Private Eye: Paper Casting Doubts on PE Returns Not Convincing

A June paper on private equity performance published by the Center for Economic and Policy Research and covered by New York Times columnist Gretchen Morgenson makes a case that investors should cool their excitement for the asset class.

“Do PE buyout funds deliver outsized returns to investors and will they do so in the future?” ask authors Eileen Appelbaum, senior economist at the center, and Rosemary Batt, a professor of women and work at Cornell University’s School of Industrial and Labor Relations. Their answer, after reviewing “the most recent empirical evidence” on fund performance, is no. I’m not so sure.

In “Are Lower Private Equity Returns the New Normal?” Appelbaum and Batt rightly point to recent academic papers showing a post-Great-Recession sag in performance vis-à-vis the public equity markets. It’s an important development to keep an eye on. But the authors leave out or misinterpret evidence in the industry’s favor. Shown the main points of my critique, Batt wrote back that my conclusion is “entirely unwarranted,” and I detail her response below where appropriate.

Appelbaum and Batt review several academic studies, including the results of a recently revised, five-year-old paper based on data from a single institutional investor. It was written by two business professors, David Robinson of Fuqua School of Business at Duke University and Berk Sensoy of Fisher College of Business at Ohio State University.

Using a Public Market Equivalent calculation, the paper finds the average liquidated buyout fund from vintage years 1984-2010 outperforming the S&P 500 by 18 percent in total value over its life. That works out to 3 percent per year assuming, as Robinson and Sensoy do, a five-year average holding period for portfolio companies.

That may or may not be an adequate premium. But Appelbaum and Batt favor showcasing the more modest 9 percent outperformance generated by a median fund on the basis that the average fund “is not particularly relevant for the typical PE investor who invests in one or a few funds.” Maybe so. But institutional investors and advisers with large portfolios do play a major role in the asset class.

Appelbaum and Batt also feel that the paper should have based its per-year calculation on a 10-year, rather than a five-year, holding period. Their own calculations bring the average annual outperformance over public equities down to a more modest 1.7 percent. Data provider Preqin reports that average holding periods in early 2015 were 5.5 years, down from 5.9 years in 2014 and up from 4.1 years in 2008.

In her emailed response, Batt wrote that “the assumption that [GPs] return earnings in five years after calling capital from LPs is a very strong assumption presented with no evidence that this is actually the case. … Many funds are on record asking LPs for an extension of the fund’s life beyond 10 years. …”

Appelbaum and Batt also present results of a 2015 paper from three professors: Robert Harris of the Darden School of Business at the University of Virginia, Tim Jenkinson of the Said Business School at the University of Oxford, and Steven Kaplan of the Booth School of Business at the University of Chicago.

Also based in large part on an analysis of PMEs, but using a larger data set of 781 North American buyout funds from nearly 300 investors, the paper finds that North American buyout funds beat the S&P 500 by about 3 percent to 4 percent per year in value creation for vintage years 1984 to 2005. For 2006 to 2010 vintages the buyout funds studied roughly equaled the performance of the S&P 500.

In analyzing the results Appelbaum and Batt reverse numbers from a table to conclude that “fund performance over the 2000s was below that of the 1990s.” In fact the paper shows that performance improved, with North American buyout funds producing a median PME of 1.19 in the 2000s on average, higher than 1.16 in the 1990s and 1.09 in the 1980s.

Acknowledging the mistake, Batt responded that our “overall point still holds … the numbers in the rest of the table for the years 2005-2009 are correct, and show a remarkable downward trend. …”

Appelbaum and Batt again use a 10-year fund life to calculate average annual outperformance figures that are lower than those presented in the actual paper, and more on the order of 1.5 percent to 1.8 percent. “This is well below the 3 percent return that most investors in private equity view as a reasonable premium for the added risk associated with these investments,” they write.

They seem to dismiss the paper’s explanation that the 3 to 4 percent per year outperformance “reflects the reality that committed capital is drawn down over a five-year investment period (rather than all at the beginning of the fund). …”

Appelbaum and Batt make much of the finding that North American buyout firms only kept pace with the S&P 500 in the period 2006-2010.  But they ignore context provided in the paper that the “eventual performance” of the 2006-2010 funds “will improve if the historical J-curve pattern of private equity funds — in which fund multiples increase over a fund’s life — continues to hold. …”

Batt responded in her email that buyout firms may well hold portfolio companies at conservative valuations to get a “pop at the end [in IRR] as a selling point.” But she wrote, “that’s one reason why PME is a better measure of ultimate fund performance than IRR.”

That may be, but even the PME for an unrealized fund can’t reflect unknowable valuations at exit time.

Photo: Image of Sherlock Holmes courtesy of ©iStock/Ostill, Getty Images