A large body of academic research (for example, here, here, here, here, here and here) demonstrates that, in general, private equity—which invests in leveraged buyouts and venture capital—has underperformed similarly risky public equities. And that’s before considering their use of leverage (particularly in LBOs) and adjusting for their lack of liquidity. However, research offers some hope, with evidence suggesting that private equity partnerships are learning—older, more experienced funds tend to have better performance with greater persistence.
The most common interpretations of this persistence are either skill in distinguishing better investments or the ability to add value post-investment (e.g., providing strategic advice to their portfolio companies or helping recruit talented executives). The research, however, offers another plausible explanation—Based on their reputational value, successful firms can charge a premium for their capital.
Reputation and the Cost of Venture Capital
The empirical research (for example here, here and here) has found that successful VC firms obtain preferential access to investments and better terms, as both entrepreneurs and other VC firms want to partner with them. That enables them to see more deals, particularly in later stages, when it becomes easier to predict which companies might have successful outcomes. It is the access advantage that perpetuates differences in initial success over extended periods of time. That access has enabled high-reputation VCs to acquire startup equity at about a 10%-14% discount, leading to a perpetuation of the advantage. However, these edges applied only to venture capital, not to leveraged buyouts.
Long-Term Private Equity Performance: July 2000 through June 2023
One of the problems with evaluating the performance of private equity is the potential for bias in the data, including self-reporting. To address this concern, Cliffwater used data provided in the Annual Comprehensive Financial Reports published by 94 state pension systems and represented the actual results achieved by large institutional investors. To achieve consistent performance measurement periods, the list of 94 was narrowed to the 65 state systems that used the same June 30 fiscal year-end date. Nineteen of the 65 state systems operated private equity portfolios for all 23 fiscal years. Private equity holdings for the study group grew from approximately $60 billion (4% of $1.6 trillion in total study assets) to approximately $500 billion (15% of $3.2 trillion in total study assets). The returns were time-weighted, avoiding problems that can occur with internal rates of return.
Cliffwater chose the period 2000-2023 not only for ease of data collection but also because it covers three full market cycles, encompassing three bear markets and three bull markets. They it created a “private equity composite” return series, calculated by taking the average of all state systems reporting private equity portfolio returns for that fiscal year. The number of state systems included in the yearly average grew steadily over the study period, from 19 to 61.
To evaluate the performance of private equity, Cliffwater created a “public stocks benchmark” by calculating a weighted average of the Russell 3000 Index and the MSCI ACWI ex-US Index, rebalanced annually. The weights varied by year based on Cambridge Associates’ reporting of U.S. and non-U.S. private equity assets for buyouts and distressed debt. The average weightings to the Russell 3000 and MSCI ACWI ex-US indices were 71% and 29%, respectively, for the entire period. The percentages were chosen to match the global allocations of the private equity investments. Yearly Russell 3000 weightings ranged from 65% to 82%.
Cliffwater found that its private equity composite returned 11% annualized over the entire 23-year period, outperforming the 6.2% annualized return for the public stocks benchmark. They also found no significant deterioration in relative outperformance over the period.
Before jumping to conclusions, a few issues should be considered. First, research (for example, here) has found that private equity funds investing in LBOs tend to select small firms with low EBITDA (earnings before interest, taxes, depreciation and amortization) multiples (value stocks). Stocks with these characteristics have historically provided higher returns due to their greater risk. With that in mind, we can compare the private equity composite return of 11% to that of 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 the outperformance is not quite as impressive (while noting that at least some of the private equity was likely international, thus understating the outperformance). In the case of the S&P 600 Value Index, the outperformance was 1.4%. For some investors, that might not be considered a sufficient enough premium to sacrifice the liquidity available in public securities. In fact, Cliffwater noted in their report that the typical benchmark for private equity by the state plans was for a 3% premium to compensate them for the illiquidity.
Second, while LBOs tend to invest in small-value companies, venture capital tends to invest in small-growth stocks. Over the same period, the Russell 2000 Growth Index returned just 5.4% and the S&P 600 Growth Index returned 8.6%.
There is, however, another issue we need to cover.
The Impact of Sarbanes Oxley
In 2002 Congress passed the Sarbanes Oxley Act. The act contains provisions affecting corporate governance, risk management, auditing and financial reporting of public companies, including provisions intended to deter and punish corporate accounting fraud and corruption. While providing benefits of increased investor confidence in published reports, the act significantly increased the costs of going public, leading many smaller companies to remain private until they grew to market capitalizations that were much higher than was the case before 2002. The result is that unless investors utilize private equity, they have less ability to invest in smaller companies, those with the greatest opportunity for outperformance.
Innovations Making Private Equity More Accessible and Competition Driving Down Fees
Recently, we have seen innovations that have made investing in private equity not only simpler but less costly. One of the negatives of private equity was that investments were generally in the form of partnerships, with investors being limited partners who received Schedule K-1s at the end of the year. The K-1s typically arrived well after the April 15 filing date, requiring extensions. The preparation of the K-1s and the need to file extensions increased the costs of investing in these vehicles. Another negative was that investors had to make commitments with capital calls coming at unknown dates, requiring them to keep liquid assets sufficient to meet the capital calls. A third negative was the expense, typically 2% plus a carry (performance) fee of 20% once returns exceeded a hurdle rate (such as 7% with catchups for years when performance was below the hurdle). And a fourth negative was often very large minimums (such as $1 million or more).
Today, fund families such as Voya, JPMorgan and Pantheon (full disclosure: I have personal investments in the latter two) have introduced what are called “evergreen” funds. These funds typically have the following attributes:
- Smaller minimum investments (for Voya, it’s just $25,000);
- Utilize 1099s for tax reporting instead of K-1s;
- No capital calls. Investments can be made on a quarterly basis, as can requests for withdrawals (which are subject to limitations, typically 5% of total fund assets);
- Can provide diversification across multiple managers; and
- To help minimize expenses, typically have significant allocations to secondaries (usually bought at discounts ranging from 8%-12%, or more in times of distress) and direct co-investments (avoiding the expenses of the originating private equity fund). For example, as of Oct. 31, 2023, almost 90% of Voya’s fund, Pomona Capital, were either secondaries or co-investments (AMG Pantheon’s allocations were even higher). Pomona’s I-shares had a management fee of 1.65% and total direct expenses of 2.4% (well below the typical 2% management fee/20% performance fee). Note that underlying manager fees do apply, but some of that is offset by the discounts available on secondaries. Even so, total costs should be well below those of a 2/20 structure.
Investor Takeaways
The research shows that private equity is one asset class where there has been evidence of persistence in performance among both the top and bottom performers. However, this advantage has been true only in venture capital, not in leveraged buyouts. In addition, because of the extreme volatility and skewness of private equity returns, it is important to diversify the risks. That is best achieved by investing indirectly through a private equity fund rather than through direct investments in individual companies. Because most such funds limit their investments to a relatively small number, it is also prudent to diversify by investing in more than one fund or in a fund that invests across multiple managers. And it’s worth considering investing in funds that focus on secondaries and co-investments to further reduce costs. Finally, if you are willing to sacrifice liquidity to gain access to the asset class, you should restrict the vehicles you consider to those investing in venture capital and require that a manager has a long history of persistent superior (top quartile) performance and relatively low expenses compared to their competitors.
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.
For informational and educational purposes and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third party data and may become outdated or otherwise superseded without notice. Third-party information is deemed reliable, but its accuracy and completeness cannot be guaranteed. The opinions expressed here are their own and may not accurately reflect those of Buckingham Strategic Wealth, LLC or Buckingham Strategic Partners, LLC, collectively Buckingham Wealth Partners. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. LSR-23-617
