Has private equity lost its ‘edge’?

A paper estimates US private equity will return less than 100bps more than US stock market returns for the next five to 10 years.

Investor demand for private equity may reflect a misplaced conviction in its return potential, a new report reveals.

Unless institutional investors “de-smooth” private assets’ returns and take into account mark-to-market accounting, volatility and equity beta, the alpha they think they are getting is overstated, according to Demystifying Illiquid Assets: Expected Returns for Private Equity, a report by Greenwich-based investment firm AQR Capital Management.

“Private equity does not seem to offer as attractive a net-of-fee edge over public markets as it did 15 to 20 years ago, from either a historical or forward-looking perspective,” the report concludes.

AQR looked at PE returns from multiple lenses – theoretical required returns, historical returns and yield-based analysis that covers valuations and market conditions – and zoomed into the returns of US buyouts, the largest segment of the private equity market.

“While PE has low reported risk, it is economically riskier and has higher exposure to the equity risk premium than public equities, a combination that many investors may find appealing… the full risk of PE is most likely to materialise in prolonged bear markets, not in relatively fast ones like 2008-09,” the report says.

Comparing PE’s historical performance to various publicly traded benchmarks and stock indices over the period 1986 to 2017, the report showed PE outperformed large-caps by 2.3 percent (arithmetic means). But when compared with a leveraged small-cap index – a more appropriate benchmark according to AQR – PE outperformance falls to just 0.7 percent (geometric means). In addition, the asset class underperformed small-cap value stocks by 1.6 percent. Historical data, therefore, show PE on average, has offered scant illiquidity premium.

The report also notes two trends that have underscored declining PE outperformance: increasing investor demand has driven up PE valuations; and PE fund returns tend to be lower after “hot vintage” years (or years that saw a large volume of fundraising). Other factors such as record dry powder and competition for deals will also make it more challenging for PE to deliver the returns it has in the past.

In fact, the paper estimates a real expected return of 3.9 percent net of fees over the next five to 10 years, compared with a US public equity real return estimate of 3.1 percent.

Why, then, do investors increase exposure to PE and have high return expectations? Some reasons behind this include the lack of transparency on returns and fees, slow learning about performance and the use of mis-specified benchmarks, the report says.

“PE returns are often presented as IRRs, which can be easy to game and which evolve slowly.”