The term “private equity” is used
to describe various types (e.g., buyout funds and venture capital funds) of
privately-placed (non-publicly 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
percent 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
In their 2019 whitepaper “Demystifying Illiquid Assets: Expected Returns for Private Equity,” the research team at AQR Capital began their analysis by noting that “the challenge is that modeling private equity is not straightforward due to a lack of good quality data and artificially smooth returns.” They attempted to bring clarity by considering theoretical arguments, historical average returns, and forward-looking analysis.
AQR analyzed whether private equity’s realized and estimated expected return provided superior risk-adjusted returns over lower-cost, more highly diversified, and highly liquid public equity counterparts. In other words, is all the hype and hope justified? Their study covered the period from July 1986 through December 2017. Following is a summary of their findings:
The market beta of PE has been more than 1 (about 1.2), indicating it has about 20 percent more risk than the market. In addition, PE tends to invest in small and value stocks, which have also historically provided above-market returns. Thus, the overall market, or the S&P 500 Index, is not a good benchmark. And that is without considering their illiquidity.
PE outperformed the S&P 500 Index by 3.4 percent in annualized returns. But when compared to a 1.2x leveraged small-cap index, this falls to just 0.7 percent (not much of an illiquidity premium). And PE outperformed a basket of unleveraged small-cap value stocks by just a compound 0.4 percent per annum.
There has been a decreasing trend over time in both expected and realized returns, which has not slowed the institutional demand for private equity.
Using earnings before interest, tax, depreciation and amortization-to-enterprise value (EBITDA/EV) as their metric for expected returns, the ex-ante return premium for private equity fell from about 5 percent at the start of the period to zero by 2006—and has lingered around zero ever since. The narrowing gap reflects the demand by investors: As PE has grown relatively richer and the valuation gap has narrowed, PE’s outperformance over public equities has declined, with realized outperformance for post-2006 vintages dropping to virtually zero, even before adjusting for size and leverage.
The research team at AQR noted that
many academic studies have found that “PE fund returns tend to be lower after
‘hot-vintage’ years characterized by high fundraising activity or capital
deployment, attractive financing conditions, and easy leverage. Skeptics stress
that the current environment can be characterized by low financing rates
coupled with increasing institutional demand for PE, more PE firms, record-high
dry powder (committed uncalled capital), and competition from cash-rich public
companies and sovereign wealth funds. Thus, PE faces headwinds that make it
less likely to deliver the strong returns it has in the past.” They added that
richness versus history is not unique to PE. Many other asset classes appear
expensive today, perhaps reflecting the easy global monetary policies of the
In their study “Have Private Equity Returns Really Declined?” published in the Fall 2019 issue of The Journal of Private Equity, Gregory Brown and Steven Kaplan noted that EBITDA multiples averaged 10.9 in 2017 and 2018. That’s higher than any other period, including the late 1990s.
Explaining Increased Demand in the Face of Poor
AQR’s team hypothesized that the increased demand in the face of lowered returns is due to investors’ preference for the “return smoothing” properties of illiquid assets. Unfortunately, the smoother returns are illusory. For example, in his 2017 study “Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting, Erik Stafford found that the reported volatility of the PE indexes is considerably lower (about half) than those of the aggregate market (about 9 percent versus 17 percent) and the replicating portfolio of levered selected stocks (21-22 percent). That is illogical (it cannot be the case), especially since the private equity firms have much higher betas than the market and use much more leverage than typical public companies. The lower reported volatility results from the lack of daily mark-to-market accounting, long holding periods and the considerable flexibility PE has in determining valuations. In other words, return smoothing creates the illusion of less risk. It also creates the illusion of PE having low correlations to equity markets as well as the illusion of alpha if measured on a naïve basis. Note that Stafford also found that the long-run average excess returns of PE over public equity can be matched by a leveraged, small-cap value strategy. David Foulke and Wes Gray previously covered this in blog posts here and here. Thus, it appears that the PE industry, on average, has offered scant illiquidity premium beyond these typical factor tilts, all while collecting large fees—close to 6 percent.
Unfortunately, despite the evidence of little more than perhaps a scant premium, AQR noted: “In contrast to our conservative forecasts, institutional investors widely expect PE to outperform public equity by 2-3%.” They added: “This may be due to the inherent difficulty of modeling illiquid assets, and lack of transparency on fees and performance.” Perhaps. The field of behavioral finance provides us with another explanation for the demand for PE, despite the findings of poor risk-adjusted returns.
Behavioral Explanation for the Demand for PE
In an interview with AAII, Meir Statman, a leader in the field of behavioral finance, provided us with another explanation:
“Investments are like jobs, and their benefits extend beyond money. Investments express parts of our identity, whether that of a trader, a gold accumulator, or a fan of hedge funds. We may not admit it, and we may not even know it, but our actions show that we are willing to pay money for the investment game. This is money we pay in trading commissions, mutual fund fees, and software that promises to tell us where the stock market is headed.”
Meir Statman, Interview with AAII
He went on to explain that some invest in hedge funds for the same reason they buy a Rolex or carry a Gucci bag with an oversized logo—they are expressions of status, available only to the wealthy. Just substitute PE for hedge funds and you have an explanation for the demand for PE investments.
PE offers what Statman called “the
expressive benefits of status and sophistication, and the emotional benefits of
pride and respect”—they’re ego-driven investments, with demand fueled by the
desire to be a “member of the club.” With that in mind, investors in PE (and
hedge funds) would be well served to consider the following from another leader
in the field of human behavior, Groucho Marx: “I don’t care to belong to any
club that will have me as a member.”
As Chief Research Officer for Buckingham Strategic Wealth and Buckingham Strategic Partners, Larry Swedroe spends his time, talent and energy educating investors on the benefits of evidence-based investing with enthusiasm few can match. Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has since authored seven more books: “What Wall Street Doesn’t Want You to Know” (2001), “Rational Investing in Irrational Times” (2002), “The Successful Investor Today” (2003), “Wise Investing Made Simple” (2007), “Wise Investing Made Simpler” (2010), “The Quest for Alpha” (2011) and “Think, Act, and Invest Like Warren Buffett” (2012). He has also co-authored eight books about investing. His latest work, “Your Complete Guide to a Successful and Secure Retirement was co-authored with Kevin Grogan and published in January 2019. In his role as chief research officer and as a member of Buckingham’s Investment Policy Committee, Larry, who joined the firm in 1996, regularly reviews the findings published in dozens of peer-reviewed financial journals, evaluates the outcomes and uses the result to inform the organization’s formal investment strategy recommendations. He has had his own articles published in the Journal of Accountancy, Journal of Investing, AAII Journal, Personal Financial Planning Monthly, Journal of Indexing, and The Journal of Portfolio Management. Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television shows airing on NBC, CNBC, CNN, and Bloomberg Personal Finance. Larry is a prolific writer and contributes regularly to multiple outlets, including Advisor Perspective, Evidence Based Investing, and Alpha Architect. Before joining Buckingham Wealth Partners, Larry was vice chairman of Prudential Home Mortgage. He has held positions at Citicorp as senior vice president and regional treasurer, responsible for treasury, foreign exchange and investment banking activities, including risk management strategies. Larry holds an MBA in finance and investment from New York University and a bachelor’s degree in finance from Baruch College in New York.
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