Private equity managers should be preparing for a winter of discontent. Or at least disgruntlement from their limited partners.

As we close in on the 10th year of a bull run, private equity has started to look pretty expensive, causing some LPs to wonder whether it still justifies the hefty price-tag.

Earlier this year, Pennsylvania state treasurer Joe Torsella claimed the two state pension systems had “wasted” up to $5.5 billion in investment expenses and would have been better served by low-cost passive funds. Then an Oxford University Saïd Business School analysis showed US private equity managers may have pocketed $400 billion in fees and expenses since 2006 while, on average, failing to beat the returns from an S&P tracker fund.

There is, of course, an argument as to whether the S&P 500 is an appropriate benchmark for private equity in the first place. S&P 500 companies need a market capitalisation of at least $6.1 billion, well beyond the reach of most private equity funds, so it’s not really a like-for-like comparison. But if the alternative for an investor to putting capital into private equity is to put it into an S&P 500 index fund, then the comparison is highly relevant.

Data analysed by hedge fund Verdad Advisers show that over the past five years, the S&P 500 has outperformed most major asset classes – including private equity. But over a 25-year period, private equity has outperformed the S&P 500 by 300 basis points – the exact illiquidity premium most institutional investors are looking for from the asset class.

What’s more, research from investment advisory firm Cliffwater shows that over the 10-year period to 30 June 2017, private equity provided state pensions with the highest asset class returns, at 9.19 percent average return. The next highest returning asset class for the period was US stocks, at a considerably lower 6.75 percent.

(However, Cliffwater notes the outcomes for private equity vary widely across state pension plans, underscoring the oft-made point that manager selection is crucial.)

The Verdad analysis shows that when prices are high, private equity performs in line with or worse than the S&P 500, but when prices are low, the asset class outperforms. The median US deal multiple reached 12.9x EBITDA in 2017, eclipsing the previous high of 10x EBITDA set in 2006, according to valuation experts Murray Devine. Meanwhile, the  average price-to-earnings ratio for the S&P 500 based on trailing 12-month “as reported” earnings as of 1 February was around 25x, according to the Seeking Alpha website.

Private equity prices, then, are very high compared with historical averages. But if it holds true that the asset class outperforms in a low-priced environment, surely continuing to allocate aggressively to private equity is exactly what investors should be doing as we head into the next downturn.

Well, possibly. Private equity has completely transformed over the last 25 years, and in the main isn’t backing those smaller, high-growth companies that used to be the industry’s bread and butter.

“Private equity has gone from being small value on steroids to being more similar to the worst performing of all public equity asset classes – small growth – with the added negative of burdening these small growth companies with large amounts of leverage,” Verdad notes in its analysis. “For this reason, private equity seems less likely than historically to offer attractive performance relative to the S&P 500.”

If this is indeed the case, managers should expect continuing robust pressure on fees from their investors – and in a less buoyant fundraising environment, they may just need to capitulate.

Write to the author: isobel.m@peimedia.com