Which performs best: private equity or publicly held stocks?
By: ARLEEN JACOBIUS
Pension & Investments
May 31, 2010

Apollo Global Management founder Leon Black and others are touting private equity's consistent outsized returns, but some insiders — including investors — are not so sure.  So, if private equity returns are not expected to be stellar and the asset class is not proving to be a diversifier, what are investors getting for their $2.3 trillion private equity investment?

The answer depends on whom you ask. “It's the only asset class” that will provide the 8% annual rate of return needed by pension funds to meet their long-term forecasts, Mr. Black said in an interview. Scott Sperling, co-president of Boston-based Thomas H. Lee Partners, says private equity has outperformed stocks for 22 of the last 24 years.

Believing in the outsized return and diversification potential, investors have been piling into private equity. As of year-end 2009, private equity firms worldwide had $1.2 trillion in combined assets and $1.1 trillion of capital waiting to be spent, up from $870 million total private equity assets under management in 2003, according to Preqin, a London-based alternative investment research firm.

But not everyone agrees that private equity delivers what its promoters promise. Publicly traded stocks are a better buy, according to Harold Bradley, chief investment officer of the $1.8 billion Ewing Marion Kauffman Foundation, Kansas City, Mo.

Stocks have outperformed private equity, venture capital and hedge funds over the long haul at a fraction of the cost, Mr. Bradley said during a panel discussion in April at the Milken Institute Global Conference in Beverly Hills, Calif. Mr. Bradley is not alone in his assessment. If an investor analyzes stocks the same way as private equity — on an internal rate-of-return basis — the performance between the two classes would not be all that dissimilar, said another institutional investor who declined to be identified.

Matter of weighting

“An average private equity manager, after fees, will not outperform listed equity. This is generally the case whether market performance is calculated on a money-weighted or time-weighted basis,” Mark Calnan, senior investment consultant, manager research, in the London office of consultant Towers Watson & Co., wrote in an e-mail in response to inquiries.

Mr. Calnan points to a 2006 paper by Ludovic Phalippou, a professor at the University of Amsterdam, that found private equity fund performance is lower than the S&P 500 by as much as 3.8 percentage points per year.

“The top quartile of private equity outperformed equities and the rest broadly matched the equity markets, based on a 2001 Harvard Business School study of private equity performance,” said Marshall Sonenshine, chairman and managing partner of New York investment bank Sonenshine Partners LLC and adjunct professor of finance and economics at Columbia University in New York.

“Private equity is illiquid and often leveraged, but with most private equity managers over long periods you may not be getting better returns than you would have gotten from public equity markets,” Mr. Sonenshine said.  “One should understand that the word 'alternative' in 'alternative asset class' does not necessarily mean 'superior.' It simply means different. It may mean inferior,” Mr. Sonenshine said.

Added Mr. Sonenshine: “I would guess that if you redo the study today, post financial crisis, you might find fund performance lower still.” Towers Watson analysis confirms this, Mr. Calnan said. A key part of Towers Watson's due diligence is performing public market equivalent track record analysis and removing leverage in the private equity manager's returns to similar leverage levels seen in listed markets.

“Managers who are able to demonstrate outperformance relative to listed equity net of both fees and leverage are clearly able to boast genuine 'alpha',” Mr. Calnan said. “However, only a small proportion of managers are able to demonstrate this type of performance. This is why we avoid a highly diversified approach to the asset class as we believe there is a danger of returns reverting to the mean. ... Mean returns in private equity are not worth the effort.”

At the height of the financial crisis, private equity went down along with publicly traded stocks, showing it did not serve as a portfolio diversifier. “The short answer is that private equity, over most five- or 10-year periods, has outperformed public equity,” said Mario L. Giannini, CEO of Hamilton Lane, an alternative investment consulting firm and fund-of-funds manager in Bala Cynwyd, Pa. “This is particularly true for buyouts of any size, although the median has not outperformed by much. This is not true of venture capital except for ... the top decile.”

But for shorter periods, private equity generally outperforms public equity only in falling markets, Mr. Giannini said.

One of the problems for investors is that there is no industrywide benchmark. Instead, investors have cobbled together benchmarks of 300 to 500 basis points above a stock index.  Investors use this proxy because of the difficulty in “getting good data that can be attributed so you know what's in the benchmark,” Mr. Giannini noted.

Benchmark development

Both Hamilton Lane and the investor industry group, the Institutional Limited Partners Association, are developing private equity benchmarks. Beau Hurst, partner at private equity fund-of-funds manager Private Advisors LLC in Richmond, Va., said that it would be near impossible to compare private equity to public equity because one would have to calculate a public market equivalent for the private equity portfolios.

“While there is an established methodology for comparing public market to private equity returns, in practice it is very problematic,” Mr. Hurst said. “Two key issues with the comparison are finding data that accurately track the cash flows of the private equity industry as a whole, and determining what you consider to be 'private equity' returns.”

All of the available indexes rely on private equity fund managers to report their own returns. This can be a matter of interpretation. Part of the return number is “unrealized return” on companies that the private equity fund has yet to exit. These companies could turn out to be everything from future big wins to walking dead.

“Private equity managers tend to be optimistic in their valuations,” Mr. Sonenshine said. “Private equity returns include erratically timed capital calls, realization events and often realized and unrealized gains,” he said. “Managers choose their time periods and return calculation methods.” 

Private equity returns are inherently hard to measure accurately, he noted. “As they are not regulated, managers can calculate returns as they like, leaving it to limited partners to make their own comparisons and determinations,” he said. “People making investment decisions may not always be able to cut through the data and some may not even have incentives to try.”

Contact Arleen Jacobius at ajacobius@pionline.com

Sonenshine Partners is a leading independent investment bank focused on providing integrated strategic, financial and corporate advisory services.  The firm was founded in 2000 and is headquartered in New York City.