Is Private Equity Fooling Investors?

A recent CFA Institute article considers whether private equity (PE), which it describes as the most popular alternative asset class, provides “uncorrelated  returns relative to equities.”

Here are some key takeaways:

  • The absence of performance metrics for alternative assets classes makes it difficult to analyze PE returns, the article says, and “creates an information asymmetry that favors the asset manager over the investor.”
  • PE returns are reportedly calculated by “money-weighting them in contrast to the time-weighted returns of public markets,” which are not directly comparable. CFA Institute compared the internal rate of returns (IRRS) of US private equity funds, their public market equivalents and S&P 500 returns between 1994 and 2017 and found that PE “outperformed their public market equivalents between 1994 and 2005, but not much thereafter.”
  • CFA Institute can replicate PE returns by constructing an index targeting “small and undervalued firms that can be leveraged” that tracks the US Private Equity Index’s performance, provide daily liquidity and charge low fees, “all  of which is preferable to locking up capital for years and paying high management fees.”
  • The replication index, however, shows “much more volatility” that the US PE index, in part because PE firms report performance on a quarterly basis. The article argues, “However, there is no reason, other than intrinsic self-interest, why private equity firms cannot provide daily valuations for portfolio companies using public market multiples.”
  • Since PE funds represent equity positions in corporations, the article asserts, their low volatility “must be artificial, the product of smoothed valuations. Private equity portfolio companies are influenced by the economic tides just as much as public companies, even if they don’t want this reflected in their valuations.”
  • If PE returns are exaggerated and their volatility understated, the article notes, perhaps the appeal lies in a low correlation with the public market. It argues, however, that this only holds true in an equity-bond portfolio. Once public market equivalent returns are compared, it adds, “the correlation becomes positive and elevated.”

The article concludes that, while PE has generated strong returns in recent decades, “that track record was fueled in part by increasing valuation multiples and falling financing costs, tailwinds that may not hold since multiples tend to mean-revert and interest rates “can hardly fall much further.”