In the June 2016 issue of Investment Advisor, Jack Rivkin, the Chief Executive Officer and Chief Investment Officer of Altegris, a provider of alternative investment vehicles, wrote about how the track record of private equity funds “has attracted university endowments, foundations, pension funds and wealthy investors.”
Rivkin observed that “in the 25 years through September 2015, the Cambridge U.S. Private Equity Index returned 13.4% annually compared with 9.9% for the S&P 500 Index, according to Cambridge Associates.”
It’s important that Rivkin noted private equity (PE) didn’t provide the benefits of daily liquidity that mutual funds do. And he suggested that investors make sure they consider the risk of a liquidity trap before investing. He then closed with the following: “With a potentially lower return from the traditional markets, meeting an investor’s financial goals today requires a fresh look at allocations [to private equity].”
There’s a reason that the phrase “lies, damned lies, and statistics” (popularized by Mark Twain, among others) has become cliché. Wall Street’s marketing machine is great at using the persuasive power of numbers, particularly the use of statistics, to bolster weak arguments. And comparing the returns of private equity to the S&P 500 and claiming outperformance could be described as the poster child for the lies told by Wall Street.
At least, in Rivkin’s case, he referred to the 3.5 percentage point difference in the return between the Cambridge U.S. Private Equity Index and the S&P 500 over that 25-year period as an “illiquidity premium.” However, at best, you can consider the statement a “white lie.” Let’s see why this is the case.
Private Equity Is a More Risky Option
In their October 2014 study, Private Equity Performance: A Survey, Steven Kaplan and Berk Sensoy found that, in addition to the illiquidity element, PE is much riskier than investment in a publicly-traded S&P 500 index fund, making it wholly inappropriate as a benchmark. For example:
Firms in the S&P 500 are typically among the largest and strongest companies – while venture capital typically invests in smaller and early-stage companies with far less financial strength. Studies have estimated the betas for buyout funds at about 1.3, and for venture capital funds from 1.6 to 2.5. Adjusting for the higher betas alone would have wiped out any evidence of outperformance.
The median return of PE is much lower than its mean (arithmetic average) return. PE’s relatively high average return reflects the small possibility of getting a truly outstanding result combined with the much larger probability of a more modest or negative return. In effect, PE investments are like options (or lottery tickets). They tend to provide the small chance of a huge payout, but the much larger chance of a below-average return. And it’s difficult, especially for individual investors, to diversify this risk.
The standard deviation of PE is in excess of 100 percent. Compare that to standard deviations of about 20 percent for the S&P 500 and about 35 percent for small value stocks.
Clearly, given its greater risks and the fact that PE investments typically occur in smaller companies, the S&P 500 is an inappropriate benchmark. Yet it remains the one typically used by investment firms. Why? A more appropriate benchmark would lead investors to conclude that the returns to PE investments are not justified by the risks involved.
Small Value Comparison
A more appropriate benchmark than the S&P 500 Index is the Fama-French Small Value Index. For the 89-year period from 1927 through 2015, small value stocks outperformed the S&P 500 by 3.7 percentage points a year (13.7 percent versus 10.0 percent). During the same 25-year period cited by Rivkin, when the Cambridge U.S. Private Equity Index outperformed the S&P 500 Index by 3.5 percentage points, the Fama-French Small Value Index returned 13.8 percent, outperforming PE by 0.4 percentage points. And that’s even before considering the illiquidity premium investors should demand.
In case you’re wondering, from inception in April 1993 through February 2016, the DFA U.S. Small Cap Value Fund (DFSVX) returned 11.2 percent, the same return as the Fama-French Small Value Index during that period. Thus, investors could have realized the returns suggested by the index. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)
It’s also important to note that Sensoy, Yingdi Wang and Michael Weisbach, authors of the 2014 study Limited Partner Performance and the Maturing of the Private Equity Industry, found that in their more recent sample of PE funds raised between 1999 and 2006, there was no evidence that endowments outperformed other limited partner types or displayed any superior skill at selecting general partners.
Finally, returning to the aforementioned paper, Kaplan and Sensoy concluded that “the disappearing endowment advantage is consistent with other secular trends in the industry, particularly the decline in VC [venture capital] performance since the late 1990s and the decline in performance persistence in BO [buyout] firms.”
The Bottom Line
The bottom line is that, if you’re willing, able and have the need to take more risk in search of higher returns, the most likely place to find them is not in PE but rather in publicly available small value stocks. And you can access these higher expected returns through low-cost, passively managed and tax-efficient mutual funds. You can globally diversify their risks as well. In addition, you’ll have all the benefits of daily liquidity and transparency.
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