The Quantitative Approach to Private Equity (Part 2)

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 week’s article was first published in April 2024.

In last week’s edition, we tried to make sense of private equity’s historical performance. From a simple comparison, the average private equity fund managed to outperform broad stock indices, like the S&P500. But as always, things aren’t so easy: Such a simple comparison doesn’t take into account the differences in risk, where we were able to demonstrate that private equity is more concentrated in companies with certain common characteristics, and that PE uses significant amounts of leverage to boost returns. 

With that newfound knowledge, we want to look at our original question: What (excess) return should an investor expect from their private equity investment to be properly compensated for the risk that they take?

We’ll consider it from two perspectives: First, the practical viewpoint, and then, the quantitative viewpoint.

The Practical Viewpoint

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.

The first practical viewpoint that I experienced was when an entrepreneur compared a PE fund investment to a different type of PE investment. Entrepreneurship, or more specifically, his own business. Many individuals who end up investing in private equity built their business as a private company (with or without funding) and have seen the associated challenges, just as electing the right management team or picking the right growth initiatives. Accordingly, some entrepreneurs voiced to me that the return they achieved on this business (which can be tremendous given the initial investment might just be their notional capital) is their true benchmark for private equity, which can be 25% p.a. before fees or even higher. In other words, significantly above public equities, as well as the private equity figures we previously shared).

However, if one were to use this 25% p.a. figure as a reference, there’s two things to keep in mind: First, for every successful entrepreneur that achieved such returns, there are 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.

On the other side, a much more pragmatic viewpoint: If an investor believed 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. Of course, there is no guarantee that the historical outperformance of illiquid investments will continue, and investors might underestimate if and when they actually require liquidity at a future point in time. In addition, it brings us back to our previously mentioned point on risk-adjusted returns, under which the average PE fund might actually struggle (but more on that below).

From my 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. Instinctively, that seems right to us as well.

But that’s just our expectation. What is the necessary excess return? For that, we finally turn to academia one more time.

The Quantitative Viewpoint (and the importance of Manager Selection)

As we outlined last week, 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. (Of course, leverage can vary significantly, ranging from no to little leverage for small-cap funds to 7-10 ‘turns’ (i.e. multiples of EBITDA) of leverage for very large buyouts.) As we also outlined in the last post 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, but as I also mentioned last week, I’ve yet to see a strategy maintaining those returns over a long period.

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. 

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.

Manager Selection: What it takes for PE to be worth the effort

In public equities, manager selection has become less important than it used to be, especially for retail investors, as the many studies that outline the challenges of active management drive investors to easily accessible index funds. In private equity, such products 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. Whether those returns are luck or truly manager skill is a question that is hard to answer, but 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 at least achieve public-market equivalent performance, with a chance at risk-adjusted outperformance. Of cour

Does Private Equity make sense for you?

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. Said differently, private equity is simply an asset class that offers more risk for a chance at higher returns. 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, as explained last week) - unlike its close peer of venture capital, where historically a simple index fund actually bet the average venture capital fund for long periods, not even taking into account the higher 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 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: Yes, private equity has a chance at offering higher returns through higher risk - but if your return target is actually achievable through less risky, public options, consider whether the chance at a slightly higher return really is worth the effort. 

More often than not, not just the lower-risk, but lower-effort investment might be a better way to go.

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