Private equity (PE) is off many investors’ radar even though it has a reputation for outperforming equities markets. With high fees, a long investment horizon, and an opaque structure many people simply aren’t interested. A recent paper from the National Bureau of Economic Research tried to quantify these effects and determine just how much alpha PE has to generate to be a better deal than investing in other assets.

Private Equity Sector PE

Average return of private equity funds

“While it is generally accepted that the average return of private equity (PE) funds exceeds the return on the market, it remains controversial whether this outperformance is sufficient to compensate investors (LPs) for the costs of risks and long-term illiquidity,” write NBER researchers Morten Sorensen, Neng Wang, and Jingqiang Yang.

They point out that PE investments are characterized by three characteristics: they are illiquid and long term; they are risky; and management is handled by a general partner (GP) who gets a management fee of around 1.5% of committed capital and a performance fee of around 20% of profits.

“We find that without leverage, the break-even alpha is 3.08% annually with the typical 2/20 compensation contract,” they write. “Interestingly, leverage reduces this alpha.”

PE leverage puzzle

Leverage reduces the break-even alpha because it increases the total assets that the GP has to work with and because some risk has been transferred away from the LP to a diversified group of creditors. “This may provide an answer to the PE leverage puzzle,” they write. The puzzle is that PE uses as much leverage as the credit market can bear. “This behavior is inconsistent with standard theories of capital structure. In our model it is optimal.”

For someone thinking about investing in private equity, these findings should give them pause. Consistently hitting 3% alpha is no small matter, and that’s necessary just to give you a fair return for the other fees and lost trading opportunities over the lifetime of the investment. PE firms with a few good years under their belts might look promising, but most will revert to the mean over a decade. That’s not to say there aren’t any PE funds with a strong enough track record to justify investing, but your standards should be high.

H/T Brendan Conaway