Private Equity: Is the Edge Still There?

Private equity: is the edge still there? If you’re a private equity professional, this question is probably instills one of two feelings inside you.

First, it could strike fear into your heart as you attempt to raise funds for new investments.  Why would people invest in an illiquid asset class if the promised return is not measurably higher than competing, liquid asset classes? 

Second, and counter to the first, this question could install in you a feeling of drive.  If you know that the answer to the question is almost assuredly no, then there’s nothing to fear.  You could confidently go out and sell investments into private equity as a way for investors to realistically expect higher returns over time.

Well, what is the answer to the question – Private equity: is the edge still there?

Here’s a look, based upon information put together by AQR Capital Management and discussed on Private Equity International.

What did AQR Capital Management do to evaluate the question?

AQR Capital Management took returns of the private equity industry from 1986 to 2017 and compared them to the returns of competing asset classes, such as the S&P 500 and small cap value stocks. 

What did they find?  AQR Capital Management found that, on an arithmetic basis, private equities generally offered a small amount of potentially higher return compared to some asset classes, while underperforming other, more comparable asset classes.

Their study’s results follow.

Overall, the Cambridge Private Equity buyout class and the Cambridge Private Equity de-smoothed buyout class provided investors 9.9 percent and 9.9 percent returns, respectively.  By way of comparison, the S&P 500 returned 7.5 percent over this period.  

The Russell 2000 returned 7.6 percent, the 1.2x Russell 2000 returned 9.1 percent, and the Russell 2000 Value returned 8.5 percent.  These three were bested by the private equity industry’s returns.

Interestingly, a more reasonable comparison would be small cap stocks, such as the Fama French small cap value stocks.  These small cap value stocks bested the private equity industry’s return at 11.4 percent.  Tough to sell investment in an illiquid asset class when there’s a publicly traded alternative that bested private equity’s return.  Hmm.

The Geometric View

What about a geometric view of the data?  Any difference there?

The following figure contains the results.

In the geometric case, private equity performed on top.  The Cambridge Private Equity (US buyout) non-de-smoothed provided investors a 9.8 percent return.  This beat the Fama French small value stocks by 0.4 percentage points.

What are the reasons for the decline in the private equity risk premium?

Overall, the net-of-fee expected returns of the private equity industry has declined over the years.  What might be causing this?

The authors speculate that a few issues are at play.  First, increasing investor demand has driven up PE valuations.  Second, PE returns tend to be lower following hot vintage years.  Third, competition for deals has made it difficult for PE to deliver market-beating returns.

Conclusion

Overall, as one might have expected, it depends upon how return is measured in order to answer the question of whether private equity has lost its return edge.