A version of this article was originally published by CFA Institute for Enterprising Investor.
Quotes like this are circulating:
“We need private equity, we need more of it, and we need it now.”
“Retail investors are missing out and we want to make sure they are not left behind.”
I’m all for access, but in this case I wonder:
I started investing in private equity on behalf of clients in the early 2000s and still invest in the space in large absolute dollar amounts.
Some private investment opportunities can provide investors with solid returns.
When considering giving access to larger groups of investors, though, should commentators keep in mind what I’ve had access to?
Below, I’ve reproduced a private equity return chart that is published every quarter. It is normally the first headline chart in a presentation book that highlights what are called “Net to Limited Partner” returns. These returns appear in many private equity marketing presentations, are quoted in various publications, and are used to create standard deviation and correlation charts to make a case for private equity.
From the Index Firm Disclosures:
Private indexes are pooled horizon internal rate of return (IRR) calculations, net of fees, expenses, and carried interest. The timing and magnitude of fund cash flows are integral to the IRR performance calculation. Public indexes are average annual compounded return (AACR) calculations which are time weighted measures over the specified time horizon, and are shown for reference and directional purposes only. Due to the fundamental differences between the two calculations, direct comparison of IRRs to AACRs is not recommended.
Over some periods, private investments may perform better than public investments.
But how about this question:
How was a private index made up of highly levered small cap equity funds down less than 2% for the quarter ending 12-31-18 when, during the same period, a public index of small cap stocks was down more than 20%?
Looking at the complete 2018 calendar year that is illustrated in the chart above, it’s easy to understand why Cliff Asness and AQR were so excited about their S.M.O.O.T.H. strategy when an index made up of funds that follow a similar approach were up over 10% versus small-cap public indices being down over 10%.
In addition, this should probably be asked before access to these return comparisons are made available to larger audiences:
Why are these private equity returns compared with public indexes when, in small print, there’s the following disclosure (see the last sentence of the chart disclosures above that appear in the firm’s reporting of returns comparisons)?
“Due to the fundamental differences between [how private equity and public market returns are calculated], direct comparison… is not recommended.”
In fairness, other disclosures say that “for a more accurate means of comparing private investment performance relative to public alternatives,” investors should look to adjusted public market returns on subsequent pages.
This is useful material but, unfortunately, limited partners likely did not receive what the firm states on these pages are “actual private investment returns”?
As I’ve written before, for decades leading investors and academics have published warnings about what these “returns” might be:
Related to this, you can find the language below in disclosures about returns.
“The timing and magnitude of fund cash flows are integral to the performance calculation.”
Do all potential investors understand what this means and how it can impact return presentations and comparisons?
What about other issues, like the “use of fund level engineering that can optically boost” marketed returns?
As one leading private equity professional recently said, a form of this return engineering could lift returns by 3% or more beyond the returns I mentioned earlier, which might already be high as compared with the actual cash-on-cash returns investors have received.
It may be even more dramatic for newer funds.
Research from Carnegie Mellon University states that for funds with an age of ﬁve years or less, this engineering may inflate a private investment fund’s reported returns by 6.0%, while decreasing the final returns that investors actually receive.
As I said at the start, many good private investment opportunities exist and we should keep an eye open for them.
In addition, far as I know, nothing is technically wrong or non-compliant in the way the private equity returns I’ve mentioned can be presented to what regulators call “accredited” or “sophisticated” investors.
As Howard Marks noted some time ago, there is no easy way to evaluate private investment returns.
Experienced private equity investors have the background and the resources to conduct such analyses.
To hopefully help others, with the assistance of some leading academics and private investment professionals, we have put together a list of somewhat technical Private Investment Questions and Issues to Consider.
Before making more types of private investments available, however, how about more work as an industry on making this all easier to understand in plain language?
As I wrote in a piece for the CFA Institute, “I believe it would be a positive for investors and for Wall Street, which many studies show has a big image and confidence problem, especially among younger generations who are the industry’s future.”
Until then, maybe private access should be accompanied by clear warning labels stating something like the following:
“Unless you are well versed in the myriad ways private investment returns, standard deviation, and correlation metrics are calculated and fully prepared to ask a lot of technical and often hard questions, buyer beware:
You may be purchasing returns that no investor has received.”
Private Investment Questions and Issues to Consider – Preston McSwain – with help from many such as Victoria Ivashina – Harvard Business School, Ludovic Phalippou – University of Oxford, Etc.
Are We Baking Portfolios with Bad Ingredients? – Tommi Johnsen, PhD – Research Roundtable
Internal Rate of Return: A Cautionary Tale – McKinsey & Company
The Truth about Private Equity Performance – Harvard Business Review
Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting – Harvard Business School
Private Equity Laid Bare – Chapter 11, – Ludovic Phalippou – University of Oxford, Said Business School
Are Lower Private Equity Returns the New Normal? – Center for Economic Policy Research
Private Equity’s Trick to Make Returns Look Bigger – Wall Street Journal
Distorting Private Equity Performance: The Rise of Fund Debt – James F. Albertus, Matthew Denes – Carnegie Mellon University
Private Equity’s Diversification Illusion: Evidence from Fair Value Accounting – Kyle Welch – George Washington University
Persistence That Just Ain’t So – CFA Institute