This paper on private equity investing is the third in a series on alternative investments. The alternatives industry is making a concerted effort to gather more assets from individuals due to declining appetite from institutional investors. The purpose of the series is to help individual investors recognize the drawbacks of alternative investments before investing in them. If you are considering private equity for your portfolio, you should be aware of the following issues:
Returns as reported by private equity firms can be misleading.
Even as reported, private equity returns have not been better than the outcomes of similar public equity portfolios in the past decade.
The high fee burden, particularly for funds of funds, detracts from private equity outcomes.
There are severe liquidity strains in the private equity ecosystem – a rapidly growing number of private equity-backed companies are facing a shrinking exit window.
Success in private equity investing requires organizational capabilities and access that, for the most part, are not available to individuals or their advisors.
Why Private Equity?
The lasting appeal of private equity investing is understandable. The apparent advantages include:
A much greater opportunity set. Of the more than 20,000 US companies with over $100 million in revenue, only about 2,700 (13%) are listed on the stock market.
Greater influence. A private equity investor in a company typically has the means to improve operations and optimize capital structures to boost performance.
High historical returns. In the earlier years of private equity, average investment returns were meaningfully above public equity returns, and allocators skilled at selecting managers did even better. High private equity returns helped generate exemplary outcomes for early adopters of alternative investing.
Returns as Reported Can Be Misleading
Private equity performance can be challenging to decipher. Reported investment results are based on the Internal Rate of Return (IRR), a deeply flawed metric. IRRs are often misleading and typically exaggerate true performance.
One source of distortion has been the increased use of subscription lines of credit (SLCs) to manipulate IRRs. These lines permit fund managers to make investments with borrowed money, delaying capital calls. By reducing the time between the capital call and the exit, managers increase the IRR. A 2019 paper estimated that the use of SLCs improved reported IRRs by about 6% per year. Twenty years ago, a private equity fund that achieved a multiple of invested capital (MOIC) of 1.6 (the long-term average) would report an IRR of around 10%. Today, the same outcome often reports an IRR of 15% or more.
Company valuations, as set by private equity firms, often overstate performance as well. Since private equity firms are largely unable to sell their mature holdings at the valuations being reported, reported performance is likely higher than what it would be at fair market value.
Even as Reported, Returns Do Not Look Better Than Public Equity
On the surface, it appears that private equity returns have exceeded public stock market indices. However, private equity holdings differ in sector allocations, leverage, risk, and market capitalization. Most studies that adjust for these factors have found that private equity firms, on average, have generated net-of-fee performance below comparable public market portfolios.
The chart below shows ten-year annualized returns through December 2023 for three private equity indices and three public market benchmarks. The private equity indices show annual returns in the range of 14.0% to 16.5%. An investment in S&P 500 sector indices with the same weights and leverage as private equity would have returned 17%. A 2024 PitchBook study found that replicating private equity characteristics in public markets—small, underperforming companies with moderate leverage—would have achieved 19.2% per year.
Manager Fees Impact Performance
The fees paid to private equity managers are a significant obstacle to achieving attractive returns. Private equity firms typically charge a 2% management fee plus a carried interest of 20% of profits.
Often an individual investor will invest via a “fund of funds” vehicle, which can improve diversification across managers and vintages but adds another layer of fees. These additional fees can reach 1%/10%. The chart below illustrates how the return of the S&P 500 since 1997 would have been impacted if 2%/20% fees were applied—and even more so if both 1%/10% and 2%/20% were applied. An investor paying both layers of fees would have lost over 60% of their potential gains to fees.
Private equity funds raised between 2000 and 2019, reporting to Preqin, invested roughly $8 trillion in capital commitments. The carried interest paid on those investments now exceeds $1 trillion. In contrast, Vanguard earns about $7 billion annually on its $8 trillion in assets under management. Despite this enormous fee disparity, endowments and institutions heavily allocated to alternatives have not demonstrated superior results.
Private Equity Exits Are Scarce
There is an escalating mismatch between the capital flowing into private equity and the money flowing back out, creating liquidity strain for both firms and investors.
The chart below shows the growth of US private equity assets. The $3.1 trillion invested in private equity at the end of 2023 is more than four times the amount invested in 2006. This includes $2.1 trillion in portfolio companies and $960 billion of undeployed “dry powder.” The size of the private equity universe now rivals the combined value of all companies in the Russell 2000 Index.
For each portfolio company, the goal is a successful “exit,” either via IPO or sale to another buyer. However, the number and value of such exits have declined significantly over the past two years.
The chart below shows that IPO activity aligns closely with stock market cycles, yet the rebound in public equity valuations since 2022 has not triggered a rebound in IPOs. The years 2022–2023 marked the lowest two-year period for buyout-backed IPOs since 1981–1982.
Private equity-backed sales to strategic or financial buyers have also slowed, partly due to higher interest rates. Roughly 20,000 US companies are backed by private equity, with 500–1000 added each quarter, yet only around 1,000 exits occurred in 2023. The proportion of private equity investments distributed back to investors fell below 9% in 2023 — the lowest level since 2009. The long-term average has been about 30%.
Who Should Invest in Private Equity?
There is significant dispersion in outcomes among private equity managers. According to JP Morgan, the top quartile of global private equity funds outperformed the bottom quartile by more than 20% per year over the past decade. The investors most likely to benefit are large institutions with the expertise to identify superior funds and relationships to access them.
University endowments and similar institutions have extensive due diligence processes, involving on-site visits and in-depth analysis of a manager’s people, strategy, and operations. Without comparable resources, access, and analytical rigor, individuals are unlikely to achieve above-average results.
Summary
David Swensen, Yale’s legendary Chief Investment Officer, once said: “In the absence of truly superior fund-selection skills (or extraordinary luck), investors should stay far, far away from private equity investments.” Individual investors lack Yale’s experience, access, and resources for manager selection and should not attempt to replicate institutional strategies. Instead, they should focus on diversified portfolios of liquid assets implemented at the lowest possible cost. For most individuals, private equity outcomes have been disappointing, and avoiding the category entirely is often the most prudent course.
Disclaimer
The information and opinions contained in this document are for background purposes only and do not constitute investment advice. Atlas Capital Advisors does not guarantee the accuracy or completeness of this information and accepts no liability for any loss arising from its use. This document is not an offer or solicitation to buy or sell any security or investment product. Opinions expressed are subject to change without notice.
Certain data and statements have been obtained from third-party sources believed to be reliable, but Atlas does not warrant their accuracy or completeness. Past performance is not indicative of future results. Investments are subject to risk, including possible loss of principal.
Investment advisory and management services are provided by Atlas Capital Advisors, Inc., registered as an investment advisor with the SEC.
What’s Discussed
This paper on private equity investing is the third in a series on alternative investments. The alternatives industry is making a concerted effort to gather more assets from individuals due to declining appetite from institutional investors. The purpose of the series is to help individual investors recognize the drawbacks of alternative investments before investing in them. If you are considering private equity for your portfolio, you should be aware of the following issues:
Why Private Equity?
The lasting appeal of private equity investing is understandable. The apparent advantages include:
Returns as Reported Can Be Misleading
Private equity performance can be challenging to decipher. Reported investment results are based on the Internal Rate of Return (IRR), a deeply flawed metric. IRRs are often misleading and typically exaggerate true performance.
One source of distortion has been the increased use of subscription lines of credit (SLCs) to manipulate IRRs. These lines permit fund managers to make investments with borrowed money, delaying capital calls. By reducing the time between the capital call and the exit, managers increase the IRR. A 2019 paper estimated that the use of SLCs improved reported IRRs by about 6% per year. Twenty years ago, a private equity fund that achieved a multiple of invested capital (MOIC) of 1.6 (the long-term average) would report an IRR of around 10%. Today, the same outcome often reports an IRR of 15% or more.
Company valuations, as set by private equity firms, often overstate performance as well. Since private equity firms are largely unable to sell their mature holdings at the valuations being reported, reported performance is likely higher than what it would be at fair market value.
Even as Reported, Returns Do Not Look Better Than Public Equity
On the surface, it appears that private equity returns have exceeded public stock market indices. However, private equity holdings differ in sector allocations, leverage, risk, and market capitalization. Most studies that adjust for these factors have found that private equity firms, on average, have generated net-of-fee performance below comparable public market portfolios.
The chart below shows ten-year annualized returns through December 2023 for three private equity indices and three public market benchmarks. The private equity indices show annual returns in the range of 14.0% to 16.5%. An investment in S&P 500 sector indices with the same weights and leverage as private equity would have returned 17%. A 2024 PitchBook study found that replicating private equity characteristics in public markets—small, underperforming companies with moderate leverage—would have achieved 19.2% per year.
Manager Fees Impact Performance
The fees paid to private equity managers are a significant obstacle to achieving attractive returns. Private equity firms typically charge a 2% management fee plus a carried interest of 20% of profits.
Often an individual investor will invest via a “fund of funds” vehicle, which can improve diversification across managers and vintages but adds another layer of fees. These additional fees can reach 1%/10%. The chart below illustrates how the return of the S&P 500 since 1997 would have been impacted if 2%/20% fees were applied—and even more so if both 1%/10% and 2%/20% were applied. An investor paying both layers of fees would have lost over 60% of their potential gains to fees.
Private equity funds raised between 2000 and 2019, reporting to Preqin, invested roughly $8 trillion in capital commitments. The carried interest paid on those investments now exceeds $1 trillion. In contrast, Vanguard earns about $7 billion annually on its $8 trillion in assets under management. Despite this enormous fee disparity, endowments and institutions heavily allocated to alternatives have not demonstrated superior results.
Private Equity Exits Are Scarce
There is an escalating mismatch between the capital flowing into private equity and the money flowing back out, creating liquidity strain for both firms and investors.
The chart below shows the growth of US private equity assets. The $3.1 trillion invested in private equity at the end of 2023 is more than four times the amount invested in 2006. This includes $2.1 trillion in portfolio companies and $960 billion of undeployed “dry powder.” The size of the private equity universe now rivals the combined value of all companies in the Russell 2000 Index.
For each portfolio company, the goal is a successful “exit,” either via IPO or sale to another buyer. However, the number and value of such exits have declined significantly over the past two years.
The chart below shows that IPO activity aligns closely with stock market cycles, yet the rebound in public equity valuations since 2022 has not triggered a rebound in IPOs. The years 2022–2023 marked the lowest two-year period for buyout-backed IPOs since 1981–1982.
Private equity-backed sales to strategic or financial buyers have also slowed, partly due to higher interest rates. Roughly 20,000 US companies are backed by private equity, with 500–1000 added each quarter, yet only around 1,000 exits occurred in 2023. The proportion of private equity investments distributed back to investors fell below 9% in 2023 — the lowest level since 2009. The long-term average has been about 30%.
Who Should Invest in Private Equity?
There is significant dispersion in outcomes among private equity managers. According to JP Morgan, the top quartile of global private equity funds outperformed the bottom quartile by more than 20% per year over the past decade. The investors most likely to benefit are large institutions with the expertise to identify superior funds and relationships to access them.
University endowments and similar institutions have extensive due diligence processes, involving on-site visits and in-depth analysis of a manager’s people, strategy, and operations. Without comparable resources, access, and analytical rigor, individuals are unlikely to achieve above-average results.
Summary
David Swensen, Yale’s legendary Chief Investment Officer, once said: “In the absence of truly superior fund-selection skills (or extraordinary luck), investors should stay far, far away from private equity investments.” Individual investors lack Yale’s experience, access, and resources for manager selection and should not attempt to replicate institutional strategies. Instead, they should focus on diversified portfolios of liquid assets implemented at the lowest possible cost. For most individuals, private equity outcomes have been disappointing, and avoiding the category entirely is often the most prudent course.
Disclaimer
The information and opinions contained in this document are for background purposes only and do not constitute investment advice. Atlas Capital Advisors does not guarantee the accuracy or completeness of this information and accepts no liability for any loss arising from its use. This document is not an offer or solicitation to buy or sell any security or investment product. Opinions expressed are subject to change without notice.
Certain data and statements have been obtained from third-party sources believed to be reliable, but Atlas does not warrant their accuracy or completeness. Past performance is not indicative of future results. Investments are subject to risk, including possible loss of principal.
Investment advisory and management services are provided by Atlas Capital Advisors, Inc., registered as an investment advisor with the SEC.
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