Private Equity Access: Do We Need More or Should We Beware?

This essay was originally published by CFA Institute on the 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…”

“[They don’t have] access to [private investments and] we want to make sure retail isn’t left behind.”

I’m all for access, but in this case I wonder:

What Type of Access Will People Have?

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, however, we should keep in mind what I’ve had access to:

Comparisons That Are “Not Recommended”

Below, I’ve reproduced a private equity return chart that is published every quarter. It is normally the first headline chart in the presentation book that highlights so-called private equity “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. For a more accurate means of comparing private investment performance relative to public alternatives, see the analyses in this document using XYZ Modified Public Market Equivalent (mPME).

As one of those quoted above said, it is true that “over some periods of time [these] investment opportunities [may] perform better.”

But how about this question:

How was one classification of equities down 13-20% for the quarter ending 12-31-18, but yet another, which tends to be more highly levered and small-cap in nature, was down less than 1%?

Looking at the complete year end 2018, it’s easy to understand why Cliff and AQR were so excited about their S.M.O.O.T.H. strategy when an index made up of other funds that follow a similar approach were up approximately 10% versus small-cap public indices being down well 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 words in bold avoid below the chart)?

“Due to the fundamental differences between [how private equity and public market returns are calculated], direct comparison . . . is not recommended.”

In fairness, the disclosure goes on to 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 the next page.

This is useful material, as are the other metrics presented in an analysis section at the back of the book.

But did any limited partner or investor receive what the firm states on this subsequent page are “actual private investment return(s)”?

As I’ve written before, some firms disclose, in fine print, what these “actual returns” might be:

Returns “No Client Received”

Some firms don’t.

Again, why not?

In fine print, you also find this about the calculation of the net to limited partner 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 potential issues to consider, like the “spreading rapidly, like a zombie outbreak” use of “fund level engineering” that can “optically boost” the limited partner returns that academics have reported might already be inflated in the first place?

As one leading private equity professional recently said, a form of this return engineering “could potentially lift [the returns I’ve been mentioning] by 3% or more.” beyond returns that might already be high compared with the actual cash-on-cash returns that investors receive.

And, 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 reported returns by 6.0%, while decreasing final cumulative returns that investors actually receive.

On the page I referenced that might portray a more “accurate” comparison of private and public equity returns, the firm does make adjustments to the public market returns in an attempt to create a better apples-to-apples comparison. But they still use the prone-to-be-engineered in more than one way, net to limited partner returns that some say “no client received.”

Again, why?

Access can be great, and to be clear, as 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 “accredited” or “sophisticated” investors.

As Howard Marks, CFA, noted some time ago, there is no easy way to evaluate private investment (PE, venture capital, etc.) returns and so:

“Complex, Multi-Dimensional Analysis Is Required.”

Marks and other truly sophisticated investors have the background and the resources to conduct such analyses.

Are most individual investors (regardless of size), and even some investment advisors, who may soon have expanded PE access, similarly equipped?

Before making more of the “best stuff” available, should a few of more “why” questions be answered in an easy-to-understand manner?

As I wrote in my first 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 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 ‘why’ questions, buyer beware:”

“You may be purchasing returns that no client received.”

Related Reading and Research:

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