At The FT, Jonathan Ford reports that after 2006, private equity returns have been about the same as those from tradeable stocks. Yet, despite higher fees and lower liquidity, investors are still clamoring for private equity investments. He writes:
Academics have long questioned whether the internal rate of return (IRR) calculations favoured by buyout firms overstate their performance against quoted stocks.
Consequently, most recent studies favour the so-called “Public Market Equivalent” measure, which takes all the cash flows between the investors and a buyout fund, net of fees, and discounts them at the rate of return on the relevant benchmark (for example the stock market). On this basis, the outperformance vanishes.
A large study conducted in 2015 by three academics looked at nearly 800 US buyout funds between 1984 and 2014. They found that before 2006, these funds delivered an excess return of about 3 per cent per annum, net of fees, relative to the S&P 500 index. In subsequent years though, returns have been about the same as on the stock markets. A study of European markets produced similar results.
So why are pension fund investors continuing to pump huge allocations at private equity? Last year $301bn was poured into US buyout funds, a quarter more than the previous record set in 2017.
The investment in private equity funds that perform about the same as the market could simply be a case of cheap, abundant money chasing limited opportunities. But what happens when liquidity dries up and investors want their money back? Ford explains:
“Liquid, accurately priced investments let you know how volatile they are and smack your face with it,” he says.
Opaquely-priced and illiquid private equity, by contrast, obliterates the temptation. Just as Odysseus stuffed beeswax in his crew’s ears and had them lash him to a mast to resist the call of the sirens, pension funds use the manacles of a private equity contract to resist liquidity’s lure.
Of course, there are ways they could avoid paying up for the privilege, such as trimming that average 6 per cent fee charged by private equity.
But that presumes it is a conscious decision, not something they have slipped into almost out of habit.
Odysseus may have understood what he was doing when he had himself trussed up. But how many of the pension funds accepting private equity’s “illiquidity discount” are doing so knowingly?
Illiquidity is not costless. That is why it is supposed to be compensated. Those costs have been suppressed in recent years, when bear markets have tended to be short and sharp. But consider the impact of a prolonged 1970s style downturn. Then investors might rue the shackles they paid to don.
Read more here.