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Stepan Lavrouk
Stepan Lavrouk
Articles (195) 

The Myth of Private Equity

Funds struggle to beat the market

June 17, 2019 | About:

Private equity is a glitzy industry, but does it actually beat the market? The data suggests it does not. In an October 2018 episode of "Talks at Google," former fund manager and academic Jeffrey Hooke explained why the sheen has come off of private equity in the last decade.

What is private equity and what is its objective?

At its core, a private equity vehicle exists to make investments in a concentrated portfolio of privately owned companies. The time horizons of private equity investors are quite long - typically around 10 years. The investments are made usually within the first four years of the fund, after which time the managers will spend around three years attempting to improve their companies in some way. The final three years are spent trying to sell the holdings, usually through mergers and acquisitions, but also occasionally through an initial public offering.

The main objective of a private equity vehicle is to beat the stock market. Just matching the performance of the S&P 500 is not enough - otherwise investors would not be willing to pay the fund’s fees. Moreover, as private companies are significantly less liquid holdings than publicly traded ones, investors demand additional outperformance to compensate for this additional risk. Hooke said the average additional rate of return demanded is 3%.

Have they been able to do this?

In the early days of private equity, between 1985 and 2005, funds actually did outperform the market. Statistics provided by Hooke show that between 1999 and 2004, leveraged buyout funds beat the S&P 500 by an average of 11.8%. However, since 2005, it has been a different story.

The average leveraged buyout fund actually underperformed the S&P 500 in four of the 11 years between 2005 and 2016, and only beat the 3% mark in one of those years. As the funds got larger and competition between managers became more fierce, the easy gains in private equity were increasingly eroded.

Of course, averages do not tell the full story. The top quartile of funds do outperform the S&P 500. So the question for institutional investors becomes: how do we pick the correct funds to invest in? According to Hooke, this is not so easy. The statistical probability of a fund manager in the top quartile of funds replicating their success with another fund is just 30% - in other words, fund performance is mean-reverting. Moreover "brand name" funds - household names like Goldman Sachs (NYSE:GS), Blackstone (NYSE:BX) - on average, also do no better than unknown funds.

Why invest at all?

So it seems that private equity does not really benefit the institutional investors that throw money at it. Why do they choose to invest then? Hooke thinks it comes down to a number of factors.

First, investors are prone to wishful thinking and assume their funds are the ones in the top quartile. Second, they are lobbied by consultants who have an incentive to promote the private equity funds. Third - and this is probably the most significant - since their job is to pick managers, institutional investors aren’t going to admit their reason for existence is invalid. Finally, they may be suffering from a form of Stockholm syndrome, wherein they are socialized into believing the hype. So while they may not produce good returns, private equity funds are probably not going anywhere anytime soon.

Disclosure: The author owns no stocks mentioned. 

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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