Reconciling returns

Private equity decisively outperforms public equities, but top GPs are struggling to maintain their performance. 

Private equity has grown from the equivalent of 1.5 percent of global stock market capitalisation in 2000 to 3.5 percent in 2012. During those years it has boomed and busted alongside public markets. In fact, many have observed that private equity—though ostensibly an “alternative” asset class—has drifted towards the mainstream. Several researchers concluded in the mid-2000s that, on average, buyout funds underperformed the S&P 500 on a risk-adjusted basis; only about a quarter of firms consistently beat the index. Other research has found that private equity returns have become highly correlated with public markets.

As the perception of private equity’s differentiation has waned, the fees that the industry charges its investors, already under pressure, have come to seem especially exorbitant to some. And as firms have come under fire for some of their practices, they have not always done a good job of explaining their role to the public.

These are serious challenges, but if returns are only average, none of the rest matters very much. Private equity returns are, however, notoriously difficult to calculate. By and large, the industry does not publish its results; and the data that is available can be inconsistent and hard to reconcile, as both private equity firms and their limited partners use diverse approaches for their calculations. Making things more difficult, a database on which researchers have relied turns out to have had serious methodological issues.

Encouragingly, new research, based on more recent and more stable data, suggests that private equity returns have been much better than previously supposed. The conventional wisdom on returns stems from analyses of funds raised in 1995 and earlier. In January 2011, McKinsey developed an analysis for the World Economic Forum, in which we found that funds created since 1995 appear to have meaningfully outperformed the S&P 500 index, even on a leverage-adjusted basis. Two academic teams have since reached similar conclusions.  Both find that over the long term, private equity returns have outstripped the public market index by at least 300 basis points.

However, another McKinsey analysis finds that the tendency of top firms to replicate their performance across funds is not nearly as strong as it once was. Until 2000 or so, private equity firms that had delivered top-quartile returns in one fund were highly likely to do so again in subsequent funds.  That characteristic was vital to LPs, as due diligence consisted mainly of identifying top-quartile funds for many years.

Since the 2000 fund vintage, however, this persistence has fallen considerably, such that fund-to-fund performance may now be approaching the randomness characteristic of public markets. Meanwhile, returns remain widely dispersed:  the best funds in any vintage generate returns of about 50 percent, while bottom funds lose up to 30 percent of their investment. With persistence waning and dispersion still significant, LPs’ selection risk remains as high as it was in the 1990s, but it has become tougher to predict which firms will deliver top-performing funds. 

Three hundred extra basis points of return will more than compensate for this risk. We expect that alpha-seeking LPs, especially pension funds that crave stability as well, will likely increase allocations to private equity, as will high net-worth individuals. That raises a question: where will this additional capital be deployed? We will take up that question and others in a second article to be published in the coming weeks.

Conor Kehoe is a director in McKinsey & Company's London office. McKinsey partners Sacha Ghai and Bryce Klempner and director Gary Pinkus also contributed to this article.