and other Asian countries, could have several more years to go.

But were private-equity returns ever that superior to begin with? Some past data points have strained credulity. “It is curious that U.S. private equity was reported to have generated an 11 per cent IRR [internal rate of return] in 2008 when the global economy was hemorrhaging, and the S&P 500 fell 38 per cent,” observed Nicolas Rabener, managing director of investment-research firm FactorResearch.

The IRR yardstick has methodological issues, and an attempt has been made to adjust for them with the public market equivalent (PME) methodology. But it, too, leads to puzzling results. Using data from Cambridge Associates, Rabener’s research has found that PME yields a return of 14 per cent for 2008, “which is equally difficult to explain.”

Methodologies for calculating returns are only as good as the input data. Unlike public equity, returns for private equity are not quoted daily on stock markets. They are based on quarterly valuations by appraisers, using data supplied by private-equity firms.

Given the measurement and methodological issues underlying existing comparisons of the performance of private and public equities, Rabener developed an alternative approach. This was done by selecting the subset of public companies with traits similar to private companies: small capitalization, low valuation, and leverage. Then, indexes were calculated from the stocks in the subset to proxy private-equity returns.

From his research published by the Journal of Investing, CFA Institute and other sources, we find that the replication indexes based on publicly traded small caps with low valuations and leverage have “almost identical returns” to the U.S. Private Equity Index. The alpha thus achieved by private equity appears to be real, but it likely loads up more on the factors of market cap and valuation than illiquidity.

The replication indexes also suggest that the low volatility and lack of correlation with other assets may be more a manifestation of the way private equity returns have been calculated and reported. As Rabener notes: “Private equity funds represent equity positions in corporates. Hence this low volatility must be artificial, the product of smoothed valuations. Private equity portfolio companies are influenced by the economic tides just as much as public companies.”

Private-equity investors with preferences for liquidity and transparency can therefore consider exposure to the returns earned on subsets of public equities with similar characteristics to private equities. Some investment firms provide this service.

Yet, the lengthy holding periods required by private-equity investment firms, and the smoothing of reported returns, facilitates the type of long-term investing that benefits investors. There will be less of the panicky feelings and urges to dump everything at the bottoms. So, there does seem to be merit in obtaining some exposure through these firms.

Moreover, as Rabener points out, “private-equity firms serve a useful policing function in the financial markets: They identify poorly run companies, acquire, improve, and ultimately sell them.” This further points to the value of arranging at least part of one’s exposure through private-equity firms, along with the exposure derived from liquid alternatives.

Larry MacDonald is a retired economist who blogs at Investing Journey.

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