The Private Equity Pitch

Summary

Private equity has gained significant attention, with Vanguard offering it to its customers. However, while the pitch of illiquidity premiums and manager skill sounds enticing, studies reveal mixed results. Private equity returns, particularly when compared to public equities, have often been similar after fees. The asset class presents challenges in selecting funds, with considerable variance in fund performance. Many investors can't access top-tier funds, and any diversification illusion is often due to reporting methods rather than distinct risk exposures. Ultimately, unless one can negotiate fees or access top-performing funds, the appeal of private equity may be overstated.

Takeaways

• 😀 Vanguard, traditionally known for low-cost index investing, is now offering private equity to certain customers, promising potential long-term excess returns.
• 😀 Private equity's illiquidity and market dynamics are believed to provide diversification opportunities and higher returns for suitable investors, though the risks are substantial.
• 😀 Private equity can be divided into two categories: buyouts (investments in later-stage companies) and venture capital (investments in earlier-stage companies).
• 😀 Performance metrics for private equity include IRR (Internal Rate of Return), multiples of money, and PME (Public Market Equivalent), but these are often difficult to compare to public equities.
• 😀 PME can reveal how a private equity strategy performs relative to a public market benchmark, but results can vary based on the chosen benchmark.
• 😀 Studies suggest that private equity in aggregate has historically delivered returns similar to public equities, with buyouts slightly outperforming public markets in some cases.
• 😀 The performance of venture capital funds, however, tends to be more volatile, with a significant skew in the distribution of returns, making it difficult to access the top performers.
• 😀 Private equity returns are negatively related to aggregate capital commitments, meaning that as more capital flows into the sector, expected returns may decline.
• 😀 Despite the theoretical potential for high returns from illiquidity and manager skill, the actual returns to investors often fail to justify the high fees charged, which can be as high as 6-7%.
• 😀 Private equity's perceived diversification benefits may be an illusion, as reported correlations with public markets increase when fair value accounting is used, revealing a closer risk relationship.
• 😀 Ultimately, private equity investors may not be capturing the illiquidity premium or manager skill that was promised, as returns after fees have historically been comparable to public equities.

Q & A

What is the primary pitch of private equity investments?

The primary pitch of private equity is that illiquid assets in markets that are more difficult to access provide opportunities for higher expected returns and portfolio diversification.

What are the two main types of private equity investments?

The two main types of private equity investments are buyouts, which involve purchasing entire businesses in later-stage companies, and venture capital, which focuses on investing in early-stage companies.

What is the key issue with comparing private equity returns to public equity returns?

Private equity returns are often compared using metrics like internal rate of return (IRR), but IRRs are not comparable to time-weighted returns typically used for public equities, and they can be easily manipulated.

What is the Public Market Equivalent (PME) and how does it help evaluate private equity performance?

The PME compares the results of a private equity strategy to a benchmark index, assuming the same investment timing and amounts. A PME of 1.2, for example, indicates that the private equity strategy outperformed the benchmark by 20% over the holding period.

What is the significance of the Russell 2000 as a small-cap benchmark for private equity?

The Russell 2000 is often used as a small-cap benchmark for PME calculations. However, it is known for being one of the worst-performing small-cap indices, which can lead to inflated performance comparisons in private equity studies.

What is the performance of venture capital funds compared to buyout funds?

Venture capital funds typically show a much wider performance distribution, with the median venture capital fund underperforming public equities. Only a few high-performing venture capital funds drive the overall average return.

Why do investors struggle with the diversification claim in private equity?

The diversification claim is often an illusion. Since private equity returns are not valued daily, reported returns appear less volatile and uncorrelated with public equities, even if the underlying economic risks are similar.

What do studies show about the persistence of performance in private equity funds?

Studies show that there is no persistence in buyout fund performance, meaning past top performers do not continue to deliver high returns. However, in venture capital, some top funds do show persistent outperformance, although access to these funds is limited.

What role do fees play in private equity returns?

High fees in private equity significantly reduce net investor returns. Even though gross returns can be strong, after accounting for fees (typically around 6-7%), the net returns are often comparable to public equity returns.

How does private equity's historical performance compare to public equities over the long term?

Studies show that private equity has generated returns similar to public equities over long periods, particularly when compared to risk-appropriate small-cap indices, and this trend continues since at least 2006.