A large body of academic research (e.g. here, here, here, here, here and here) shows that, in general, private equity investments in leveraged buyouts and venture capital underperform similarly risky public equities. This is before taking into account their use of leverage (particularly leveraged buyouts) and adjusting for lack of liquidity. However, Research Offering some hope, there is evidence that private equity partnerships are learning – with older, more experienced funds tending to achieve better results through more sustained efforts.
The most common explanation for this persistence is skills that distinguish better investments or the ability to add value after an investment (e.g., providing strategic advice to its portfolio companies or helping to recruit talented executives). However, this study offers another plausible explanation – that successful companies can charge a premium for their capital based on the value of their reputation.
Reputation and the cost of venture capital
Empirical studies (e.g. here, here and here) finds that successful venture capital firms receive priority investment opportunities and better terms because entrepreneurs and other venture capital firms want to work with them. This allows them to see more deals, especially in later stages, when it’s easier to predict which companies are likely to succeed. It is the access advantage that makes the difference in initial success persist over long periods of time. This access allows well-known venture capital firms to acquire equity in new startups at a discount of approximately 10%-14%, thereby extending the advantage. However, these advantages only apply to venture capital and not to leveraged buyouts.
Long-term private equity performance: July 2000 to June 2023
One of the problems with assessing private equity performance is the potential for bias in the data, including self-reporting. To solve this problem, cliffwater Data provided during use Annual Comprehensive Financial Report Published by 94 national pension systems and represents actual conditions Results achieved by large institutional investors. To achieve a consistent performance measurement cycle, the list of 94 state systems was narrowed to 65 state systems that use the same June 30 fiscal year end date. Nineteen of the 65 state systems operated private equity portfolios in all 23 fiscal years. The research group’s private equity holdings increased from approximately $60 billion (4% of total research assets of $1.6 trillion) to approximately $500 billion (15% of total research assets of $3.2 trillion).Returns are time weighted to avoid question This can happen with internal rate of return.
Cliffwater chose the period from 2000 to 2023 not only to facilitate data collection, but also because it covers three complete market cycles, including three bear markets and three bull markets. They created a “private equity composite” return series, calculated by averaging all national systems reporting private equity portfolio returns for that fiscal year. The number of national systems included in the annual average grew steadily during the study period, from 19 to 61.
To assess private equity performance, Cliffwater creates a “public equity benchmark” by calculating a weighted average of the Russell 3000 Index and the MSCI ACWI ex-U.S. Index, which is rebalanced annually. Weightings vary by year, according to a Cambridge Associates report on U.S. and non-U.S. private equity asset acquisitions and distressed debt. Over the entire period, the average weightings of the Russell 3000 Index and the MSCI ACWI ex-US Index were 71% and 29% respectively. The percentages were chosen to match the global allocation of private equity investments. The Russell 3000 Index weight ranges from 65% to 82% each year.
Cliffwater found that its private equity composite index returned 11% annually over the full 23-year period, beating the public equity benchmark’s 6.2% annualized return. They also found that relatively excellent performance did not deteriorate significantly during this period.
Before drawing conclusions, several issues should be considered. First, research (e.g. here) found that private equity funds investing in leveraged buyouts tend to choose small companies (value stocks) with lower EBITDA (earnings before interest, taxes, depreciation, and amortization) multiples. Stocks with these characteristics have historically provided higher returns because they are riskier. With this in mind, we can compare Private Equity’s combined return of 11% to the Russell 2000 Value Index’s return of 8.6% and the S&P 600 Value Index’s return of 9.6% over the same period.Now, performance isn’t that impressive (also noting that at least some private equity may be international, so endostating excellent performance). For the S&P 600 Value Index, the outperformance was 1.4%. For some investors, this may not be enough to sacrifice the liquidity of public securities. In fact, Cliffwater noted in the report that the typical benchmark for state plans on private equity is a 3% premium to compensate for its lack of liquidity.
Secondly, leveraged buyouts tend to invest in small value companies, while venture capital tends to invest in small growth stocks. During the same period, the Russell 2000 Growth Index returned only 5.4%, and the S&P 600 Growth Index returned 8.6%.
However, there is another issue we need to discuss.
Impact of Sarbanes-Oxley Act
In 2002, Congress passed Sarbanes-Oxley Act. The bill contains provisions affecting corporate governance, risk management, auditing and financial reporting of public companies, including provisions designed to deter and punish corporate accounting fraud and corruption. While the act increased investor confidence in published reports, it significantly increased the cost of going public, causing many smaller companies to remain private until their market capitalizations were well above pre-2002 levels. The result is that, unless investors leverage private equity, they are less able to invest in smaller companies that are most likely to outperform.
Innovation makes private equity more accessible, competition lowers fees
Recently, we’ve seen innovations that make private equity investing not only easier, but also less expensive.One of the disadvantages of private equity is that investments are generally made in the form of partnerships, where investors are limited partners who receive Schedule K-1 End of the year. K-1s often arrive well after the April 15 filing date and require extensions. K-1 preparation and the need to file for extensions increase the investment cost of these vehicles. Another negative is that investors must commit to capital requirements at an unknown date, requiring them to retain sufficient liquid assets to meet the capital requirements. The third negative is fees, which are typically 2%, plus a 20% arbitrage (performance) fee once the return exceeds the threshold rate (e.g., 7% on multi-year catch-up when performance is below the threshold). The fourth negative factor is usually a very large minimum (such as $1 million or more).
Today, fund families such as Woya, JPMorgan and Pantheon (Full disclosure: I am personally invested in the latter two) So-called “evergreen” funds were introduced. These funds typically have the following attributes:
- The minimum investment is small (for Voya, just $25,000);
- Use 1099 instead of K-1 to file taxes;
- There are no capital requirements. Investments can be made on a quarterly basis, and withdrawals can be requested (with limits, usually 5% of the fund’s total assets);
- Can provide diversity across multiple managers; and
- To help minimize expenses, there are often large allocations to secondary markets (often purchased at a discount of 8%-12%, or even higher in hard times) and direct co-investments (avoiding the fees of the original private equity fund). For example, as of October 31, 2023, nearly 90% of Voya’s fund Pomona Capital was in secondary investments or co-investments (AMG Pantheon’s allocation was even higher). Pomona’s I-share management fee is 1.65%, and total direct expenses are 2.4% (well below the typical 2% management fee/20% performance fee). Please note that underlying manager fees do apply, but some of these fees are offset by discounts available in the secondary market. Even so, the total cost should be much less than the cost of a 2/20 structure.
Important points for investors
Research shows that private equity is an asset class where there is evidence of sustained performance by both the best and worst performing companies. However, this advantage only exists in venture capital, not in leveraged buyouts. In addition, because private equity investment returns are highly volatile and skewed, it is important to diversify risk. The best way to achieve this is through indirect investment through private equity funds, rather than through direct investment in individual companies. Since most such funds limit their investments to relatively small amounts, it is also prudent to diversify by investing in multiple funds or investing in funds from multiple managers. It’s worth considering investing in funds that focus on secondary investments and co-investments to further reduce costs. Finally, if you are willing to sacrifice liquidity for access to an asset class, you should limit the vehicles you consider to those that invest in venture capital and require managers with long-term sustained superior (top quartile) performance and relatively low history record. Fees compared to competitors.
Larry Swedroe is director of financial and economic research at Buckingham Strategy Wealth, LLC and Buckingham Strategy Partners, LLC.
Provided for informational and educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. Some information is based on third-party data and may be outdated or superseded without prior notice. Third-party information is deemed reliable, but its accuracy and completeness cannot be guaranteed. The views expressed here are his own and may not accurately reflect the views of Buckingham Strategic Wealth LLC or Buckingham Strategic Partners LLC (collectively, Buckingham Wealth Partners). Neither the U.S. Securities and Exchange Commission (SEC) nor any other federal or state agency approved, determined the accuracy, or confirmed the adequacy of this article. LSR-23-617
