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Private Equity Creates Public Headaches

According to the New York Times, private equity doesn't seem to have delivered the market-beating results that managers have been touting. Public pension funds are among those still waiting for those big returns. It's too bad they didn't look at the historical evidence before investing.

The term private equity is used to describe various types of privately placed (non-publicly traded) investments. Over the past 30 years, the asset class has seen tremendous growth, going from raising $200 million in 1980 to $200 billion in 2007. During this time, public pension funds jumped on the bandwagon, now having $115.9 billion invested in private equity. Typically, these funds charge fees totaling 2 percent of the managed assets and 20 percent of any profits.

Of course, as the Times noted, "Private equity executives generally say their fees are justified by their market-beating returns." Let's see if that has been the case.

  • The study "Private Equity Performance: Returns, Persistence and Capital Flows," covered private equity funds launched from 1980 to 1997 and returns through 2001. Net of fees, the average private equity fund had returns roughly equal to the return of the S&P 500 Index. And this study covered included one of the greatest private equity booms in history -- the Internet/ era.
  • A 2002 study, "The Returns to Entrepreneurial Investment: A Private Equity Premium Puzzle?" covering the period 1952-99, concluded that private equity investing provided returns similar to that of public equity markets.
  • The 2007 study, "The Performance of Private Equity Funds," researched the performance of 6,000 private equity deals and about 1,000 buyout funds, using data collected from investors in 852 private equity funds raised before 1993. The average private equity fund underperformed the S&P 500 by 3 percent per year.
Making matters worse is that the data from these studies likely contain an upward bias. The aforementioned study "The Performance of Private Equity Funds" attempted to correct for this bias, which results from "living dead" investments. The residual values reported in studies often include inactive funds -- those with an age above the typical age limit of funds (such as 10 years) that show no sign of any recent activity within the past four years, such as distributions or cash calls.

As a result, accounting values may not reflect market values. Poorly performing funds have an incentive to postpone liquidation to artificially raise their reported return. Thus, the authors suggest that the residual value of these funds is overstated (and should likely be written off). Studies that include only liquidated funds have a "winners" bias. Once this bias is eliminated, the return of private equity funds raised between 1980 and 1996 lagged the return of the S&P 500 by 3.3 percent per year.