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Should Private Equity Have a Place in My Portfolio?

If you are unfamiliar with the term Private Equity, it typically refers to investment funds organized to invest directly in private companies (not listed on a public stock exchange). After his failed 2012 Presidential run, Mitt Romney brought Private Equity into the public eye. Romney made his fortune through his work at Bain Capital, one of the largest Private Equity players.  

Private Equity (PE) funds are primarily made up of large institutional investors, university endowments, or wealthy individuals. In recent years, a significant amount of capital has flowed into this space as investors seek to a higher rate of return than what is offered in the public markets. And the average PE investment has outperformed the broad public market since 1993. 

The chart pictured above was sent to me by a friend who himself runs a Private Equity fund.

When you see a chart like this, what goes through your mind? Does it make you want to plunge your money into Private Equity? It’s tempting! But first, let’s take a deeper look.

You see, risk and return are related. Since we live in a competitive world, as investors we can’t expect to receive any return on our money without bearing some amount of risk. As such, any time you come across an investment that has outperformed the broad public markets, your first thought ought to be, what risks are associated with this asset that produced the higher return?  

The most reliable, academically proven way to evaluate the risk and return of a portfolio is the Fama/French Three-Factor Model. The Three-Factor Model is a fancy way of summarizing that the stocks are riskier than bonds, small companies are riskier than large, and value companies are riskier than growth. 

Since Stocks, Small Stocks, and Value Stocks, are all riskier than their counterparts, a portfolio that over-weights Small and Value Stocks should command a higher rate of return – because you are taking more risk! The Three-Factor Model is said to explain 96% of all market returns, that is to say, we can look at the performance of a portfolio, and attribute most of its return to some combination of those factors.

Therefore, using the Three-Factor Model as our guide, let’s try to think about what risks could possibly explain the historical outperformance of Private Equity, and ultimately whether it has a place in your portfolio!

In the chart above, you’ll see that while the number of listed world-wide publicly traded stocks have increased over the past 20 years, the number of publicly listed US stocks has shrunk. This is not to say the number of companies decreased, rather the number of companies deciding to go public has declined. This is important to note because the more private companies there are, the more opportunities for Private Equity investment.

Small and growing companies have historically been the ones to go public in an attempt to raise capital to provide for their fast growth. However, with the rise of PE funding, rather than going through the trouble of becoming a public stock many small companies are opting to raise capital through PE investment instead.

While there are many large private companies that would otherwise be in the S&P 500, a majority of private companies are small. According to the Three-Factor Model, small companies are riskier and as such command a higher expected return than large companies.

Additionally, Private Equity investors are typically looking to buy companies at cheap prices. They then work to make these companies more profitable to be resold later at a higher price. This is a form of Value investing – thus demonstrating that Private Equity is also heavily exposed to the Value factor.  

Therefore, according to the Three Factor Model, PE is heavily weighted towards Stocks, Small Stocks, and Value Stocks – all risk factors that have the highest expected return within the model.

Now that we have identified Private Equity’s risk profile according to the Three Factor Model, let’s go back to 1993 (where the PE performance chart begins) and compare PE Index returns with the returns of PE’s publicly traded counterpart -- the US Small Value company index.

As you can see, while the Cambridge US Private Equity Index compounded return for this period was 14.3% annualized, the Dimensional US Small Value Index returned 13.87%. Not far off! We just demonstrated that the Fama/French Three-Factor model was able to explain 97% of the Private Equity returns! But wait, there’s more….

What about the 0.43% outperformance of PE over this time period? Are there other risks associated with that type of investment that are not associated with public Small and Value companies? Let’s take a look.

Private Equity is notorious for their use of leverage in order to enhance returns. That is, they often use borrowed money to gain stakes in private companies. You don’t have to look further than the recent bankruptcy of Toys ‘R Us to see the potential downside risk of the leverage employed by PE investment. Anytime you use borrowed money, you increase the risk profile of the investment. If your investment goes belly up, not only do you lose your investment, you still owe the bank.

Another risk associated with PE is a lack of liquidity. Since private companies are not publicly traded, it’s not easy to find a buyer if you want to sell. It’s not uncommon for a PE deal to lock up investors’ money for 5-10 years. When there is a lack of liquidity, investors command a higher rate of return in order to compensate them for not having access to their money. That’s another risk that public Small Value companies avoid by being listed on a stock exchange that brings together buyers and sellers.

Additionally, unlike the Small and Value factors, there are no PE indices available for use by retail investors. Therefore, if you want the returns offered in PE, you have to take manager risk to get them. Manager risk is the risk that the given portfolio manager you select ends up being a chump. Manager risk is idiosyncratic, meaning it’s a risk you have to take that doesn’t historically compensate investors. While in hindsight it’s easy to see which managers have performed best, it’s very difficult to identify in advance which managers will be the future top performers.

Additionally, since no PE index exists, typical PE funds charge a 2% management fee and take an additional 20% of profits. As such, assuming you invest with an average PE manager, your after-cost return would be far below the return of a passive Small Value manager like Dimensional Fund Advisors, who charges only .50%.

For any asset you are considering investing in, you must ask yourself, is this asset worth investing on a risk-adjusted, after cost basis?

After comparing PE to Small Value in terms of risk profile of the companies typically invested in, taking into account the leverage, liquidity, and manager risks, then deducting the expected costs associated with PE vs. Small Value, the case seems clear that a passive Small & Value fund is the better bet.