Evaluating Private Equity Returns

Abstract

Does private equity really beat public markets? Do top managers really significantly outperform their peers? Is their outperformance consistent over time? Is a top manager more likely to beat peers on the next fund? Is venture capital a different type of investment with different return expectations? How should investors choose between the two types of private equity investments?

A recent pair of studies by noted academics in the private equity field provides an interesting analysis based on a broad data set that doesn’t suffer from the flaws common to most studies of private equity. Their findings are illuminating – and in some cases startling. They provide answers to many of the questions that investors have been asking; and they signal areas where private equity investors should be cautious.

This article will review these studies in terms accessible to the investment professional. It will explore why the authors chose to use the more easily comparable Public Market Equivalent (and provide a useful algorithm for translating a fund’s typically-reported Multiple on Invested Capital into an approximate Public Market Equivalent). It will break-out buyout funds from VC funds and look at the risk factors that each has exposure to and attempt to answer the question: is the average fund really delivering excess returns or just higher returns for higher risk? It will reveal the difference between the returns of top and bottom managers and what the authors found about conventional ways investors choose managers. Finally, this article will offer some thoughts on how investors might use this information to make better investment decisions.

Keywords: Private equity, factor exposure, leveraged small value, manager selection