The Private Equity Pitch

huge amounts of capital have been flowing into private Equity even Vanguard the hero of low-cost index investors everywhere has started making private Equity available to some of its customers according to Vanguard private equities significant illiquidity and market dynamics provide suitable investors the opportunity to earn long-term excess returns while increasing portfolio diversification through expanded Equity Market coverage this is the private Equity pitch in a nutshell it's obvious theoretically that illiquid Assets in markets that are more difficult to access would have higher expected returns and opportunities for managers to add value by bringing new information to the market possibly even enough to justify the high fees which are estimated at around six or seven percent all in I'm Ben Felix portfolio manager at pwl Capital and I'm going to tell you what anyone trying to sell you on private Equity does not want you to hear the most studied segments of private Equity fall into two categories buyouts which is usually what people mean when they say private equity and Venture Capital without getting too into the details buyouts tend to be investments in later stage companies where the fund purchases the entire business well venture capital is earlier stage and typically buys only a portion of companies by assets buyouts are by far the largest segment of the private Equity Market evaluating the performance of private Equity is not straightforward illiquid assets with lumpy cash flows cannot simply be compared to the returns of a public Equity index private Equity performance is often presented as an irr an internal rate of return irrs though are not typically comparable to the time weighted rates of return that most investors are used to seeing I won't get into the technical details but stated simply irrs are not investment returns and should not be compared to them they're also easily manipulated due to the well-known issues with irr other metrics are used to evaluate private asset performance one metric is the multiple of money which simply takes the sum of all cash inflows and divides them by the cash outflow when the initial investment was made the other introduced by Kaplan and Shore in 2005 is the public market equivalent or pme the pme Compares the results generated by a private Equity strategy to that generated by a benchmark index assuming the same amounts were invested with the same timing for example a pme of 1.2 would indicate that the private Equity strategy beat The Benchmark by 20 cumulative over the holding period importantly the pme is sensitive to its Benchmark Choice a pme of 1.2 relative to the S P 500 May simply represent a small cap premium and a small cap index might give a pme closer to one for the same investment another important Nuance here is that the Russell 2000 a small cap index is often used as the small cap Benchmark for pmes but the Russell 2000 is well known for being the worst performing small cap index available the 2014 paper private Equity performance what do we know studies the performance of nearly 1400 buyout and Venture Capital funds and finds a sample average of 1.2 relative to the S P 500 equivalent to a more than three percent per year excess return they also test performance relative to the NASDAQ Russell 2000 and Russell 2000 value indexes and find that the other performance results are robust though measured against the Russell 2000 value the pme drops down to 1.07 now I'm just a guy on YouTube and this paper was published in the Journal of Finance but I have a nitpick over the period studied in the paper the Russell 2000 value index which gave the lowest pme of all indexes used in the paper underperforms other small cap value indexes like the s p small cap 600 value index the msci U.S small value index and the dimensional U.S small cap value index by a wide margin with these other benchmarks those pmes start to look a lot closer to or maybe even below one for Venture Capital individually the authors find a sample average pme of 1.2 the same as the full sample average but venture has an important difference in the way fund returns are distributed the median Venture fund the fund in the middle when all funds are sorted by performance delivers a pme of 0.88 it underperformed public equities by a lot this is a Telltale sign of a skewed distribution a distribution where relatively few outliers heavily influence the average this is important in evaluating the asset class because I'm sorry to tell you you probably can't access the best performing Venture Capital funds based on that the sample median in venture capital is likely more relevant for most investors since those outliers driving the average aren't accessible Venture Capital has a big adverse selection problem the best funds tend to perform exceptionally well and be persistently good but most investors can't access the best funds making Venture relatively unattractive for most investors unlike in public markets or in buyouts which do not demonstrate persistence meaning good Managers from the past don't continue to be good there is evidence of persistence in Venture Capital funds but the best funds have limited capacity and pretty exclusive access importantly for investors today the authors of this paper also find that for both buyout and Venture Capital funds absolute performance and performance relative to public markets are negatively related to aggregate Capital commitments 2021 was a massive year for both private equity and Venture Capital likely related to the increasing interest in private assets the authors of the 2020 paper demystifying illiquid assets expected returns for private Equity demonstrate that the valuation multiples in private Equity markets have been rising driving down their expected returns historically as the valuation gap between public and private equities has declined the future Returns on private equities relative to public equities has also declined in the 2020 paper An Inconvenient fact private Equity returns and the billionaire Factory Ludovic falipu shows the historical performance of private equity in Aggregate and buyouts separately for vintage's 2006 through 2015 for the period ending December 2019 overall the findings in his paper suggest that private Equity Funds have generated returns that are about the same as public Equity indexes since at least 2006. for fund vintages 1996 to 2005 private Equity has delivered pmes well above one when compared to the S P 500 but only slightly above one compared to more risk appropriate small cap benchmarks for fund vintages 2006 to 2015 private equity in aggregate has generally trailed small cap public equities while buyouts have had a slight Edge falipu also shows that the reported private Equity multiples of money for five Pension funds from Investments made between 2006 and 2015 are similar across all Pension funds similar to the aggregate data and also similar to public Equity indexes over the same period finally the paper analyzes the big four private Equity firms Apollo Blackstone Carlisle and KKR and finds that their net multiples of money for vintages 2006 to 2015 are remarkably similar to the aggregate data which to reiterate are not much different from public equities speaking to the cheeky title of his paper falipu points out that while private Equity as an asset class has not delivered much value to investors after fees private Equity as an industry has minted 19 new billionaires from 2005 through 2020. these were not the investors in the funds but the people running the funds that became wealthy the hoped for extravagant returns from illiquidity and manager skill are simply not there for investors after fees let's next test the diversification claim on paper private assets will almost always look like they offer diversification relative to publicly listed assets but looks can be deceiving unlike listed assets private assets are not valued daily the result is that reported private Equity returns will appear both uncorrelated to and less volatile than public equities even if their economic risk exposures are identical the 2014 paper private equities diversification illusion economic co-movement and fair value reporting finds that cost-based methods of accounting understate the systematic risk of private Equity creating an illusion of diversification the authors show that after European private Equity Funds switched to fair value accounting reported correlations between accounting-based private Equity returns and those of public Equity markets increased and private Equity Funds access to Capital decreased now if you're an investment manager the smoothing effect of illiquid assets returns even if they're only an illusion can smooth the ride on paper for your investors a systematic preference for the smoothing effect of illiquid assets could explain why we don't see an illiquidity premium in private asset returns the illiquid nature of the underlying assets also makes it difficult to know what you're really buying well the pitch is that illiquid markets create opportunities for managers the reality seems a little bit different multiple Studies have demonstrated that private Equity Funds either selectively time the raising of new funds to coincide with high valuations in existing funds or they inflate the values of the illiquid assets in their existing funds when they're raising new funds the effect of higher asset values is the appearance of better past performance which is of course attractive to prospective investors the problem is that it increases the challenge of identifying good managers which is a big deal in private markets due to the massive difference in performance between the best and worst managers to be fair private Equity investors may still be harvesting premiums associated with smaller and lower priced companies but private markets may not be necessary to do that in the 2021 paper replicating private Equity with a value investing homemade leverage and hold to maturity accounting Eric Stafford finds that direct investments in private Equity Funds earn lower mean returns than a replicating strategy consisting of low priced small cap public equities and Leverage following the methodology for private Equity expected returns in demystifying illiquid assets expect the returns for private Equity the updated figure as of q1 2022 was a 5.9 percent expected real return net of a five percent estimated fee for the current vintage of U.S buyout funds compared to about a five percent real expected return for a global portfolio of public stocks with tilts toward alternative risk premiums now I would use at least a six percent fee estimate unless you were in a position to negotiate fees which drops that net expected return figure to parity with public equities tilted toward higher expected return Securities I don't find that to be an unreasonable assumption based on the aforementioned data showing that public equities have performed about the same as private Equity the private Equity pitch of an illiquidity premium the opportunity to benefit from manager skill and diversification with respect to public equities does not stand up to the data there is no evidence of a distinct liquidity premium managers in private Equity likely are skilled based on their high gross of fee returns but they are the ones that benefit from their skill knock their investors which is what we should expect in a rational Market on metrics like pme and multiples of money net of fee private Equity returns have been similar to public Equity returns since at least 2006 and over longer periods when they're compared to risk appropriate indexes additionally there is a huge dispersion in fund returns between the best and worst private Equity Funds and even more so with Venture Capital unlike with public equities you can't just buy the whole private market so that wide distribution and manager returns matters a lot bio funds do not exhibit persistence and performance so picking a fund with a good track record is not helpful there is evidence of persistence in the best Venture Capital managers but it's not so easy to get access to those funds finally any illusion of diversification from private Equity is likely due to smooth returns not exposure to distinct economic risks I don't know about you but unless you can negotiate down fees get access to a top Venture Capital fund or both I do not find the private Equity pitch to be compelling thanks for watching I'm Ben Felix portfolio manager at pwl Capital if you enjoyed this video please share it with someone who you think could benefit from the information if you want more on this topic we spoke about it on the rational reminder podcast with venture capitalist and Economist Bill Janeway in episode 194 Ludovic fallopou who I mentioned in this video in episode 210 and Gus solder former CIO at Vanguard in episode 216. 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Channel: Ben Felix

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Length: 13min 24sec (804 seconds)

Published: Wed Sep 28 2022