Private equity has come to be very important. Both to investors and ordinary people.

It matters to ordinary people because it changes the way companies operate. Companies acquired by PE tend to run lean, grow fast and take on a lot of debt. The mere presence of PE causes companies to run leaner, grow faster, and borrow more money – lest they be bought out by PE. PE puts the economy into a higher gear of efficiency.

For investors, PE has grown to be a non-trivial slice of their total portfolios. PE of all types is now estimated at $4.5 trillion, which is about 4 per cent of total global equity markets. The number is growing quickly.

Investors have been attracted to PE because it promises good returns. Public markets have been expensive lately. They promise lower returns in future. Return-hungry equity investors have moved the frontier outward, looking for better value among small private companies. 

Does it work?

The question of whether private equity is good for society is laden with value judgments and is too hard to answer (though I did take a stab at it once). 

More tractable is the question of whether private equity is good for investors. After fees, does PE return more than similar public market investments?

PE funds are always actively managed, so they have managers who need paying. Fees have been estimated at 5.7-6.0 per cent per year. To beat public market investments, gross private equity returns need to be at least 5.7 per cent higher than the S&P500, which is the standard public-market benchmark.

As described by Anti Ilmanen in his book Investing Amid Low Expected Returns, the evidence has swung back and forth on this seemingly straightforward question. Stucke (2011) found that PE had outperformed the S&P500 in the long run. Then Harris-Jenkinson-Kaplan (2014, 2016) found that newer PE funds — those launched after 2006 — didn’t beat the S&P500. The following chart is taken from the book.

A takeaway of all this research seems to be that the returns to PE have reduced over time. In the 1990s, PE firms were able to buy companies at a discount to the S&P500. But, over time, the discount went away. And since 2011, PE investors have if anything been paying more than public company investors.

Then there’s the evidence from France. Returns to private equity are much higher in France than in mature markets like the US. Boucly, Sraer and Thresmar (2009) found French companies acquired by private equity became more profitable, grew faster and invested more than peer companies.

You could imagine a simple model for what’s happening here. Before private equity shows up, companies do a bunch of things that are good for managers, workers, and creditors — but not shareholders. Examples would be owning a lot of low-returning assets, or carrying very little debt, or paying above-market wages, or under-investing in growth opportunities. Then private equity comes along and buys up all these companies. It gets all these target companies to do things that make shareholders better off. The targets sell off non-core assets, lay off workers in some cases, hire more workers in other cases, increase incentive pay for managers, and borrow more money. Pulling those levers makes the companies more valuable and the PE firm makes a profit.

But over time, two things happen. One is that companies get leaner. They get leaner because a) their competitors are now leaner and b) they might find themselves targets of a leveraged buyout unless they get lean.

The other thing to happen is that the word gets out about the returns on offer from private equity. A big chunk of the finance industry sets out to make its fortune by buying and selling medium-sized private companies. And due to competition for deals, PE firms end up paying more for targets.

This would imply PE has a bigger effect in its early years — like in the US in the 1990s or France in the 2000s. That’s when it does the most to shift business culture. And that’s when its investors make the most money. 

Hidden risk

Then there’s the question of whether PE investors really understand the risks they’re taking. Is the S&P500 really a fair benchmark for a fund stuffed full of tiny, illiquid and deeply-discounted companies?

Normally small companies are riskier than big ones, so investors get a premium for investing in them. It’s the same thing for illiquid investments and value stocks. The idea is that they come with more risk, so they pay a premium. 

When you compare PE returns not to the S&P500, but to benchmarks that account for all these risks, they don’t look so good. The following chart from Ilmanen’s book shows US PE’s performance compared to an index that accounts for size, leverage and sector risks. As you can see, US PE underperforms its index for most years, apart from the early 2000s.

Warren Buffet’s investing partner Charlie Munger is no fan of PE. He thinks you only get to look at the companies owned by PE firms at the moment when they’re most saleable — which isn’t a true picture of their worth or their riskiness.

He tells a story: A friend of his had a beautiful horse. The horse was lean and strong with an elegant gait. But every once in a while the horse would buck violently, throw the rider off, put them in the hospital or worse. The friend took the horse to the vet to see what could be done. The vet examined the horse and said, ‘Here is what you must do. You must wait for the next time the horse is behaving well — and then sell it’.