Let’s take an investment proposition whose model is to pay a significant premium to current market rates for acquisitions, throw in lots of leverage, charge enormous fees, and which allows the investment manager to value a company using basically any measure that they choose. Are you as an investor ready to take the plunge and commit your savings?
Well what I have just described is Private Equity (PE), formerly known as the LBO business .1 Those that currently are invested in PE, as well as those who work in PE, point to the superior returns of this sub-asset class2 in the past. Yet in aggregate, what have those returns really been? Of equal importance, what do investors really think their returns will be going forward based on the dynamics I outlined in the first sentence?
My skepticism over historical returns in PE, is derived from a number of factors. One of the most significant is that unlike the stock market and hedge funds, there is no easily definable and frequently cited index. Equity markets have the most ubiquitous ones, such as the S&P 500 and Russell 2000, which are quoted daily in newspapers, radio, and TV, and can be brought up in real time on any financial website: Yahoo, Bloomberg, WSJ, etc. Hedge funds also have easily obtainable indexes that are updated monthly soon after the funds report returns. Here are two that are quickly googleable: HFRX and Barclay’s HFI. While I would be the first to admit that these indexes are imperfect as they lump together a lot of completely different types of investment strategies under the vague moniker of “Hedge Funds”3, and may have many other imperfections4, at least third-party organizations have taken the time to painstakingly quantify a general number on a regular basis. Furthermore, these indexes have increasingly been cited in the financial press, mainly to note how poorly hedge funds have been performing recently relative to other investments, and to question the large fees being paid out for this under-performance. While PE supposedly also has third-party organizations compiling returns, just try and actually see them – it’s absolutely not going to happen on Google. Worse, Continue reading
- Sure, I know that PE encompasses so much more than LBO’s these days, but whether a PE firm is buying a whole company in the public markets or a private company or a division of either public/private, it still usually entails a bidding process w/ the winner paying the highest price. Leverage/fees/valuation methodology all still apply. This goes for real estate, distressed situations, credit, and all the other assets lumped into PE [↩]
- Alternative Investments is the usual moniker given to the full asset class, though really when you break it down PE is simply leveraged equity. Furthermore, I fully concur with the sentiment that Alternatives are a compensation scheme, masquerading as an asset class [↩]
- Where do I even start w/ this term: first off, some completely hedge, and some very transparently do not at all, and some do so to varying degrees. Some use leverage, some do not, and then some use massive amounts. About the only similarities that most hedge funds do share is that they charge much higher fees than conventional money managers, and are predominantly invested in publicly traded securities [↩]
- are they weighted by AuM or not? Survivorship bias? [↩]