Welcome to this week’s edition of Cape May Wealth Weekly. If you’re new here, subscribe to ensure you receive my next piece in your inbox. If you want to read more of my posts, check out my archive. This piece is an updated version of the two-part series originally published in spring 2024 and revised in 2025.

Last spring, I told you that private equity was still en vogue, especially with the so called "democratization" of private equity (more on that in Private Equity for the Masses). At that time the trend towards a higher share of illiquid, 'private' assets within client portfolios continued at a steady pace. 

The main reason for the success of private equity over the last decade was likely being the performance thrown around by both GPs and fintech platforms. But as I’ve also written before, those performance figures should be taken with a grain of salt: The often-used “IRR” metric used by private equity (and other private asset classes) differs significantly from the cash-on-cash returns of public equities. Hence, investors need to ensure that they are comparing apples to apples, and to subsequently ensure that they are being properly compensated for the risks and illiquidity that private equity brings.  

However, things look somewhat different today. After a couple of years of buyout funds underperforming public equities, a fundraising environment that has been much more difficult, and distributions to LPs sitting near their lowest levels since the global financial crisis, investor enthusiasm has cooled. Even Yale, the institution most associated with the illiquidity-heavy “endowment model”,  has moved to sell several billion dollars of PE stakes on the secondary market for the first time in its history. 

None of this means private equity is a bad investment. Markus and I continue to be constructive on the asset class - albeit cautiously so. But that raises an important question: What (excess) return should investors expect from private equity, especially in relation to its public counterpart? And what drives this outperformance - is it the often-mentioned “illiquidity premium”, or another factor? Lastly, if there really is a stable source of excess return, is it simply a consequence of a structural advantage inherent to private equity, or are there actually additional risks that investors should be aware of?

But before we can answer these questions, let’s take a look at something slightly different: At how academia looks at performance. 

The very basis of risk and return is that if you accept a higher risk, you should expect a higher long-term return. Historically, the “Capital Asset Pricing Model” (CAPM) suggested that the performance of public equities can be explained by just two factors: the risk-free rate (i.e. the interest rate on “risk-free” cash or government bonds) and the equity market risk premium. Depending on whether a stock or a portfolio of stocks was more (or less) risky than the overall market, you could expect a higher (or lower) return.

Curiously enough, certain types of stocks have continuously performed better or worse than the simple logic of CAPM would predict. More clarity arose through the discovery of so-called “factors”, including but not limited to Value, Small Size, or Momentum, which could better explain stock performance. But beware: they can and will underperform for prolonged periods of time before they deliver the desired excess return. They are called “risk premia”, after all.

This brings us back to the "illiquidity premium": pairing CAPM with those factors, we should be able to better understand the performance drivers of private equity. And if additional unexplained performance remains after accounting for those factors, it might be the elusive illiquidity premium, which is supposed to compensate an investor for taking on the risk of an illiquid as opposed to a liquid investment.

And indeed, some of those factors do help explain PE's historical performance:

Small Size Factor: smaller companies' stocks outperform larger ones', even when adjusted for their higher volatility.

Value Factor: cheaper stocks outperform more expensive ones. The PE industry is particularly focused on low EBITDA purchase multiples as a key measure.

Leverage: PE firms use borrowed money and aim to generate returns above their funding costs. This can boost returns dramatically, but equally increases risk.

Low, positive profitability: while not a traditional academic factor, PE firms have shown a clear selection preference for companies that have low but positive earnings, leaving room to grow profitability over the holding period.

From a practical standpoint, this sounds about right: PE tends to buy smaller businesses with more growth and optimization potential (“Small Size,” “Low, positive profitability”). They usually do so at lower valuations (“Value Factor”), and often facilitate those transactions through the use of debt funding (“Leverage”). The implication is that much of what gets attributed to “operational value creation” may actually be systematic factor exposure that a sophisticated investor could, in theory, replicate in public markets.

But of course, we don't just want something that sounds right in theory. We want real-world data to show us whether PE actually managed to outperform its public counterpart, and how much risk those investments entailed.

Academia has been tackling the question of PE's long-term performance and risk with increasing rigor, and several papers stand out.

The first paper was published by investment firm AQR, in which they converted PE returns into cash- and time-weighted figures and compared them to its public counterparts. They show that from 1986 to 2017, the Cambridge US PE benchmark (which shows the aggregate performance of a large number of US buyout funds) posted a 9.9% p.a. return. During the same time period, the S&P 500 averaged 7.5% p.a. It’s an impressive difference, especially if assuming a 30-year compounding. (We also see this in updated figures by Cambridge Associates through year-end 2025, which showed a 20-year annualized return for US PE of 13,2% compared to 9,2% for the MSCI World and 8,7% for the Russell 2000. In other words, a 20-year annualized outperformance of roughly 4%).

It is worth noting that the S&P 500 does not reflect PE’s bias for small, value stocks: AQR used the standard academic factors to construct a small-cap value strategy in public equities, which would’ve yielded average returns of 11.4% in the same time period - ahead of private equity. (Perhaps worth noting that AQR founder Cliff Asness is not necessarily known as a fan of private equity - which I understand, but only to a degree.)

The second paper comes from Harvard University, which analyzed nearly 700 public-to-private transactions by PE firms from 1984 to 2017 in order to understand PE selection criteria and construct a replicating portfolio in public equities. Using 2x portfolio leverage, comparable to the analyzed PE transactions, their replicating portfolio saw volatility of around 27% and a maximum drawdown of -78%. Roughly twice the numbers you get for the S&P 500. Harvard's fictional portfolio also achieved a higher return than the PE benchmark: 14.8% p.a. net IRR versus 11.4%.

To us, there are three takeaways:

First, that PE success, on average, is less driven by operational efforts (the often-mentioned “value-add”) and more by systematic factor exposure. One view to support this comes from Dan Rasmussen of Verdad Research, who invests into public equities according to a similar approach after he discovered during his time at PE giant Bain Capital that most of PE profits were driven by cheap deals, and not other factors such as management or company quality. 

Second, that PE is much more volatile than many GPs say. Markus and I have seen more than one "chart crime" where GPs show PE outperforming public equity with lower volatility because they compare public equities with daily mark-to-market pricing against PE's quarterly NAVs. The Harvard paper suggests a more realistic picture, with PE volatility (i.e. the ‘risk’ of the asset class) approximately twice that of public equities. 

Third, that the academics need to be mindful of the differences in how leverage is implemented in both PE and the replication portfolios. Anyone invested into risky small caps would almost certainly face a margin call, if not much more likely a liquidation, when incurring a 78% maximum drawdown. At the same time, maximum drawdown or changes in value matter a bit less in a loan to a PE-backed asset. As long as debt and interest keep on getting paid, and as long as the company isn’t worth less than the outstanding loans, they’d likely prefer working with you to see their debt repaid rather than push the company into default.

We do have two sets of numbers to work with as anchors: AQR's 2.4% p.a. PE outperformance on a time- and money-weighted basis, and Harvard's 1.8% p.a. PE outperformance on an IRR basis versus the S&P 500. The average PE investment has, historically, outperformed public equities though with considerably more risk, and with fees that some studies estimate at as much as 6% p.a. in aggregate (split across management fees, carry, and portfolio-level costs).

So let us rephrase our initial question: What (excess) return should an investor expect to be properly compensated for the risk they are taking? There are two ways to approach this, practically, and quantitatively.

While any investment decision should in the end be made on quantified, rational behavior, it can be worth also looking at things in simple, practical ways. The same applies for private equity. Let’s look at two practical approaches that we’ve encountered.

First, was when an entrepreneur client compared a PE fund investment to a different type of PE investment - their own company. They had made their money as a private equity investor (think roll–up / buy & build / ETA), and had done tremendously well. Accordingly, new PE investments, whether fund or direct, had to compare themselves to how well he had done - translating to a return expectation of 25% p.a., if not higher. 

While understandable, we would struggle to support that figure. First, for every successful entrepreneur that achieved such returns, there are eight or nine others who failed with their business, so 25% p.a. might be an unreasonably high bar. Second, even assuming that some companies can achieve such a return, it’s unlikely that a diversified portfolio (which you would always try to have as a PE investor) as a whole can achieve such returns.

Secondly, and essentially the ‘other extreme’: If an investor believes that an illiquid investment can outperform its liquid counterpart by just 1% p.a., and is not reliant on investing this capital in liquid assets, it is unsurprising that they might aim to maximize their allocation to illiquid assets.

From our point of view, an adequate PE return goal is probably somewhere in between. To me, 25% p.a. can never be a realistic return assumption without having capital at serious risk of loss. But equally, just 1% higher returns might probably not be worth the significant work involved in managing a PE portfolio, unless your portfolio is very large. Most of the experienced PE investors that we speak with aim for a long-term excess return of 2-4% p.a., and/or an absolute return of 10% p.a. over a 10-year period. We would also agree with that figure as a reasonable (excess) return goal.

As we outlined, both AQR and Harvard saw a return difference between public and private equity of about 2.0% to 2.5% p.a. At the same time, we highlighted that private equity has been much more risky than public equity on a number of factors, one of them being leverage.

The average PE buyout fund uses 100% to 200% of leverage, meaning that for every dollar of equity they invest, they would borrow one to two additional dollars. When looking at the PE replication portfolios created by AQR and Harvard, such levels of leverage are challenging for an investor into publicly listed, small-cap stocks. To get to the Cambridge US PE benchmark return of 9.9%, we would’ve needed to add “just” ~60% leverage to our unlevered S&P 500 return of 7.5% to achieve the same returns.

While of course riskier than a traditional public equity investment, the leverage and the volatility of a leveraged S&P 500 investment is still lower than the actual leverage employed by the average PE fund, and their assumed volatility. If we trust the backtests, some of the mentioned small-cap strategies even achieved average PE returns without the use of leverage. (I yet have to find a PE relocation strategy that has managed to translate backtest returns into real-world returns, but that’s for another time.)

Lastly, our analysis wouldn’t be complete to also highlight a key characteristic of private equity: Illiquidity. Your liquid investment, even if it’s leveraged, can be liquidated on a daily basis, something that private equity does not offer (although the rise of so-called Evergreen Vehicles is changing that to some degree). Accordingly, the required excess return should be even higher than the figures that we’ve shown you in this piece.

Which brings us back to the question of the illiquidity premium: Does private equity properly compensate investors for having their capital locked-up as opposed to investing in public, tradable equity? 

For the average (!) private equity investment, the academic answer today is no. Practically, you might be able to add modest leverage to an equity portfolio to achieve returns that are close to the long-term returns, without the complexity or illiquidity. (It’s because of those reasons that I am sceptical around retail-oriented PE products, but they translate equally to affluent investors. More on that here.)

After reading this, you might rightfully ask yourself: Why should I even bother with Private Equity if I can get the average PE return through a less risky, liquid equity investment? The answer to that is a key aspect of private equity: So-called Manager Selection, or in other words, the practice (and art) of picking the right active managers, from which you expect outperformance and/or superior risk-adjusted returns.

In private equity, “passive index funds” don’t exist, given that an individual PE fund tends to have much fewer underlying companies (10-20). Accordingly, investors need to invest significantly more time in identifying, screening and accessing high-quality managers (or at least a high-quality fund of funds), out of which they then try to build a sufficiently diversified portfolio, and which can hopefully generate long-term outperformance ascribed to private equity.

To assess the impact of manager selection, we can use a paper by the National Bureau of Economic Research (NBER), in which the authors compare managers based on the “public-market equivalent” (PME). In the PME method, you assume that fund capital calls are invested into a comparable equity index, which is sold when distributions take place. If PME equals 1, a PE fund generates returns identical to investments in the S&P 500 at similar points in time.

Using the results of the NBER paper, we can see how well private equity might need to perform to be worth the effort. As we outlined in the prior section, an average PE fund investment might offer worse relative risk-return given that PE, on average, uses 100% to 200% leverage, while a leveraged S&P 500 investment would “only” require 60% leverage to reach the same return (while also offering daily liquidity). 

However, as we move from average into first- and second-quartile returns, our S&P 500-based replication becomes more challenging: second-quartile return replication would require 125% leverage (already in the same range as PE), and first-quartile return replication would require a whopping 287% leverage to have historically achieved equivalent returns. At those levels, using a traditional margin loan makes it almost certain for such a leveraged portfolio to hit margin calls even during a small drawdown. It becomes clear that a first- or second-quartile PE fund might really be able to achieve returns that could be seen as risk-appropriate.

So you might think that it’s easy - you just have to pick first- and second-quartile managers. Of course, which it isn’t, which the NBER paper shows as well: With the performance data at the time when investors committed allocations to the next fund vintage, there was no telling how the following fund would perform quartile-wise.

But there’s a glimpse of hope: The paper was able to show that fourth-quartile managers were more likely to stay below average. As third-quartile managers perform roughly in-line with public equities, being able to at least avoid future fourth-quartile managers might mean that a PE portfolio should, in theory, at least achieve public-market equivalent performance, with a chance at risk-adjusted outperformance. 

After everything we analyzed and discussed, the conclusion may still be simple.

Always remember that both public and private equity investments are long-term oriented. Accordingly, if you are looking to invest for 10, 20 or even 50 years, illiquidity ideally should not concern you as long as you are properly compensated, especially on the risk-adjusted basis as outlined here. Illiquidity might even help or force you to leave emotions aside and stay committed when markets go against you.

In general, we continue to be cautiously optimistic towards private equity. After all, historical data has shown that the average private equity fund has managed to achieve excess performance over equities (although of course with a higher level of risk). So taking into account the last paragraph in our prior section, a diligent, long-term private equity investor should be able to at least achieve long-term equity returns (at higher risk), with a chance at outperformance if you end up investing in a few first- and second-quartile managers along the way as well.

But even with that hopeful message in mind, we want to give a final word of advice to our readers: Think about whether investing in private equity is worth the effort and risk. If you are looking to boost your returns, and/or diversify your equity exposure by moving from public to private, private equity can indeed be a relevant building block. However, consider carefully whether you can really stomach the long-term illiquidity and the challenges of liquidity management. And most importantly, think about your Investment Objectives.

Many of our clients ended up doing well with private equity - but only if they had the endurance to keep investing in tough times in the market. If you’re not sure if you can show the same tenacity, and if you want to put in the effort to access great managers, perhaps the winning move might be not to play.

Considering an allocation to private equity, but unsure whether individual fund commitments, a fund of funds, or an evergreen structure is the right fit for your situation? We help clients navigate the spectrum of PE access - don’t hesitate to reach out to us.

Disclaimer: Historical returns are no indicator of future performance. This article is provided for educational purposes only and does not constitute investment advice.