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?

quote:
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.

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:

quote:
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.

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:

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

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.

This post was edited on 10/8/21 at 12:19 am

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Posted by buckeye_vol

Member since Jul 2014

35252 posts

Posted on 10/8/21 at 12:45 am to buckeye_vol

I also add this article from the Financial Times, which cites a study that estimates that actual annualized return for private equity in the UK as far lower than the returns PE firms provide and even far less than the stock market:

Private equity returns are not all they seem

Here is what the data from PE firms suggest:

quote:
Take for instance the British Private Equity and Venture Capital Association’s 2017 performance measurement survey. This revealed that over the previous decade, UK private equity generated returns of 11 per cent a year, far outpacing the 6.3 per cent on the FTSE All-Share index. Over five years, the figure was a no less impressive 17.8 per cent as against 10.3 per cent for quoted stocks.

But here is the estimates from the study (using US firms as well as European firms):

quote:
Interestingly, PME figures are less flattering for private equity. A large study conducted in 2015 by three academics looked at nearly 800 US buyout funds between 1984 and 2014. They found that before 2006, these funds delivered an excess return of about 3 per cent per annum, net of fees, relative to the S&P 500 index. In subsequent years though, returns have been about the same as on the stock markets. A study of 300 European funds produced similar results.

And here is the actual study (a working paper):

How Do Private Equity Investments Perform Compared to Public Equity?

More specifically, it seems that PE used to generate alpha (3% annually) in the 1980s through 2000s:

quote:
Our estimates imply that
each dollar invested in the average buyout fund returned at least 20% more than a dollar invested
in the S&P 500. This works out to an outperformance of at least 3% per year.

But since 2005, PEs have performed similar to the S&P 500, so not really generated alpha, but with the liquidity risk that should require a premium:

quote:
k. For the more recent and less fully realized post-2005 vintage funds, however,
performance has been roughly equal to public markets.

They also discuss the potential for selection bias in the available PE data, but they think it's unlikely since their data sources are consistent with other sources. But I'm not convinced since the same issue happens with all sorts of data sources, including meta-analyses for academic studies and the file-drawer problem (i.e., only significant results are usually published), and given the lack of transparency of PE data and the incentives to publish favorable data, my guess is there is a clear risk that there is some survivorship bias and/or those that severely underperform are more likely to downplay, if not, outright omit it.

So their data source may not have selection bias, compared to the available data, but the available data may be biased. In other words, I think the results are best-case scenario for PE, especially since given those incentives, even the published data is probably as rosy of a picture as they could present.

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