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Private Equity’s Secret Sauce May Surprise You

November 13, 2018 By Jeremy Jones, CFA

By Africa Studio @ Shutterstock.com

In recent years pension funds have paid more and more in fees to private equity funds, but it turns out that the returns generated by the funds don’t seem to justify the high cost. Bloomberg’s Stephen Gandel reports:

The returns provide little justification for that. New York City said in its report that its private equity portfolio since inception in the late 1990s had returned about 3 percentage points less a year — 10.3 percent compared with 13.1 percent — than if that money had been invested in public markets. Private equity firms, which often show returns that exceed public markets, say this is not the point. Like so many other types of investors, they say their returns are better because they are “lower risk” and “uncorrelated” to the market. Those magic words apparently always get you far on Wall Street.

The study suggests that logic is flawed as well. To prove that, the authors came up with a novel way to calculate private equity returns. Most existing private equity indexes are based on the net asset values that private equity firms self-report, which tend to reflect the market as well as where those managers value the investments, which is likely to be higher than the market — the reason they made the investment in the first place. To get around this, the authors created their own index of returns based on how stakes of private equity investments traded on the secondary market. What the authors found is that the market’s view of the value of those portfolios, as measured by the price at which the stakes were being bought and sold, swung much more widely, and much more in lockstep with the S&P 500 and other public market indexes, than those self-reported NAVs suggested. That suggested that much more of those private equity returns were market-related. Add in leverage, and there is remarkably little return left to attribute to skill — in fact almost none, in the authors’ calculations.

Pension fund investors do seem to be realizing that investing in private equity funds is not as good as it looks. Inflows into PE funds have slowed a bit. But they are coming to this conclusion for the wrong reason. Many pension funds seem to think high fees are the problem. Recently, several of them have begun investing in private companies directly, or doing their own buyouts. Some states like California are forcing private equity firms to better disclose their fees. But the point of the study is not that the fees are too high, but that trying to beat the market with lower risk is impossible.

Private equity executives have done a good job convincing many investors that they have a secret recipe for supercharged returns. And with interest rates at historic lows, it’s no surprise that pension fund managers have turned to alternative investments to meet their projections. The problem is it’s difficult to back up the private equity sales pitch.

Read more here.

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Jeremy Jones, CFA
Jeremy Jones, CFA, CFP® is the Director of Research at Young Research & Publishing Inc., and the Chief Investment Officer at Richard C. Young & Co., Ltd. Richard C. Young & Co., Ltd. was ranked #10 in CNBC's 2019 Financial Advisor Top 100. Jeremy is also a contributing editor of youngresearch.com.
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