Private Equity investment. Anyone used PE to generate alpha?

Baw if you want uncorrelated returns, jump into SLI. I wouldn’t touch any Chinese stocks or funds with a 10 foot pole.

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I read a recent report by INVESCO that argued that the correlation was only 0.46 between the stock market and PE firms.

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Look around some more. It’s hard to find Asia specific data, but US buyout funds tend to have correlations north of .75.

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Honestly, net IRR >15% seems insanely impressive to me (I guess I'm easily impressed) particularly if it's uncorrelated and the risks are lower. But that also makes me think they're just leveraging up and calling it a day.

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15% is stout as hell, but I just don’t think you’ll find the lack of correlation you seek. Risk-adjusted returns are notorious difficult to find for PE, but there are sources that would suggest the net returns aren’t great there either.

Asia PE is probably a different story given the inefficiencies that likely exist there, but the data is hard to find.

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Also, side note, did you study at Stanford? Kudos if that's the case.

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I was sent an invite to apply to Stanford, so thank you, but I just use the S to match my username and make it easy to find posts while browsing.

Yo you know where to find that ALPHA?

ETA: ok felt like a dick… but 15%, give or take, should be the standard for the run the mill PE strategy.

Quoted volatility is generally quoted far lower because valuations are not calculated the same way as publicly traded markets, but obviously there is a vastly different liquidity profile vs the public markets. So relative volatility in PE is really only a number on paper.

For that illiquidity, you should require a higher return. “PE investing” is a broad statement, and there’s plenty of diversification you can aim for in that space. Different equity approaches/strategies, different vintages (commitment timing), industry/country, etc…

With equity market returns looking less attractive vs the last decade, bonds looking meager… a good PE and other sources of alternative return are worth considering.

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I'm looking for uncorrelated returns with significant alpha generation.

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So I'm admittedly just learning about investment returns for private equity, but the more I research, the more skeptical I am that it provides any positive alpha at all, if not negative.

So a couple of things that initially bothered me. First, it's difficult to actually find any useful information about returns at all, and when they do post them, it's always IRR. Typically I like IRR, or money-weighted rate of return, because index funds usually is the time-weighted rate of return (i.e., how much has $10,000 initially invested grown over various periods of time); however, I don't have the luxury of being able to invest it all at one time, and I invest it throughout the year with what I can and when I can (weekly and/or monthly in my personal accounts, bi-weekly for more work accounts, etc.), essentially dollar-cost averaging (but not technically DCA since I'm not withholding any to average in).

So when I backtest or do monte carlo simulations on portfoliovisualizer, I always do a monthly investment of the same amount (usually $1,000), and look at both the TWRR and MWRR to get a sense of how the portfolio performs under various conditions (e.g., MWRR beneficial in high volatility markets and downturns). But those are consistent cash-flows (including dividend reinvestments) so they're relatively simple and easily understandable calculations.

But with private equity (and things like Grant Cardonne's real estate investment), which uses IRR, it's a lot harder to figure out what those returns mean in reality.

And the more I research private equity, the more I realize that it's even more deceiving than the general lack of transparency would suggest. Specifically, the IRR is based on the amount that is actually put towards investments, which at first glance, this doesn't appear deceiving, until I realized it's not how much an investor "invests" in the private equity, it's what the private equity firm actually allocates to investments, and this is often not 100% and far from it:

Are Private Equity Returns Overstated?

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Let’s say your pension fund makes a $10 million commitment to a private equity fund. It’s highly likely that just $6-$7 million of that capital will be invested by the PE fund. This is because, on average, PE funds only call roughly 60-70% of committed capital (another issue is that many funds still charge fees on the $10 million of committed capital, so investors are paying much more than a 2% management fee, but I digress).

This means that while investors may be receiving decent returns on their PE investments, it’s being earned on a smaller capital base than they may realize, thus diminishing the impact of the returns on the overall portfolio.

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So if I commit $10 million to a PE investment, but they only invest 60% of that or $6 million, and they triple that $6 million in 10 years, I now have $220 million or 120% return, but they will calculate that as 200% return. But it's not a 100% return, because that $10 million I committed, and in the stock market, that would have been $10 million invested.

So that's deceiving, but it gets even more deceiving because of the timing:

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The timing of the cash flows matter. IRRs are used because they are meant to take into account the timing of cash flows. When our hypothetical pension fund makes its $10 million commitment to a PE fund, they don’t simply hand over that money all at once. It gets invested as opportunities arise. The investment period for a PE fund can last up to 10-15 years. But the IRR stat places a lot of weight on the earliest cash flows. When you invest and how quickly you get your money back can have a huge impact on the IRR calculation.

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So now let's say they don't even invest that $6 million for 5 years, so they'll calculate the IRR on that 200% return over 5 years, which is 24.6%. But in reality, I made $12 million ($22 million total including initial $10 million), or 120% in 10 years, for an annualized return of 8.2%, which is not even close to the 24.6% they'll cite.

And I was able to actually find an example of this because CalPERS publishes all of their Private Equity investments.

Private Equity Program Fund Performance Review

Specifically, they cite the overall performance as:

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As of March 31, 2021, the since inception Net IRR is 11.2% and the Net Multiple is 1.5x.

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So 11.2% is good, a bit better than the stock market (historically between 10 and 11 percent). In addition, of the 226 investments that had a long enough time frame to make a calculation (pre-2017, which seems crazy to me that 4 years isn't enough), the average IRR is 11.5% and the median is 10.15% and the average net multiple is 1.62 and the median is 1.5. So that's pretty consistent.

But again, it's really difficult to actually determine investment performance since I don't know the cash flows both in-flows and out-flows and exactly when they occurred. But there is one investment that has not had any cash distributions but it does have the NAV so it's easier to calculate.

Specifically, in 2015 (so 6 years ago) CalPERS committed $150 million to the Patria Brazilian Private Equity Fund V. 6 years later the NAV is $239,430,998.

That's a total gain of about 60% (or a net multiple of ~1.6) for an annualized return of 8%. But here is the thing, of the $150 million, only about $131 million (87%) has been put towards investments and management fees. So that multiple is 1.82, or 10.6% annualized.

That is already deceiving since they committed $150 million, but it gets worse. They cite the IRR not at 8% or even 10.6%, but instead at 31.8%. But if I invested $150 million and was told my annual return was 31.8% over 6 years, then I would expect that to have increased by 424% and be worth ~$786 million. Instead, it's increased by 60% and is worth a little less than $240 million.

So in my opinion, while the returns are probably technically correct (i.e., based on the smaller amount invested and the timing), the IRR is so deceiving that it is essentially meaningless. And that IRR is in the to 6% of all of their investments, almost 3X their overall IRR. So if that's ~4X the actual return (i.e., amount gained on the initial investment over the time period), then that 11.2% is clearly way higher than the actual return, at least in any normal sense of investing.

In other words, I would be highly skeptical of getting any actual alpha if I were you because their returns appear to be quite inflated and deceiving. And maybe I'll make another post about this, but if I were you, and I was going to invest in a PE fund, I would stay far away from that Carlyle investment because that one seems like it could be another example of an investment that is doing well and then boom it's completely gone.

Good post buckeye. I work for a PE portfolio company. This was an interesting read.

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So why do you think they remain popular investments?

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I mean I think private equity could be a good investment in one's portfolio, specifically like CalPERS and other large pension funds, which have so much money that they can invest broadly across private equity funds (e.g., essentially functioning like a private equity index) while still only being a small portion of the portfolio (e.g., CalPERS has $43 billion in private equity but that is less than 9% of its allocation).

In addition, there are clearly some firms and funds that do really well. so there are clearly good opportunities. But I think the issue is that there is a lot of variability in the quality, and it's probably even larger than the returns indicate since the funds/firms that perform well tend to be more cautious about their calculations of returns, even understating them, whereas the poorer ones overstate their returns.

So my general hypothesis is that since private equity did perform well for decades, they rightfully became a popular investment; however, as its popularity grew, it allowed for lower quality firms to enter the space, which decreased the aggregate returns in the market.

In addition, with more competition and lower quality firms, I suspect that this then led to an expansion investments investments into companies that may had historically been in the public markets instead, leading to a higher correlation with the public market. I also think that these could be companies that may have been riskier and/or of lower quality, so it's an addition by subtraction for the public markets and brings down the performance of the private equity leading to further convergence of the two.

I also think that there is something to be said about "exclusivity," which probably draws people to it, especially as access to the public markets has gotten much easier (applications, free trading, etc.). So being able to invest in something exclusive carries some level of "prestige," regardless of performance.

Overall though, I think investing in private equity, especially if unlike say those large pension funds that can broadly invest, requires a lot of due diligence on the front end if one can only invest in a single or very few funds. And given the lack of transparency, I think this is probably difficult to do, which makes it not a good option for most people.

My guess is your definition of alpha is performance above S&P annualized returns. That’s not really alpha. Why sacrifice liquidity and less risk for what amounts to be similar to inferior returns?

PE is another victim of low rates. As investors search for yield in a low yield world, they go further and further out the risk curve. Generally speaking, the lower the risk of an investment, the larger the market, such that the bond market > the equity market > the PE market > the VC market.

As more capital is allocated to riskier investments, the pig moves through the python, deal competition increases, and yields get compressed. In my experience, it’s hard to find alpha unless you’re in a market that is too small to attract much interest from institutional players (which is why I struggle with why ordinary people want to do things like get into the storage unit business after that industry has already been flooded with REIT money).

There are no doubt PE firms out there who generate alpha based on their industry expertise or because they’ve carved out a niche. But those managers are few and far between, and the better they do, the more inaccessible they become for smaller investors.

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