Does private equity outperform public markets by enough to justify the fees? The rationale for investing in the asset class may come down to that single question. A definitive answer has proved difficult to come by for several reasons, including the vagaries of PE performance metrics and questions over what should and shouldn’t be included in the analysis.

For its 21st Anniversary edition, Private Equity International asked CEPRES to run the numbers on PE’s performance over the last 21 years, and its findings should please our readers. According to analysis from the private markets data provider, the CEPRES global buyout funds index has outperformed the S&P 500 and the MSCI ACWI – which tracks a broad selection of large- and mid-cap stocks from 47 markets – every quarter in every year since 2001.

The returns produced by buyout funds have, however, been more volatile than their public market equivalents, per the CEPRES analysis, which is perhaps surprising given that many LPs often cite a perceived lack of volatility as a reason for investing in the asset class. One of the strongest periods for buyout funds over the past 21 years was 2003 to 2007, with the largest single-month increase, 11.08 percent, coming in April 2003.

CEPRES, which draws on a data set spanning around 11,000 funds and more than 107,000 PE-backed companies, also compared the performance of buyout funds with other alternative asset classes. It found that while buyouts consistently outperformed its index of real estate funds – apart from a brief period in 2004 – there was a solid stretch after the global financial crisis where private infrastructure outperformed buyouts. Infrastructure has produced the least volatile returns and clearly outperformed public equities benchmarks as well.

“This time-series variation in returns varies broadly across PE fund types [buyout, real estate and infrastructure] and is highly cyclical,” says Alka Banerjee, global head of product, market data at CEPRES. “Therefore, it appears that cyclicality in PE returns exists, and the returns cycles of the different PE fund types are not highly correlated. Accordingly, a diversified strategy across the various types of PE funds may be a beneficial approach to take for investors and advisers alike.”

As mentioned, there will never be universal agreement on the question of performance. In 2020, Ludovic Phalippou, professor of financial economics at the University of Oxford’s Saïd Business School, published an incendiary paper arguing that, net of fees, private equity funds have returned about the same as public equities since 2006.

“Anyone can generate a 1,000 percent IRR [just] by calling the capital a day before it’s distributed back to the LPs”

PE head at a pension fund

He went on to describe private equity as one of the largest wealth transfers in modern history, “from a few hundred million pension scheme members to a few thousand people” in the industry. Blackstone, KKR, Apollo and Carlyle were compelled to issue rebuttals.

There were questions raised about Phalippou’s methodology, notably how he analysed buyout, real estate and infrastructure funds as if they have the same characteristics. In truth, an LP that invests in real assets might well appreciate steady income and lower volatility more than pure returns.

Still, the fact that multiple people can study performance data and come to totally different conclusions is a problem, particularly as the industry tries to demonstrate it is safe for retail investors to back private markets.

Murky metrics

Internal rate of return has always been an imperfect metric. As PEI noted in 2018, the way it is calculated places undue weight on distributions that come early in a fund’s cycle, allowing funds to build up impressive rates of return sometimes, some claim, by exiting investments before they should.

This problem was made worse by now ubiquitous subscription credit lines, which, while useful for bridging capital calls, tend to boost a fund’s IRR by reducing the length of time that LPs’ capital is deployed. As cited by Hossein Kazemi of the Isenberg School of Management at the University of Massachusetts Amherst, in an article published by the CAIA Association in 2020, two recent studies suggest the boost from subscription lines can be as high as 6 percent.

Over the past 18 months there has been notable growth in the NAV loan market; these are loans taken out by GPs and secured against all or part of their portfolios. These loans can be used to cure covenant breaches, make add-on acquisitions and increasingly to fund distributions to investors, many of which are overallocated and reluctant to commit to a new fund until they receive something back from their existing investments.

As PEI noted in February, these loans enhance the IRR and the distribution to paid-in of funds, which may already be experiencing a boost from a subscription credit line, making it more difficult again for LPs to know whether performance figures are attributable to performance or leverage.

“It places even more importance on MOIC [multiple of invested capital] as a way to track overall fund performance, if the IRRs become less and less meaningful,” a pension fund PE head told PEI. “Anyone can generate a 1,000 percent IRR [just] by calling the capital a day before it’s distributed back to the LPs.”

In Phalippou’s words: “While the PE industry can play a positive role for society, it is unlikely to be sustainable if it continues to allow some participants to present arguably window-dressed performance information and incomplete fee information.”

Calls for greater transparency around fund performance data are not new. Indeed, PEI explored the issue in its first cover story in 2001. “To simply throw an IRR at investors without telling them how it has been worked out is completely meaningless,” Ivan Vercoutère, managing partner of Swiss fund of funds manager LGT Capital Partners, told PEI at the time. “There are too many different ways of calculating it.”

As PEI eases into its third decade, the private equity performance debate looks set to roll on as the need for greater transparency becomes ever more crucial.