Private equity’s largest funds have gotten to where they are through, among other considerations, the promise of better returns than public markets. New research calls these claims into question.
According to a study by Jeffrey Hooke, a senior finance lecturer who specialises in alternatives at Johns Hopkins Carey Business School, the industry’s brand-name large-caps are facing two significant issues. The first is that they deliver a rather negligible premium to public markets; the second is that they are holding onto a substantial proportion of unsold assets.
Hooke’s research uses the Kaplan Schoar Public Market Equivalent (PME) to measure the return from deploying a private equity fund’s cashflows into a stock market index. A PME north of 1.0 reflects a return higher than the S&P 500 index. A 1.2 PME, for example, indicates a 20 percent return over this index.
The research found a median PME of 1.22 for the 51 funds it analysed – good news for the LPs in those funds. However, the non-mega-funds in this dataset – ie those that raised less than $10 billion – outperformed their larger counterparts. Funds smaller than $10 billion had an average PME of 1.43, compared with 1.05 for those larger than $10 billion.
This, Hooke argues, comes despite a widely held assumption that leveraged buyout funds should be expected to deliver a higher risk-adjusted return than public stocks due to the “higher bankruptcy risk of such investments”, on top of the supposed illiquidity premium and comparative lack of information about the underlying assets.
More troubling for today’s cash-strained LPs is Hooke’s finding that vehicles between seven and nine years old still hold 50 percent of their stated asset value as unsold deals. This proportion sits at 34 percent for funds 10 to 12 years old.
There’s a counterargument to this unrealised NAV point, though. As Cyril Demaria, now head of private markets at Julius Baer, pointed out in 2020 in a discussion about what private equity really returns, it can be problematic to judge the performance of unrealised funds. Fully liquidated US and Western European LBO funds have significantly outperformed their public markets equivalents and NAVs are calculated conservatively, he said, adding: “NAVs will always trail the index, until assets are sold.”
Investing in large-cap strategies is, of course, also about gaining exposure to an increasingly larger pool of major companies that aren’t publicly traded. For LPs considering gaining exposure to such companies in this way, Hooke’s research suggests that – at least from a comparative returns perspective – the old adage “nobody ever got fired” for committing to a large-cap brand-name fund may begin to ring less true.