Experts split over private equity

Pension funds allocating their assets to private equity have reaped little or no rewards on average, according to a Yale study.

Martijn Cremers, associate professor of finance at the Yale School of Management, concluded in a recent paper that returns on private equity over the last 10 years were no better than the stock market. Investments in public equity were on average unlikely to yield more profit than investments in stocks or bonds, because of their high management fees. However, some experts disagreed with the findings, saying that private equity is still a good option for asset allocation.

According to the paper, private equity funds had a spectacular run in the 1990s where it returned an average net return of 21.5 percent to its investors. Impressed by this performance, institutional investors increased their investment in private equity, bringing the total funds in private equity from $200 million to $2 billion in the last 10 years. But the Midas touch of private equity disappeared at the turn of the century and the returns fell to an average of 4.5 percent in the last 10 years, the paper said.

“If I had to summarize it in a nutshell, pension funds got similar returns to what they would have gotten had they invested in passive equities,” Cremers said.

Since private equity is more volatile than stocks or bonds, a portfolio with a large asset allocation in it would have a high amount of risk. For example, the paper said, the net returns from private equity fell from a profit of 36 percent in 2000 to a loss of 21 percent the next year.

Even as the profits in private equity took a hit in the aftermath of the dot-com bubble, private equity fees continued to climb. Cremers explained that in addition to taking a cut from the share of returns, known as the performance fee, private equity managers also charge an overall management fee on the invested capital. He said the average management fee has increased from 2.4 percent in 2000 to 4.2 percent in 2010. Private equity fund managers have taken 70 percent of the gross profits made in the last decade as fees, Cremers said.

Steven Kaplan, professor of entrepreneurship and finance at the University of Chicago, disagreed with the findings. According to his research, every dollar a pension fund put into private equity earned 20 percent more than it would have in Standard & Poor’s 500 index. Accounting for management and performance fees, he said, private equity funds have outperformed public markets by an average of three percentage points over the past 20 years.

Kaplan pinned the drastic difference in results on unreliable data.

“Cremers does not have particularly good performance data [but] we do,” Kaplan said.

In the past several studies have relied on commercial data sets provided by Thomson Venture Economics, which is problematic for analysis, Kaplan said.

Ayako Yasuda, associate professor of management at the University of California, Davis, shed light on the problems of gathering definitive data. Unlike pension funds, private equity funds are not legally required to disclose their activities, so all data available is based on voluntary disclosure, which is subject to bias.

“What’s missing is not just random noise,” Yasuda said. “Even a very small percentage of the missing data could mean that it is being systematically obstructed, which could create hidden bias.”

The difficulty in collecting data about private equity makes the field’s performance uncertain, if not controversial, Kaplan said.

Yasuda contended that the 4.5 percent average return, which Cremers calculated, is no worse than the turbulent performance of the stock markets in the last decade.

“It’s a period in which the benchmark also performed poorly,” Yasuda said.

She agreed private equity funds tend to have higher fees than other investment asset classes, but said the performance fees are typically structured to avoid consuming all the net returns for investors in low-performance funds.

In an underperforming market, private equity fees may seem exorbitant, but they are within reason during economic booms, such as the 1990s, Deputy SOM Dean Andrew Metrick said. Compared to a hedge fund, private equity charges a lot less, he said.

Metrick said that private equity funds also allow its institutional investors to invest in buyouts and ventures as partners, which means that pension funds may bypass a large portion of the overall fee. Such transactions are not included in Cremers’ data because they are not available to the researchers, Metrick said.

The key for pension fund managers is to find the right private equity investments, which requires enormous skill and long-term dedication, Metrick said.

For the unsophisticated investor, making investments in private equity funds is “like throwing darts at a newspaper,” he said.

The paper was co-authored by Aleksandar Andonov and Rob Bauer of Maastricht University in the Netherlands.

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