Does the Case for Private Equity Still Hold?

Private Equity (“PE”) received a 10-fold increase in capital flows since the Great Financial Crisis (“GFC”) Investors sought higher nominal returns relative to those they could obtain in the public capital markets. This paper questions the fundamental assumptions underlying why investors should select PE as an asset class.

The basic historical premises for including PE were:
• Superior net returns relative to public markets or public market equivalents and superior returns compensating for the associated lack of liquidity
• Low correlations relative to the public markets and lower volatility
• Superior returns were due to:
o Identifying appropriate target companies at “bargain” prices
o Creating operational improvements within portfolio companies
o Generating multiple expansion and increased value due to operational improvements
o Restructuring of the portfolio companies’ balance sheets primarily by adding significant leverage
o Exiting investments at appropriate inflection points


Current data raises questions concerning these predicate assumptions. All the actions PE firms claim add value to portfolio companies should result in superior returns. The data indicate the average or median PE funds do not actually outperform the public markets since the GFC. While top quartile PE funds outperformed since the GFC, the data raises three particularly disturbing conclusions.

• General Partner (“GP”) fund performance persistence has eroded materially. Past performance is not indicative of future performance. While top quartile GPs outperform relative to public markets over time, they are not necessarily the same GPs. There may be individual firms who consistently perform exceptionally well or exceptionally poorly. Indeed, the most predictive information relates to those GPs who are more consistently in the bottom quartile. The point is that in aggregate past performance is not necessarily indicative of future performance.
• If there is little persistence among top quartile firms, then the selection of any GP is potentially a “random walk”. If accurate, then investors should expect to achieve at best only average or median PE results. There are two studies indicating the results of successful GPs may be as much attributable to “luck” than skill, mirroring the conclusions of the venerable Eugene Fama regarding active equity managers.
• There has been a shocking concentration of capital flows among a small number of firms. Is this a good attribute for the industry? Given the general lack of performance persistence among PE GPs, one should ask whether (i) capital is flowing to the best firms, (ii) capital is flowing based upon the “brand” of the PE firm, and/or (iii) capital flows are based on investors “looking in the rear view mirror” or desiring one stop shopping?

PE data suggest (i) traditional methods of evaluating a given GP partnership are questionable; (ii) evaluating performance persistence post 2008 may be subject to doubt at the time the investment is made; (iii) selecting a given GP in the hopes of obtaining top quartile results may be a random walk (one is just as likely to select a median GP as a top quartile GP) ; (iv) investment performance may possibly be as much attributable to luck rather than skill; (v) the recent median PE investments do not outperform public markets; and (vi) PE performance may actually underperform PMEs on a risk adjusted basis given the amount of leverage they employ generating equivalent results on a nominal basis.

These conclusions suggest that the PE industry may be ripe for disruption, much as the mutual fund industry after the introduction of ETFs and index funds. There are disruptive forces at play by investors attempting to reduce their costs, and thereby enhance their returns, by adopting alternative investment methods.

The question is not whether investors should invest in the private markets but how they should do it.