Jay D. Franklin

Problems with Private Equity Performance

Index Funds Advisors, Inc. (IFA) recently completed an analysis of the performance of state retirement pension plans which showed that all of them would have fared better with a portfolio of index funds such as the ones offered by IFA. When confronted with these numbers, the often heard refrain of the administrators of these plans is that confining themselves to stocks and bonds is far too limiting for funds that have billions to invest. Instead, they must search for “alternative investments” such as hedge funds and private equity that are not available to the general public. IFA has repeatedly cautioned “qualified” investors against being seduced by the notion that they are going to “beat the market” merely because they can hire talented managers in an asset class that allegedly has exploitable inefficiencies. One study that reinforces this warning is “The Performance of Private Equity Funds”¹ by Ludovic Phalippou and Oliver Gottschalg of the University of Amsterdam. The authors analyzed a dataset of 1,328 funds (including both U.S. and international funds) and corrected for the following three common practices that upwardly bias the reported returns of the public databases that track the performance of private equity funds:

1)     The residual values reported by private equity funds long after they have made their last payments to investors have traditionally been counted towards their returns. The authors argue that these residual values should be zeroed out since investors normally do not collect any part of the residual value.

2)     When calculating the performance of private equity funds as a group, the weights are often based on capital committed. The authors argue that a superior measure is the value actually invested since funds generally do not invest all their committed capital at the outset.

3)      As with hedge funds, there is a strong selection bias in that successful funds are far more likely to report their results than failed funds.

After addressing all three of these issues, the authors found that private equity funds underperformed the S&P 500 by 3% per year. Adjusting this underperformance to account for the additional risk of private equity brings it to a substantial 6% per year.  

This study deserves the attention of institutional investors such as foundations, endowments, and pensions. This study belies the often-made claim that managers and asset classes that are only accessible to “qualified” investors will provide outsized returns that are unavailable to the remainder of the investing public.

¹ Phalippou, Ludovic and Gottschalg, Oliver, “The Performance of Private Equity Funds,” The Review of Financial Studies, Volume 22, Issue 4 (April 2009), pp. 1747-1776.