Expected Return from Private Equity
While Private Equities are expected to give an extra illiquidity premium interesting for long term investors, the Supply/Demand relationship and higher may contribute to future returns being lower than public equities.
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Updated: April 20, 2012
Expected Return from Private Equity
It is generally understood that Private Equities are expected to deliver higher returns to compensate for higher risk. The extra risk and return come from the higher Beta inherent to many Private Equity investments which may be partly linked to the higher leverage, and also the extra illiquidity premium expected from such illiquid investments. The following chart illustrates the return expectation used by some investors in the mid-2000s (expected returns were much higher then...):
Since many investors like Pension Plans, Foundations and Sovereign Wealth Funds have a very long investment horizons, these investors are not necessarily concerned with the illiquidity of some investments and are willing to forego liquidity in exchange for an extra illiquidity premium. Furthermore, some of that extra risk may get diversified away at the portfolio level.
While one would expect higher returns from such investments, the observed returns have been controversial. Many academic studies have shown evidence that Private Equity investments have barely matched their public market counterpart, thus giving no compensation for the extra risk and the illiquidity of the investment.
“The performance of private equity funds as reported by industry associations and previous research is overstated. A large part of performance is driven by inflated accounting valuation of ongoing investments and we find a bias toward better performing funds in the data. We find an average net-of-fees fund performance of 3% per year below that of the S&P 500. Adjusting for risk brings the underperformance to 6% per year. We estimate fees to be 6% per year. We discuss several misleading aspects of performance reporting and some side benefits as a first step toward an explanation. ” From: “The Performance of Private Equity Funds” by Ludovic Phalippou & Oliver Gottschalg, Review of Financial Studies (2009) 22 (4): 1747-1776.
“Existing research suggests the median private equity manager does not create excess returns over public markets net of fees. In this paper, we first confirm this result...” by Ron Bird, April 2011.
The Best Manager Solution!
Many Private Equity investors and Private Equity managers have argued that in order to succeed, one has to invest with the best managers! This is a strange argument as it can be applied to all asset classes. It has been showed over and over, in all asset classes and in all sub-classifications (like Small Value, Large growth, …) that the passive benchmark is difficult to beat. The following famous quote from Nobel Laureate William F. Sharpe summarizes this well:
“If “active” and “passive” management styles are defined in sensible ways, it must be the case that, (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and, (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar. These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required. ”
He also added that: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”
The best stock pickers have only a small forecasting ability – which is why they need to build a diversified portfolio of stocks expected to outperform. Any one stock pick may well prove to be wrong but on average, a diversified portfolio of stock picks is more likely to deliver positive outperformance if the stock picker has forecasting skill. Manager picking is a similar risk budgeting exercise. If one has some forecasting skill at identifying managers with expected outperformance, then building a diversified portfolio of such managers should lead to increased probability of outperformance.
Investment in any asset classes should be based on a proper asset mix study using historical and projected asset class returns, variances and covariances. One should not base such asset mix study on any manager’s active implementation as the active return of such manager may have a very low probability of repeating itself.
The Supply/Demand Imbalance?
The lower observed return of Private Equity investments may reflect a supply/demand imbalance. The recent increased demand for Private Equity deals by both large Pension Plans and Sovereign Wealth Funds all around the world creates an environment where expected return is lowered below similar investments in public equities. (I.e. The expected illiquidity premium is negative).
The High Fees of Private Equity Investments
Private Equity managers generally charge significantly higher management fees including performance fees. This is a significant drag to the performance of these funds. Furthermore, since Private Equities are generally high Beta strategies, investors end-up paying a huge performance fee on market returns. To illustrate, one large government-linked fund assumes its Private Equity investments have an average beta of 1.3. If the market delivers on average a return of 8%, Private Equities would be expected to deliver close to 10.4% (1.3 x 8%) plus some illiquidity premium, plus the manager’s true Alpha. Why would one pay a performance fee on the market portion of returns, i.e. on the 10.4% portion which can be easily replicated with a levered market position and no performance fee? The 20% performance fee (in this example more than 2%) on the market portion of return contributes to the observed lack of performance of Private Equity funds.
Private Equity as an Alternative Investment?
Initially, investments consisted of local stocks and bonds. Over time, investors expanded the investment opportunity sets in order to increase the return-to-risk profile of their portfolio. After adding international equities and bonds, they started searching for alternative investments with different risk characteristics and, more importantly, diversifying investments. It is generally understood that such alternate investments have low correlation with other asset classes.
Private Equity is sometimes classified as an alternative asset class. Some Canadian government-linked mega funds even quote absolute return objectives. This is clearly a misclassification as Private Equities are like Public Equities which don’t trade! Private Equities are highly correlated to Public Equities. In fact, the only thing “alternative” in Private Equity is their extra illiquidity risk premium, and the extra fees!
Some investors’ confusion may come from the underestimation of traditional risk and correlation measures inherent in any illiquid assets. This will be covered in the section on Private Equity risk measurement.
Alpha and Information Management in Private Equity
Active investment management involves managing a lot of information both on the Alpha side and the risk/portfolio construction side. There has been great advances in the information management tools and techniques used to manage portfolios over the last 40 years. These tools and techniques are just starting to be used in the Private Equity world with great successes.
Read more about Alpha and Information Management in Private Equity.
For more information on Private Equity expected returns and how to build a better risk-diversified portfolio of Private Equity investments, please contact us.
Dominic Clermont, ASA, MBA, CFA
State of the Art Investment Management