Are Lower Private Equity Returns The New Normal? by Eileen Appelbaum and Rosemary Batt – Center for Economic and Policy Research
Executive Summary
U.S. private equity fundraising had its best year ever in 2015 — raising $185 billion. But is the enthusiasm of investors warranted? Do PE buyout funds deliver outsized returns to investors and will they do so in the future? This report answers this question by reviewing the most recent empirical evidence on buyout fund performance; the answer is no. While median private equity buyout funds once beat the S&P 500, they have not done so since 2006 — despite industry claims to the contrary.
Measuring Private Equity Performance
Reports of the performance of PE buyout funds depend importantly on how returns on investment are measured. The private equity industry has long relied on the “internal rate of return” (IRR) as its primary performance measure, but that metric has been widely discredited — not only in the academic finance community but among management consulting firms such as McKinsey & Company as well. Using the IRR makes investments look much better than they actually are.
In contrast to private equity general partners, most finance economists measure fund performance using a metric known as the “public market equivalent” (PME). This measure compares returns from investing in private equity with returns from comparable, and comparably timed, investments in the stock market, as measured by the S&P 500 or other stock market indexes. This measure provides limited partners with more reliable information about two things: how much money they get back at the end of their 10-year investment in a PE fund relative to their initial investment, and how that compares with the return they would have earned if they had invested in some other asset instead — say in companies that trade on the stock market.
The typical 10-year life of a PE fund means that the actual realized returns cannot be known until the fund is liquidated after 10 years. Investors, however, are anxious to know how the funds are performing each year. For this purpose, private equity general partners calculate annual fund performance based on interim evaluations of unsold portfolio companies. While national accounting standards implemented in 2008 require these evaluations to be based on “fair value,” general partners have wide discretion in the assumptions they use to calculate the value of unsold portfolio companies. As a result, actual returns realized by limited partners when the fund is liquidated may fall short of interim estimates.
Finally, another challenge for investors in private equity buyout funds is adjusting returns for the greater riskiness of these investments compared to investments in the stock market when measuring performance. We identify the many risks associated with investing in these funds in this paper. For example, compared to publicly-traded corporations, PE portfolio companies are more sensitive to market conditions and more subject to financial distress or bankruptcy because of the much higher debt burden they carry after a leveraged buyout. Industry analysts and most investors generally assume that PE buyout funds need to make returns that exceed stock market returns by at least 3 percent to compensate for the added risks.
In sum, whether the returns to investing in private equity buyout funds justify the high fees and greater risks associated with these investments is an empirical question that depends importantly on which performance metrics are used, how the values of unsold portfolio companies are calculated, and how reported returns are risk-adjusted.
Key Findings from Recent Economic Studies of PE Fund Performance
In our 2014 detailed review of private equity fund performance (Appelbaum and Batt 2014), we found that the PE industry, using the internal rate of return, reported substantially higher returns to private equity than did finance economists using the public market equivalent. Studies by finance economists available at that time found that the median (or typical) buyout fund outperformed the S&P 500 by about 1 percent per year, and the average fund by between 2 and 2.5 percent annually — an outperformance that falls short of the 3 percent widely viewed as necessary to compensate the limited partners for the added risks associated with investing in PE buyout funds.
An important new study that includes more recent data documents a downward trend in private equity buyout performance. The researchers found that the median PE buyout fund outperformed the S&P 500 by 1.75 percent annually in the 1990s and 1.5 percent in the 2000s, but performed about the same as the S&P 500 since 2006 (Harris, Jenkinson, and Kaplan 2015). Other analyses reach similar conclusions (PitchBook 2015b). Moreover, the performance of PE buyout funds is worse when compared to a stock market index based on mid-cap companies more comparable to those found in private equity portfolios rather than one based on large-cap companies, as in the S&P 500.
Another important question for investors in PE funds is whether they can rely on a general partner’s track record in deciding where to invest. Can investors assume that if an initial fund produces strong returns, then a follow-on fund managed by the same general partner will likewise yield strong results? In the period before 2000, the answer was yes: a GP with a top performing fund had a high probability that the follow-on fund would also be top performing. But since 2000, the answer is no, according to recent research by finance economists (Harris, Jenkinson, and Kaplan 2014; Braun, Jenkinson, and Stoff 2015). Thus, while limited partners used to be able to rely on the past performance of general partners to guide future investment decisions, recent evidence shows they can no longer do so. That is, there is a “lack of persistence” in performance of the buyout funds of general partners over time. A general partner’s past performance managing a buyout fund is no longer a good predictor of future performance (Harris, Jenkinson, and Kaplan 2014; Braun, Jenkinson, and Stoff 2015).
Why Has PE Buyout Performance Declined?
Several factors explain the declining performance of private equity buyout funds — most importantly, changes in economic conditions and the competitive landscape. The perception that PE buyout funds outperform the stock market rests primarily on their performance in the 1980s and 1990s, when a handful of buyout firms exploited the poor performance of large U.S. conglomerates by acquiring poorly performing divisions and selling them later for more than they paid. The use of high levels of debt to acquire portfolio companies goosed returns. In the early 2000s, private equity funds took advantage of the stock market bubble — selling portfolio companies at higher prices than they paid for them as the stock market continually rose. Low interest rates fueled high levels of debt financing, which continued to fuel outsized earnings until the market crashed in the financial crisis.
Today, the private equity industry claims it has moved far beyond the poor fund raising and performance during the financial crisis — citing the high distributions returned to investors during the stock market run up of 2013 and 2014 and the subsequent fundraising bonanza of 2015. But these distributions make up for several years during and after the financial crisis in which few distributions were made. And, as recent studies show, despite the large distributions, private equity investments have generally failed to beat the even more buoyant returns of the stock market. In the meantime, the fundamentals of the industry have changed. By 2016, 4,100 private equity firms headquartered in the U.S. were competing against one another to acquire portfolio companies in an environment in which the number of high-performing, undervalued target companies is shrinking. In addition to the $185 billion raised in 2015, buyout funds held another $460 billion in unspent funds — or “dry powder” — from prior rounds of fundraising. And since the crisis, they’ve faced steep competition from large publicly-traded corporations with deep cash reserves seeking to make strategic acquisitions of the most sought after companies.
These competitive conditions disproportionately disadvantage private equity funds as they face worse credit ratings and higher costs of debt than the “strategics,” due in part to guidance set by bank regulators in the last few years that limits bank lending on leveraged buyout deals. Finally, PE distributions have been high in recent years because the stock market surged as the economy recovered from the recession. But research shows that buying companies when the stock market is at or near a peak and prices for target companies are high — as in the current period — yields substantially lower returns when these investments are subsequently exited (Robinson and Sensory 2011, 2015).
Despite these new realities, PE firms — if not PE investors — are continuing to reap high returns fueled in large measure by the high (and sometimes hidden) fees they charge their limited partners and portfolio companies (Appelbaum and Batt 2016). As we show in this paper, most investors in private equity buyout funds will find that PE’s promise of superior performance is elusive: for most investors, PE returns now more or less match the market. Moreover, the negative impact of private equity leveraged buyouts on workers and main street companies is well documented — including lower wages and employment growth in their portfolio companies and the higher likelihood of financial distress and bankruptcy of those companies due to increased debt levels (documented in Appelbaum and Batt 2014). Given these negative effects, employee pension funds, university endowments, and other investors with a broad public purpose require a compelling reason to invest in buyout funds. In the past, the promise of high returns may have served to justify investing in PE buyout funds. Today, promises of high returns are likely to be disappointed.
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