For decades, private equity has been one of the most enduring and popular alternative asset classes.
Part of this popularity is surely driven by a perception of high returns and significant alpha across the PE space. That excitement about PE returns was once justified, but a careful look at returns data over the last 10 years suggests that, on average across all funds, PE alpha has largely disappeared. For investors, this leads to two important questions; where did all the alpha go, and do some funds still deliver the goods?
The questions are becoming even more important as the PE space is becoming more democratized. The largest PE funds are now publicly traded, and even the rarified world of venture capital is now open to the mass affluent through new vehicles like the ones offered by SeekingAlpha.
While exact data is hard to get in the PE world, there are a number of studies that have looked at the issue. Yale did a study of buyout PE returns between 1987 and 1998 and found returns of 36% annually versus 17% for the S&P 500. To generate that level of returns, PE funds had to take on significant leverage, but that performance is still impressive. On a beta-adjusted basis, economists have found that PE generated alpha of about 5.5% between 1980 and 2006, based on buyout firm investments having a beta of around 2 and VC fund betas of around 3.
All of the alpha disappeared after 2006. While PE funds have outperformed the market as a whole by roughly 3% over a 30 year period, that superior performance is entirely driven by the early part of the sample. Since 2006, PE returns have been roughly on par with those of the S&P – all without the liquidity, transparency, or low fees of public equity markets. The chart below illustrates this.
David Swensen, chief investment officer of the Yale Endowment perhaps best summed up the challenge concluding "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."
So what happened to all of that alpha? There are a couple of possible answers. One explanation is that increased competition in the space drove down alpha. Based on a research study I did recently, the number of private equity funds have more than tripled in the last twenty years, and that rise has correlated directly to the negative 26 basis points of alpha that investors saw across the PE space on average over the last two years.
A second more fundamental explanation is that as PE funds have gotten larger, incentives have become distorted. When PE funds like Blackstone were small once upon a time, the fixed cost portion of the fund used to primarily cover operating overhead. Today, as many PE funds have grown to manage tens-of-billions of dollars, the fixed cost fees have become a source of profits by themselves. That results in a misalignment of incentives between investors and fund managers. Today the incentive for many funds is to maximize AUM rather than to maximize deal quality. The democratization of the asset class will only exacerbate this problem – look at the hedge fund industry’s embrace of 40 Act compliant funds for a direct example.
All of this leads to an important fundamental question for investors – is it time to abandon the PE space, or can empirical data still be used to successfully pick high quality funds? The answer is that much like in the mutual fund space today, there are a lot of mediocre funds out there, but persistence still survives in the tails of the distribution. Fund managers that consistently underperform share certain characteristics, and fund managers that outperform share other specific characteristics. In particular, fund returns tend to be serially correlated even between vintages, so investors leverage GARCH models combined with factor-based risk adjustments when making fund selections. Following this approach leads to a sample of funds that outperforms peers by a risk-adjusted 8% annually even in recent years.
Maybe it’s not yet time to give up on the PE asset class after all.
This is Mike McDonald’s inaugural column for Dealbreaker. The column will be focused on empirical finance and FinTech. McDonald has a PhD in finance and is a university professor of finance. He is also a frequent consultant on quant matters, big data, and machine learning to a variety of financial firms, asset managers, institutional investors, and even government regulators. Prior to getting his PhD, McDonald worked for a major Wall Street bank and one of the top hedge funds.
Send feedback or suggestions to m.mcdonald@MorningInvestmentsCT.com