A commonly held belief is that private equity investments outperform other types of investments in terms of the returns they generate. Based on the expectation of outperformance relative to public markets, for over 30 years institutions like pension funds and endowments have allocated ever-increasing amounts of money to private investments. However, recently more and more research seems to indicate that these returns are diminishing, and the returns might not even have been as excessive as they first appeared.
To discuss private equity returns, we should first make sure we fully understand the structure of funds and how they generate returns. A private equity fund consists of general partners (GPs) and limited partners (LPs). The GP manages investments, owns shares in the fund, and has full liability. The LPs, or the investors, own the majority of the shares in the fund and have, as their name suggests, limited liability.
The PE fund invests in companies, which are then called portfolio companies, and acquires most of their equity. In case debt is used to help finance this transaction, we speak of a leveraged buyout (LBO). A return on investment is generated by making portfolio companies leaner or cutting costs, improving management, and financial engineering. The profits generated by the portfolio companies are distributed to the fund in the form of dividends and additional return on investment is achieved when the portfolio company is sold (exited) at a higher price than it was acquired for.
To measure the return of public equities or stocks, we simply compare the current price of the equity and the price at the time of the investment, to which we add dividends. For private equity, measuring the return is not as straightforward. Money is taken from the PE fund when investment opportunities are spotted, which can be at irregular times. Funds also generally don’t start paying dividends right from the start and the height of dividends can vary significantly per year as well. Because of these facts, the performance of funds is measured by calculating an IRR. This IRR cannot be compared directly to the return of public equities, which is often depicted as R.
In order to compare the returns of private equity to public equity, scholars have created the so-called Public Market Equivalent (PME). How this measure works is that it discounts private equity cash flows using a public equity index return as the discount factor. In other words, the cash flows from a PE fund are “invested” in a stock index. If this results in a number higher than 1, PE outperforms the stock index.
A paper recently published in the Journal of Investing by Dennis R. Hammond (2020) used a certain version of the PME measure, the modified PME, to compare private equity returns to common stock market indexes. Their goal was to determine whether private equity funds actually deliver the amazing returns they are often thought to do. As it turns out, they don’t. The authors showed that average endowments actually earn less on their private investments than they would do simply investing in the S&P 500. This result is quite remarkable, because these private investments are highly illiquid, and we would expect a great return to compensate for this. In addition to that, PE investments are quite risky. This risk is often masked using smart accounting practices. The results of the study suggest investors are not compensated for this risk as well.
This result is of course very interesting, but what is even more interesting is the position that GPs have in this story. While the LPs, endowments, for example, don’t seem to get compensated enough, things are different for GPs. They charge two fees: a performance fee and a management fee. The performance fee is a certain percentage of the profits on investments, usually in the region of 20%. The management fee is charged for managing the fund, whether it is successful or not. With fund sizes running in the billions, it is easy to see how an average management fee of 2% per year can earn GPs some real money. Whereas in 2005 PE so far had only created 3 multibillionaires, in 2020 this number has grown to 22 (Phalippou, L., 2020)! It’s a lucrative job, but maybe not such a lucrative investment.
Hammond, D. R. (2020). Should Endowments Continue to Commit to Private Investments? The Journal of Investing, 30(1), 41–62. https://doi.org/10.3905/joi.2020.1.154
Phalippou, L. (2020). An Inconvenient Fact: Private Equity Returns & The Billionaire Factory. SSRN Electronic Journal, 1–37. https://doi.org/10.2139/ssrn.3623820