Although we do not invest in private equity we, nevertheless, have a view on prospective returns for the asset class and its position in a portfolio.

Private equity (PE) as an investment seems to have become increasingly popular over the last ten to twenty years. This seems to be not only because PE funds are extremely lucrative for their managers and for the major banks, as PE has also been increasing in popularity as David Swensen (former Yale Endowment Fund CIO) and the “Endowment Model” have gained notoriety.

The Endowment Model is best described in Swensen’s book “Pioneering Portfolio Management” (2000), encouraging investors to seek out and harvest the risk premia in, amongst other things, private equity.

Whilst “owner/principal PE” i.e. private equity investments in businesses owned and run by the principal has obvious and demonstrable benefits, we are less convinced of the attractiveness of “agency PE funds” i.e. funds of private equity investments run by a manager/bank.

Here’s why:

  • Firstly, there is now a very big body of research largely from the US, where the asset class has been around for longer and the data collected has been over a much longer period, which strongly suggests that PE returns are highly correlated to listed small cap public equity returns.

Back in 2009 the Brandes Institute published a paper titled “Is US Small Cap a viable alternative to US Private Equity?”; the results and conclusions of which have been repeated and replicated in multiple studies in the following years.

It concluded, “… based on long-term performance, small cap has been a viable alternative to private equity in seeking compelling returns”.

Of course, PE is less-liquid, more opaque and the search costs involved in finding and accessing good and persistently performing funds (when the average PE fund delivers returns no better than public equity returns) should also be borne in mind.

In addition, as Professor Ludovic Phalippou (Said Business School, University of Oxford), probably the leading researcher in the performance and risk characteristics of PE funds, has shown, the generally accepted method for performance calculation in PE funds systematically overstates PE fund returns.

As shown in his paper “The Performance of Private Equity Funds” (2009) “… a large part of performance is driven by inflated accounting valuation of ongoing investments and we find a bias toward better performing funds in the data. We find an average net-of-fees fund performance of 3% per year below that of the S&P 500. Adjusting for risk brings the underperformance to 6% per year.”

For those particularly interested, Phalippou has proposed an alternative, more rigorous method to the traditional “internal rate of return” calculation favoured by PE funds – see “A New Method to Estimate Risk and Return of Non-traded Assets from Cash Flows: The Case of Private Equity Funds” (2012).

So, the case that (a) PE fund returns are overstated and (b) PE returns are highly correlated with small cap returns, in our view, is strong and very compelling.

  • Secondly, at the risk of attracting a wave of abuse, it seems to us that a large part of the PE model seems to be buy a company, swap its equity for debt and leverage the balance sheet. Increasing the balance sheet leverage increases the return on equity and, all other things considered, that lifts earnings and thus lifts the price for re-sale. Simple – more debt = better.

In fact, that looks pretty evident in the data. The following chart shows net credit market debt issuance in the private non-financial sector (as a % of GDP) versus the US Small Cap Equity Index implied 10 year annualised return.


The chart is very striking. In the period from 1980 – 1990 there does not seem to be much going on, this changes abruptly after.

Starting around 1990, the correlation between small cap equity implied returns and net debt issuance is extremely strong.

As PE returns have a large debt component and are highly correlated with small cap returns and since small cap returns are highly correlated with small cap valuation, what we see is a debt/small cap valuation/PE synchronisation over the last twenty-five years.

The next chart shows the valuation of US small cap that corresponds to the implied returns in the first chart. Right now, small cap valuation, with net debt issuance running at 4% of GDP, is within a whisper of the highest levels ever and on par with 2000 and 2008… and we know about the PE investment returns for funds entered at those points (Preqin has the data, for a fee).

PE investments made at the top of the valuation cycle at high levels of net debt issuance are never, looking back, a good idea.


The same high valuation/low implied return position is evident in European small cap.

So, implied US small cap returns look unappealing, less than 6%, suggesting very unattractive returns for US PE. Although at least with a small cap stock portfolio it can be liquidated at will, something that cannot be said of a PE Fund.

The next time you consider PE, think if you might not be better off in a cheaper, highly liquid, transparent small cap ETF instead.



Tagged on: