Why you should pass on private equity

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(MoneyWatch) In an effort to broaden its customer base, the Carlyle Group recently announced that it was letting individuals invest in its buyout funds with as little as $50,000 -- though individuals will still have to meet the standard of being an "accredited" investor, having $1 million in financial assets. Buyouts are deals in which firms leverage their investors' money with debt to buy companies, with the goal of improving the businesses and reselling them for a profit.

Historically, only pension plans, endowments and very high net worth individuals have had access to private equity funds. The question for investors is: Is this an opportunity you should be pouncing on? Or, is it fraught with opportunity?

There's plenty of evidence that private equity doesn't seem to be anything special. In fact, one study showed that private equity has had returns roughly equal to the S&P 500 Index, while another study had private equity funds lagging the S&P 500 by about 3 percent per year.

When you factor in fees, you can see why private equity is an asset class best avoided. The returns of such funds have to be very high for that outperformance to hit your pocket. In Carlyle's case, I would put their fees in the obscene category. It charges 1.5 percent plus 20 percent of the profits, with an additional fee of about 1.8 percent that will be paid to Central Park Group to manage the fund and to brokers who sell the fund.

To show you how high a hurdle these type fees create let's do a little math. Let's assume that the S&P 500 Index continues to provide its historic return of about 10 percent. If Carlyle's investments provide a pre-expense return 6 percent higher, or 16 percent, these investments would still end up underperform the S&P 500. We first have to subtract from that 3.8 percent in fees, leaving us with 12.2 percent. We then subtract the 20 percent of profit fee, leaving a net return to investors of 9.8 percent, below that of the S&P 500 Index return of 10 percent.

Of course, that's assuming the S&P 500 is an appropriate benchmark. Given the risks of private equity relative to public securities -- lack of liquidity, transparency and broad diversification, among others -- a more appropriate benchmark might be small-cap value stocks, which have returned 13.6 percent per year (as measured by the Fama/French US Small Value Index.

To beat that return, Carlyle's investments would have to provide a gross return of about 21 percent, or about 11 percent more than that of the S&P 500.

Carlyle's appealing to the all-too-human need to feel special, to be a member of some exclusive club. When it comes to such clubs, Groucho Marx provided the best advice: "I don't want to belong to any club that will accept me as a member." Private equity is one club you're best served by not joining, because the beneficiaries are much more likely to be the purveyors, not the investors. They win whether you win or not.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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