Chapter 19
Private Equity
Ask for much but take what is offered.
—Russian proverb
Rising allocations by institutional investors to alternative asset classes such as private equity have sharpened interest in how returns and risks are measured relative to public equity benchmarks. This is especially true for public pension plans since private equity generates a clear opportunity cost as dollars are allocated away from public equity. Thus, whether private equity is a viable alternative to public equity will depend upon how private equity returns are measured, benchmarked, and adjusted for risk.
In this chapter, I evaluate various measures of return and risk for private equity investments, including public market equivalents (PME), PME alphas (unadjusted for risk), internal rates of return (IRRs), and the Long and Nickels alpha (which is an excess IRR measure). This is referred to officially as the index comparison method (ICM) at www.alignmentcapital.com. We also discuss generalized method of moments (GMM) alpha and beta estimates, using both a capital assets pricing model (CAPM) and the Fama-French three-factor model with bootstrapped standard errors as outlined in Driessen, Lin, and Phalippou (2008). I highlight two important findings: First, the various performance measures often tell wildly different stories about performance. In particular, users should be aware of the sensitivity of IRR estimates to the timing of cash flows and, in general, should adopt several performance measures as robustness checks. Second, risk-adjusted performance statistics are sobering; risk-adjusted GMM estimates reject any claims that private equity outperforms the public benchmark. This is interesting because it is completely at odds with virtually all the IRR- and PME-based measures. Moreover, I argue that selective use of nonrisk-adjusted performance measures may have influenced increased allocations to private equity in the past and that private equity partners significantly underestimated the risks on their investments relative to their benchmarks.
On balance, the academic literature has been critical of claims of private equity outperformance. Moskowitz and Vissing-Jorgensen (2002), for example, study data from the Survey of Consumer Finances, the Flow of Funds Accounts, and the National Income and Product Accounts and find that risk-adjusted returns are low relative to public equity. Still, private equity continues to attract capital and this persistence may suggest that investors overestimate survival probabilities and therefore expected returns, or have a preference for skewness in the distribution of returns. These reasons notwithstanding, published academic literature finds little supporting evidence of outperformance of private equity in general relative to a public equity index such as the S&P 500 (Phalippou 2007). Kaplan and Schoar (2005) report results from a study of 746 funds and conclude that returns to limited partners (LPs) are essentially equal to that of the S&P 500 (their public market equivalent is 1.01). Phalippou and Gottschalg (2009) are even more critical, arguing that after adjusting for survivorship bias in the data (Thomson Venture Economics), and so-called living deads (residual values that do not get written off), then private equity underperforms by as much as 3 percent per year. Specific subclasses such as buyout and venture fare no better; Hwang, Quigley, and Woodward (2005) report slightly positive gross-of-fees relative performance for venture (implying low net-of-fee performance) while both Swensen (2000) and Phalippou and Gottschalg present evidence from analyses of private equity manager–supplied prospectuses that show gross-of-fees underperformance relative to a similarly leverage-adjusted S&P 500.
Risk-adjusted performance paints a bleaker picture. Estimated betas for venture lie close to two (Driessen, Lin, and Phalippou 2004; Woodward 2004; and Cochrane 2004). Buyout betas are lower. For example, Woodward reports a beta less than one while Driessen, Lin, and Phalippou calculate a beta close to zero. Estimates of beta on publicly traded firms that are recipients of private equity investment are around 1.3 (Phalippou and Gottschalg 2009).
Most of these studies measure returns using IRR and risk-using CAPM-type regressions. Kaplan and Schoar report PME estimates as well but do not extract excess IRR (see the discussion further on). Ick (2005), on the other hand, reports PME in excess of one, which, as we illustrate further on, indicates private equity outperformance (unadjusted for risk, however). Other studies, such as Ljungqvist and Richardson (2003) examine private equity cash flows and NAVs for a single large pension fund, and report annual excess returns in the 5 to 8 percent range (again, unadjusted for risk). If there is a consensus, it is that private equity risks are underestimated and that even for cases in which private equity outperforms the public market, risk-adjusted excess returns usually do not justify the investment. In these cases, we are reminded again by Moskowitz and Vissing-Jorgensen that there may be behavioral explanations that explain ever increasing capital flows to this asset class. Recent research suggests that some LPs are more experienced and, having learned how and whom to invest with, earn alpha while less experienced LPs do not (Lerner, Schoar, and Wongsunwai 2007). Fund-picking skills aside, there is evidence that limited partnerships (LPs) misprice deals, as they routinely underestimate fees (Swensen) and rely too heavily on IRR measures of performance (Phalippou).