Is PE the “ultimate asset class”?

Private equity has been widely accepted as the best-performing asset class over the past decade with returns in excess of 20%. PE falls within the category of alternative asset classes, which are investments that do not conform to the traditional asset classes of stocks, bonds, or certificates. Examples include among others hedge funds, PE, real estate, VC, and distressed securities. Especially institutional investors, seeking returns in a low-interest-rate environment, have looked to PE to generate performance and fulfill investors’ needs. PE grew to account for 25% of institutional investors’ alternative investments in 2019, a 7% increase YoY, when comparatively HF have been down from 40% to 33% over the same period [1]. The question is, however, whether these high returns and subsequent adjustment of institutional investor’s assets have been justified? Is PE the ultimate asset class?

PE funds generally fall into two categories: venture capital funds, which invest in small, early-stage, emerging businesses with high expected growth potential, and leveraged buyout (LBO) funds, which usually take a controlling stake in more mature businesses. However, there are many investment strategies that PE funds can follow:

  • Growth equity, which is comparable to a VC-type investment, but into more mature companies;
  • Distressed investing, where PE funds specialize in investing in companies in serious financial difficulty;
  • Mezzanine capital, where PE firms finance company expansion through both equity and debt (the latter of which can be converted to equity if not repaid);
  • Fund of Funds, where the PE fund’s investments are made into other funds to diversify and hedge risk;
  • Infrastructure, where PE funds invest in utilities, transportation hubs and more recently renewable energy;
  • Real-estate, where PE funds invest in low-risk rental properties with stable, predictable cash flows.

In all PE funds General Partners (GP) charge investors an annual management fee of 1.5% – 2% of committed capital to support overheads, as well as carried interest which is traditionally ~20% of any profits generated by the funds. However, to receive carried interest, the funds must first achieve a hurdle rate of typically 8%, which is the minimum annual return investors are entitled to before the GP receives carried interest. Given these comparably high fees, and long periods of committed capital (an opportunity cost), one would assume the returns of PE to be very high. 

Even though PE returns are IRRs and not CAGRs, and therefore an approximation compared to public equity returns, it appears that over the last 20 years, PE has outperformed public markets, with lower volatility as well. The latter is likely due to PE portfolio companies typically only being valued every quarter.

However, it is of utmost importance to investigate the exact definition of “returns” in the PE industry. The headline figure, widely accepted by investors and shown in most presentations and documents, is the IRR (internal rate of return). It captures the funds time-adjusted return and is the discount rate that renders the net present value (NPV) of a series of investments to zero. It takes timing and size of cash flows, as well as the fund’s net asset value at the time of calculation into account. However, the mathematical calculation for IRR relies on a flawed reinvestment assumption. This entails that a high IRR generated early in a fund’s life is likely to overstate the actual fund’s performance and create an agency problem where GPs aggressively exit portfolio companies early in the fund’s lifecycle to lock in a high IRR. The following exhibit is taken from Alberts-Schoenberg, 2019[2], and illustrates how this assumption can lead to overstates fund performance.

The above example results in an IRR of 32.4%, meaning that to get a return of 32.4% over the life of the fund, each cash flow must earn 32.4% over the life of the fund. Thus, if, as in this example, initial cash flows reflect an unusually high return, the IRR calculation assumes that these are reinvested at an implausibly high rate, regardless of whether such reinvestment opportunities exist (49.4% in investment 1 of the example). This in turn produces an IRR result that is implausibly high and should not be conflated with the rate of return the investor earns. Moreover, another mathematical consequence of this is that IRRs of funds will become artificially “sticky”. High early cash flows, reinvested automatically, due to compounding become so large in value that later cashflows, irrespective of whether they are high or low, make little difference in the overall IRR. This is especially relevant seeing that large PE firms at their inception had early investments that did very well, resulting in their IRRs to become artificially stuck at a high level, as long as these firms avoid major disasters. A notable example of this would be KKR. The IRR of its legacy funds is about 26%, whereas its SEC filings show that its reported since-inception IRR is also about 26%.[3] Now, having understood that the widely used IRR should not be conflated for actual “returns”, we must understand how we can compare PE returns to public markets, and assess whether they do or do not outperform them.

A more accurate measure to describe PE return is the fund’s multiple of money invested (MoM), which describes the ratio of the total amount distributed (capital returned to investors) plus net asset value (fair value of remaining stakes of the fund in portfolio companies), divided by the total amount paid in (total capital invested). Using this measure, it was discovered by Phalippou, 2020 that as of the end of 2019, PE funds have returned about the same as public equity indices since at least 2006. Using 3 large data sets, he found the average net MoMs across all PE funds to be 1.55, 1.57, and 1.63, which imply a net return of about 11% p.a. As further analyzed within his findings, these kinds of returns match the most relevant public equity indices, shown below.

He furthermore shows the same pattern using Public Market Equivalents (PMEs), which is the ratio of the present value of distributed capital to the present value of invested capital, using a benchmark public stock index as a discount rate. In this case, it would indicate the same returns as public markets. The results are shown below.

While there is some variation in results, it is apparent that PE funds with vintage years 2006-2015 have very similar returns to the public market indices listed in the table, across all 3 datasets.

These results are consistent with further research done on PE fund performance including Kaplan and Schoar, 2005, Phalippou and Gottschalg, 2009, Higson and Stucke, 2012, and Burgiss, Harris, et al, 2014.[4]


The case of Hedge Funds

Hedge funds are defined as investment vehicles which source capital from various types of investors such as pension funds, HNWI, sovereign funds, wealth managers, family offices, etc.
Typically, US Hedge Funds have their legal structure aligned with their nature. The speculative nature of the investment strategies, the strong incentive plans for manager and opaqueness; can only link with little disclosure obligations.
In fact, Hedge Funds are organized as a limited partnership in order to provide pass-through tax treatment to its subscribers, meaning that profits are automatically transferred to clients who pay taxes based on their personal spheres.
The disclosure of US Hedge Funds also is not required, in fact they only have to disclose, quarterly, short and long positions on equities through a 13F SEC filing. No other public disclosure is needed.
Clearly this does not come for free. Funds that opt in this legal structure cannot publicly offer their quotas but can only relate to professional investors.
In Europe Hedge Funds are subject to the AIFMD (Alternative Investments Fund Manager Directive) which puts these actors under disclosure obligations about management performance incentives, risk management, minimum capital requisites.

Nowadays, according to Hedge Fund Research and Preqin, there are more than ten thousand Hedge Funds worldwide managing around 3.2 trillion of USD. The biggest Hedge Fund out in the market is Investments Guru Ray Dalio’s Bridgewater Associates managing roughly 100bn of USD.

Hedge Fund are discretionary actively managed funds, therefore their strategy can vary a lot between players. However, market observers have classified them by four main kinds of investment rationales: qualitative and quantitative analysis of equities, economic events such as M&A, macroeconomic trends and relative value of different assets.

  • Equity Hedge: typically, this kind of funds hold both long and short positions in equity securities and derivatives; in order to catch mis-valuation or market asymmetries on the selected set of securities. This kind of strategies then are further divided into sub-categories considering the kind of stocks in which capital is invested: value or growth stocks, or the sectors or the methodology used to build the strategy.
  • Event Driven: the strategy here is to hold positions in companies who are projected to take part in a corporate transaction or other events such as restructurings, financial distress, tender offers, buybacks etc. Also, here we can distinguish different types of funds. The most important are Merger Arbitrage funds who gain upon announcements and information asymmetries. Special situations funds and distressed restructuring are similar strategies considering the target investment but the first one uses mainly equity instruments while the second is structured primarily using debt securities.
  • Macro: These funds structure their trading strategy based on movements of economic variables and how these indicators influence the movements of market securities. Here we can find funds who make active trading as opposed to systemic trading, involving only specific types of variables or multi-asset strategies.
  • Relative Value: Basically, this kind of asset managers base their investment rationale on the fact that correlated securities can express inconsistent relative valuation between them based on quantitative methods. Here the funds are distinguished by the kind of assets they compare.

Hedge Funds are not obliged to disclose their performances and neither want to, in order to prevent their strategies to be analyzed from competitors. As a result, the data available to be analyzed is only referring to indexes tracking Hedge Funds performances. Bearing in mind that super star Hedge Funds do exist (one above others is the Medallion fund providing an average 60% annualized return in the last twenty years to the exclusive convenience of its employees), we see the next exhibition, showing Hedge Funds returns based on their strategies, provided by Evestment, a data provider owned by Nasdaq.


As compared to the main global benchmarks:

This further underlines the impossibility to consistently assess Hedge Funds’ global performances, reinforcing the necessity to put the spotlight on another important aspect related to returns: fees.

A usual structure is the 2-20 structure, meaning that a 2% of asset under management is paid as the management fee, while a 20% of ANY profit is paid as performance fee, meaning there is neither a hurdle rate nor a benchmark to compare returns.

Furthermore, while it is a certainty that Hedge Funds who consistently beat the market year over year do exist, broader industry seems not to be able to constantly beat the market as shown in the tables above.

Conclusion

Overall, the aggregated comparison leads to the conclusion that the most efficient asset class is the market itself as many theorists have stated in their papers. Nevertheless, treating the issue in a more practical way, it is clear that the asset allocation for institutional investors not solely depends on returns, but furthermore on the duration of their liabilities as well as internal policies and the manager’s discretion. Still, it is not evident that Private Equity is a “better” asset class compared to Hedge Funds. Also, because they constitute the riskiest part of an entity’s portfolio, the investment appears to be more of a substitute rather than an alternative. Generally, institutional investors seem to be shifting towards PE in the last years, driven by the global pressure on returns and attracted by a wider variety of strategies, the possibility to invest vertically on specific sectors through specialized Private Equity Funds.

Authors:
Antonio Gagliardi
Maurits Giese