On PE returns — What is it we REALLY know?

The most frequent reason people give about why they invest (want to invest, or increase investments) in PE is: past performance has been amazing. I have been hearing this since I started researching this field — 15 years ago!

For a Financial Economist the above always sounds a bit weird: How can there be an asset that is such a great bargain given that: i) fund managers can increase their fees (there’s always a level of fees high enough to turn a great investment into a poor one), ii) capital can flow into PE funds (capital flows push prices up, and again, there’s always a buying price that is high enough to turn a great investment into a poor one). We all know by now that alpha is rare. Having an entire industry with an alpha for more than fifteen years… should give a few Nobel prize winners some grey hair … or at the very least puzzle any financial economist.

Fifteen years ago, when I started to look into this, I quickly came to a conclusion, which has been reinforced ever since, conversations after conversations, data points after data points. There are two performance measures floating around. There is a fake measure of performance that is being shown repeatedly but it is not obvious at all that it is fake. the culprit is called IRR. On top of that there are a few more tricks like choosing a benchmark among many,…, which enables one to show amazing returns. In fact, returns like 30% p.a. are shown quite often. It should be easy to see that this is fake because compound any investment at 30% p.a. over a long period of time and you will obtain an implausible figure (a single $100m invested in 1990 at that rate would be worth $150 billion, which would make you the richest person on earth, by miles!).

We actually do not know how to measure returns correctly (that may be why fake measures can thrive), but we can work with measures that are reasonable, and these measures are based on Net Present Value. PME is one of them. So, what does PME say?

The landmark study is that of Harris, Jenkinson and Kaplan (2014) in the Journal of Finance. Data are as of 2008 and they find that US LBO funds outperform by 3% p.a., US VC funds do not. Let’s pause here for a second. First note that this is the most accurate estimate we have as of 2008 and note that it cannot be on the lower side of the truth (investors who gave the data consented to the data being shared for research, there is data backfilling, it is US only while emerging market PE returns are lower, Europe VC returns are lower,…). So if we take from that study that PE returns are 3% above those of the S&P 500 index, we can only say that we are on the optimistic side of things.

Pause again: 3% p.a. extra compared to Vanguard S&P 500 index fund and you have all the costs of due diligence, legal, illiquidity, credit line management (you offer capital commitments), leverage, have no control on underlying investments, have signed an incredibly complex contract that gives a lot of flexibility to the fund manager (including the possibility to take a lot of money from your underlying investments, thereby putting a large amount of trust on the line)…

Is 3% extra return that great a bargain?

But this is not the elephant in the room. Back in 2005-2008, any presentation for any investment opportunity was showing  its past returns against those of the S&P 500 index. You know why? because it was one of the worse performing indices among the well known ones out there. Indices are are active trading strategies, there is no such thing as passive investing. This is why index providers/designers are making a lot of money. Most interestingly, the average stock in the US from 1990 to 2008 outperformed the S&P 500 index. Do you know by how much?

3% p.a.

But let’s ignore all of the question marks above and go beyond 2008. What happened from 2008 to 2017? Let’s look at the most comprehensive dataset again (the same one as that used in Harris et al.): PE funds have the same returns as the S&P 500 index. Interpretation: so much capital has flown into PE that returns have compressed.


Other interpretation: From 2008 to 2017 the return on the S&P 500 index have been EXACTLY equal to the return of the average listed stock. Hence, over the last ten years, just like over the twenty years before that, PE simply matched the returns of the average listed stock. Nothing has changed.

Oh, in case you have not noticed, over the last four years, the S&P 500 index has disappeared from investment presentations. It has been replaced by the MSCI world index. Have a wild guess as to why it is so.

But let’s ignore all of the above question marks again, and stubbornly argue that PE delivered 3% p.a. more than public equity. I guess it is not controversial to assume that expected returns are lower than past returns for any asset class. In the past, PE funds returned 18% p.a. gross of fees, charged (at the very least) 6% p.a., to return 12% p.a. with public equity (carefully choosing the representative index) at 9% p.a. So, let’s work with the heroic assumption that PE delivers twice as much as public equity. Going forward, if public equity delivers 5% p.a. (a figure that is quite consensual) and PE funds heroically deliver 10% gross of fees, then after fees this 10% will become 5% net (simply applying the average fee structure in place). To sum up, even if PE will deliver twice as much as public equity before fees, in a low-return environment, and given existing fee structures, investors would make as much with PE as with listed equity after fees.

The bigger point is: The enduring belief of great past performance — mostly based on a fake return metric — means that too much capital flows into PE and, in particular, flows to bad funds (which hurts the good funds) AND has postponed any serious conversation on reducing fee levels and on better interest alignment (which hurts the many honest PE professionals out there because they do not get rewarded for their better aligned contract initiatives). Both facts threaten the sustainability of the PE industry, which is a serious issue for all of us who believe PE has an important role to play in the economy. There’s bound to be a wake call, but in PE, everything (except the holding of investments) takes a long time.





Phafa Le Hardi Written by: