Will the returns of private equity save the pension system and offer non-correlated and above average returns for the family offices, institutional investors and others who continue to throw money at it?
Maybe but probably not, I want to say?
It’s hard not to be impressed with the returns the industry has produced over the decades. Skeptics will point out that you can reduce the source of these returns to well-known factors that also explain returns in the public markets – the small cap premium, the illiquidity premium (these two might be the same thing, that’s a hot debate) and the value premium. But even if you reduce the magic of these past returns down to a handful of mathematical constructs, that doesn’t negate them. It doesn’t take the money away from those who’ve earned it.
But it is constructive to understand these concepts because they might offer a clue as to whether the outperformance can continue. If private equity is really just a new form of public equity now that so many players and so much money have come into the space, shouldn’t that alter its prospects as a strategy going forward? You can’t argue to that size is the enemy of performance (incontrovertible) but then say it won’t apply to one asset class because you don’t want it to.
A few things worth pointing out – as a very experienced private equity portfolio manager explained at our Evidence-Based Investing conference this fall, the multiples PE investors are paying for companies are systematically higher than anyone ever thought possible. Massive amounts of capital coming into the space have fundamentally changed the starting point at the mid to high end for valuations, and it’s not possible to say that this won’t have an effect on forward returns.
As Jason Zweig noted recently, get a few drinks into anyone in the PE space and they’ll start lamenting the lack of reasonably priced opportunities – from this standpoint it’s no different than the public equity markets.
Additionally, the space has become incredibly crowded with intense competitors, which has to make it harder to produce high returns as the alpha is competed away. If every team in the league is the Golden State Warriors, then no team is the Golden State Warriors. People have trouble coming to grips this concept, that absolute skill level is not the problem, it’s a relative skill level game.
Finally, one of the primary reasons so much money is pouring into PE is because the institutions are using the past as their guide for expected returns – and allocating more heavily to a strategy that has produced high returns in the past makes the return assumptions in their model easier to theoretically hit, thus obviating the need for any kind of tough political spending decisions. No need to cut any programs, we’ll just generate higher returns to pay for it all.
Here’s what you need to read on this topic for your own edification, before committing capital or advising clients that PE is the silver bullet for the alleged “low return” environment that public markets currently offer…
Start with Verdad Capital’s two-part interview with Benzinga about his idea – that leveraged small cap value is as good as if not better than many private equity funds:
Dan just dropped a monster article fleshing this all out…
Next, Ben’s new piece at Bloomberg View about the “private equity Hail Mary” that pensions are throwing up and out over the end zone…
Finally, Paul Davies at the Wall Street Journal got so much feedback from readers on his recent series about the PE boom that he was forced to do a follow up piece addressing all the comments.