Private equity involves pooling capital to invest in private companies either in the form of providing venture capital to startups or by taking over and restructuring mature firms via leveraged buyouts. Private equity investors believe that the benefits outweigh the challenges not present in publicly traded assets—such as complexity of structure, capital calls (and the need to hold liquidity to meet them), illiquidity, higher betas than the market, high volatility of returns (the standard deviation of private equity is more than 100%), extreme skewness in returns (the median return of private equity is much lower than the mean), lack of transparency, and high costs. Other challenges for investors in direct private equity investments include performance data, which suffers from self-report bias and biased net asset values and understates the true variation in the value of private equity investments.
Empirical research on private equity performance
Unfortunately, the empirical research findings on the performance of private equity, including publicly listed private equity, have not been encouraging. In general, private equity has underperformed similarly risky public equities even before considering their use of leverage and adjusting for their lack of liquidity. But the authors of the 2005 study “Private Equity Performance: Returns, Persistence, and Capital Flows” did offer some hope. They concluded that private equity partnerships were learning—older, more experienced funds tended to have better performance—and that there was some performance persistence. Thus, they recommended that investors choose a firm with a long track record of superior performance.
The most common interpretation of persistence has been either skill in distinguishing better investments or the ability to add value after the investment (for example, providing strategic advice to their portfolio companies or helping recruit talented executives). Research by Verdad showed a lack of evidence supporting either hypothesis. But the research does offer another plausible explanation for persistence: Successful firms can charge a premium for their capital.
Reputation and the cost of capital
David Hsu, author of the 2004 study “What Do Entrepreneurs Pay for Venture Capital Affiliation?,” analyzed the financing offers made by competing venture capital firms, or VCs, at the first professional round of startup funding. He found that offers made by VCs with a high reputation are 3 times more likely to be accepted, and high-reputation VCs acquire startup equity at a 10%-14% discount.
Ramana Nanda, Sampsa Samila, and Olav Sorenson provided confirmation of a reputational discount in their 2020 study, “The Persistent Effect of Initial Success: Evidence from Venture Capital.” Their findings led them to conclude:
“Our investment-level analyses suggest that initial success matters for the long-run success of VC firms, but that these differences attenuate over time and converge to a long-run average across all VC firms. Although these early differences in performance appear to depend on being in the right place at the right time, they become self-reinforcing as entrepreneurs and others interpret early success as evidence of differences in quality, giving successful VC firms preferential access to and terms in investments. This fact may help to explain why persistence has been documented in private equity but not among mutual funds or hedge funds, as firms investing in public debt and equities need not compete for access to deals. It may also explain why persistence among buyout funds has declined as that niche has become more crowded.”
They added: “The picture that emerges then is one where initial success gives the firms enjoying it preferential access to deals. Both entrepreneurs and other VC firms want to partner with them. Successful VC firms, therefore, get to see more deals, particularly in later stages, when it becomes easier to predict which companies might have successful outcomes.” It is the access advantage that perpetuates differences in initial success over extended periods.
Robert Harris, Tim Jenkinson, Steven Kaplan, and Ruediger Stucke confirmed the prior research findings of persistence of outperformance in their November 2022 study, “Has Persistence Persisted in Private Equity? Evidence from Buyout and Venture Capital Funds.” However, it was only true for venture capital (not the full spectrum of private equity), as they found that there was no persistence of outperformance in buyout firms.
Latest research
In their article “The Dispersion Illusion,” Brian Chingono and Dan Rasmussen of Verdad pointed out that “advocates for private equity investing often note that the dispersion of performance between top-quartile managers and bottom-quartile managers is significantly wider than the range of performance in liquid asset classes. The implication is that private markets are less efficient, that there’s a larger role for skill, and that investors in private equity can take advantage of this dispersion through manager selection.” However, Harris et al. found that while there was some persistence in venture capital, there was no persistence in buyout firms. Thus, at least for private equity buyout firms, the wide dispersion could not be attributable to high skill.
If skill doesn’t explain the wide dispersion, what does?
Explaining the wide dispersion in performance
Chingono and Rasmussen showed that there is a simple, non-skill-based explanation for the wide dispersion of performance: It reflects the differences in portfolio composition between private equity and public funds. They explained, “Private equity portfolios are quite different from mutual fund portfolios. First, private equity portfolios tend to have about 20 firms, whereas a typical mutual fund holds about 200. Second, private equity portfolios are overwhelmingly comprised of micro-caps, while most mutual funds focus on large and mid-caps. Even the median small-cap mutual fund holds companies with market caps about 10 times the size of a typical [leveraged buyout]. Third, private equity funds hold highly leveraged companies, with the median proportion of debt financing being 49% Net Debt/EV [enterprise value] and the median leverage ratio being 4 times Net Debt/EBITDA [earnings before interest, taxes, depreciation, and amortization].”
To test that hypothesis, they created simulations of public equity portfolios that varied in concentration, company size, and timing of investment. Since private equity doesn’t sample randomly, instead choosing smaller and more profitable businesses, they compared the median returns of private equity against simulated micro-cap portfolios of 20 stocks that were selected from the cheapest 5% (value companies) and the most profitable 5% (quality companies) of companies within each year. Within their micro-cap data, there were typically 30-50 stocks in the top 5% of any given year, and the factor-ranked simulations were randomly selected from this opportunity set when forming the 20-stock micro-cap portfolios over the course of three years (at a pace of six to seven investments per year).
Their simulations started by randomly selecting a vintage year between 1995 and 2017 and then included the two subsequent years to form a three-year investment period. The authors explained, “For example, if 2000 is randomly chosen as a vintage year, the investment period will comprise 2000, 2001, and 2002. Each investment within a portfolio is sold after being held for four years. This iterative process of portfolio formation and realization is repeated 10,000 times in our simulations to create a distribution of return outcomes.” The following is a summary of their findings:
- Value characteristics appeared to have the biggest impact on micro-cap returns, boosting the median return from 10% in a totally random sample to 18% in a value-ranked sample of 20 stocks.
- Quality mattered, with an improvement of 4 percentage points in the median return, from 10% in a totally random sample to 14% in a profitability-ranked sample of 20 stocks.
- The dispersion was about the same, at 20.7% in private equity versus 20.4% in the micro-cap simulation; private equity’s dispersion was in line with the random outcomes from volatile portfolios of leveraged, cheap micro-caps. The most notable difference was that private equity managers underperformed their simulated benchmark by 2 to 4 percentage points per year, which is easily explained by fees.
Their findings led Chingono and Rasmussen to conclude, “The implication of this result is that private equity’s value creation is not sufficient to overcome its fees, in our opinion. While PE may create value through deleveraging and other management decisions, those benefits appear to be fully offset by fees.” They added, “Our results suggest that the dispersion in private equity can be fully replicated in public markets, provided that investors focus on buying cheap, leveraged micro-caps and hold them in a concentrated portfolio, similar to the portfolio construction in PE.”
Investor takeaways
There are several key takeaways for investors. First, the claims of superior risk-adjusted performance by the private equity industry are exaggerated. Given private equity’s lack of liquidity, opaqueness, and greater use of leverage, it seems logical that investors should demand a roughly 3% internal rate of return premium. Yet there is no evidence that the industry overall has been able to deliver that. Second, the failure to appropriately mark-to-market investments during public market drawdowns leads investors to underestimate the risk of these investments, as the volatility is significantly understated. Third, investors should expect that much of their capital might be outstanding even well beyond a decade—and that should certainly require a risk premium.
Investors desiring exposure to the risk and potential rewards of private equity investing should recognize that the wide dispersion of potential outcomes highlights the importance of diversifying risks. This is best achieved by investing indirectly through a private equity fund rather than through direct investments in individual companies. Because most such funds typically limit their investments to a relatively small number, it is also prudent to diversify by investing in more than one fund. And finally, top-notch funds are often closed to most individual investors. They get all the capital they need from the Yales of the world. Forewarned is forearmed.
Larry Swedroe is a freelance writer and head of financial and economic research with Buckingham Strategic Wealth. The views expressed here are the author’s. For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. The author does not own shares in any of the securities mentioned in this article.