For most investors, PE is irresistible for its dazzling brand halo of outsized “My PE portfolio returns 4x and 5x. Can your hedge fund match that?” and stable “My PE investment has been a cash cow and my exit was at 5x.” returns.

Let’s, for a moment, shield our eyes away from the shiny object and get down to brass tacks: What returns should investors expect from private equity (PE)? Is PE the superior risk-adjusted instrument compared to public equities?

Simple questions that are not straightforward to answer (due to a lack of good quality data and artificially smooth returns).

Until now.

AQR’s “Demystifying Illiquid Assets: Expected Returns for Private Equity” (Jan 2019) and Nicolas Rabener’s “Private Equity Is Still Equity, Nothing Special Here” (Dec 2020) have done the heavy lifting.

And fortunately for us, Alpha Architect has provided easy-to-read summaries of these two dense research papers (here and here). Here are some highlights:

  • U.S. private equity returns can be replicated systematically through public equities, historically by selecting small, cheap, and levered stocks.
  • 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. (Data from Jul 1986 through Dec 2017.)
  • 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. (Data from Jul 1986 through Dec 2017.)
  • Investing in private equity entails the same economic exposure as investing in public equities, resulting in the high correlation of both asset classes. For example, using quarterly reporting, the correlation of returns of private equity and the S&P 500 was almost 0.8 — adjusting for smoothing of private equity returns would result in an even higher correlation.
  • The volatility of private equity returns is understated as a result of smoothing, and the risk-adjusted returns are comparable to those of public equities. An unsmoothing approach results in comparable standard deviations of returns for private equity and the S&P 500.
  • There are not many sound arguments for private equity firms to avoid using public market multiples to measure the changes in the valuations of portfolio companies and provide daily returns to their investors. Doing so, however, would make private equity look much more like public equities and seem far less unique from a capital allocation perspective.
  • While most private equity firms highlight the value, they create by improving the operations of acquired firms, these efforts do not translate into consistent outperformance compared to public equities.

Do these findings matter in real life? Will these insights change investor behavior?

Apparently not. Because according to the WSJ “The USD900 billion cash pile inflating startup valuation”, dry powder hit about USD440 billion for venture capitalists and roughly USD310 billion for growth-focused PE firms in early Dec 2021.

“Despite billions of dollars in lost market value for publicly listed startups, the cash hoards represent buoyant demand from investors with interest rates near zero and stock indexes at or near records.”

See also FT’s “Private equity chiefs wonder at their own success” and “concern over the state of collective delusion”.

“The combination of hefty valuations, large sums of capital flowing into companies and high leverage created the risk of “the dotcom boom meeting with the financial crisis.”

In a low interest rate environment, investors are driven by both FOMO and storytelling to take outsized bets on shiny objects. And there is nothing as bedazzling as PE’s promise of entry into the club and 5x returns for investors to open their chequebooks.

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Email hello @ alphalyticscm dot com for more about our investment strategies: (i) High performance targeting 25% CAGR and (ii) All Weather targeting better performance than equities with similar stability as bonds.