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Waning returns have some doubting private equity’s value

Andrea Auerbach
Andrea Auerbach sees more ‘hand-wringing’ on the performance question.

Private equity returns for many asset owners are failing to outperform their benchmarks over several time periods, and some observers are wondering whether investment in the asset class is worth it.

“There's been a lot of hand-wringing about returns,” said Andrea Auerbach, managing director, head of global private investment research of Cambridge Associates LLC in the Menlo Park, Calif. office. “Where is performance really going?”

“I don't think private equity on a risk-adjusted basis provides an appropriate return,” said Jeffrey Hooke, senior lecturer at the Johns Hopkins Carey Business School, Washington.

In the coming year, the $306.6 billion California Public Employees' Retirement System, Sacramento, will be investigating whether private equity's performance justifies its illiquidity and fees as part of a study of all of the risk-return scenarios of its investments, spokeswoman Megan White said in an email.

CalPERS' $26.4 billion private equity portfolio underperformed the pension fund's private equity benchmark in all but two time periods ended June 30 — the one-year and 20-year periods. However, it outperformed, in all but the most recent one-year period, the pension fund's static long-term return expectation of 9.3%.

“Private equity is by nature a very long-lived asset class, meaning it makes sense to evaluate its performance over long periods of time — 10 years or more,” Ms. White noted.

Despite the concerns, institutional investors are not turning their backs on the asset class.

General partners have been warning investors not to expect the same performance they had come to know, but most firms have had no trouble raising capital.

Some 807 global private equity funds raised a total of $345 billion in 2016, according to preliminary numbers from London-based alternative investment research firm Preqin. When the final numbers are tallied, Preqin expects the total capital raised will amount to 10% more, which would be a record since the fundraising boom years of 2007 and 2008. Half of the funds raised last year exceeded their target.

Lower returns since 2006

Academic study findings differ, but many more recent reports note that private equity funds raised after 2006 have had lower returns than funds raised before that year. What's more, over the 10 years ended 2016, only buyout funds in the first quartile consistently beat the return of the Standard & Poor's 500; the remainder do not consistently top that index.

Indeed, a study released in January by Johns Hopkins University, Baltimore, showed fund returns of the largest 18 private equity managers — including Apollo Global Management LLC, Bain Capital LP, Blackstone Group LP, The Carlyle Group LP, KKR & Co. LP and TPG LLC — reverted to the mean over the past 10 years. The study was conducted by Mr. Hooke and Ken Yook, associate professor at the Carey Business School.

Funds raised before 2008 performed better than funds raised since then. The majority of buyout funds raised in 1994 through 2007 outperformed the S&P 500 average, with 23% of funds sponsored by large private equity managers falling short and 29% of funds of small firms failing to match the average, the paper found.

The reverse was the case for private equity funds with vintage years 2006 to 2016, with 75% of all buyout funds consistently underperforming the S&P 500, Mr. Hooke said.

“At least in the last 10 years, private equity has not met the simple benchmark, despite a structure with illiquidity and leverage, which is higher than (the companies in the S&P 500),” Mr. Hooke said.

What's more, since 2006, half of the portfolio companies held by all buyout funds have not been sold yet, he said.

“The long hold period leaves limited partners confronting that their only assurance that their GP is beating the S&P 500 is the word of the GP,” Mr. Hooke said. “If they were worth anything they would have been sold by now.”

But countering that is a report by alternative investment consultant Cliffwater LLC, Marina del Rey, Calif., that said private equity has been the best-performing asset class for U.S. public pension funds.

Private equity outperformed all other asset classes, with an 11.9% median net return over the 10 years ended June 30, 2015, compared to a 7% return of global stocks, according to Cliffwater's most recent study, released in September. Cliffwater's report relied on data from the comprehensive annual financial reports of 64 state pension funds, which used a mix of net and gross returns for equities.

But returns for many have dropped since 2015.

Private equity returns of the $196.4 billion California State Teachers' Retirement System, West Sacramento, underperformed the pension fund's custom benchmark for all periods except for the 12 months ended March 31, 2016, with its 4.1% net return exceeding its custom benchmark by 2.4 percentage points and its since-inception return of 12.9% at 20 basis points above the benchmark, according to CalSTRS' latest performance report for its $17.2 billion private equity portfolio.

Oregon underperforms

The $70.5 billion Oregon Public Employees Retirement Fund, which is run by the Oregon Investment Council, Tigard, underperformed its benchmark for all time periods it tracks — the three, seven and 10 years ended Sept. 30, according to a report from staff and the council's private equity consultant, TorreyCove Capital Partners LLC, that was provided to the council for its Feb. 1 meeting.

One of the first pension fund investors in private equity, the Oregon fund's $14 billion portfolio has consistently generated second-quartile performance since 2005. The report attributes the portfolio's returns to weak vintage years of 2005, 2006, 2007 and 2008. Sixty-four percent of the portfolio, or about $9.3 billion, is in buyouts, with $6 billion in large buyouts, the private equity report shows.

Still, the underperformance is not slowing Oregon down. Pension officials plan to commit $2.5 billion to $3.5 billion in private equity this year, with a continued emphasis on large, developed market buyout funds. Some 78% of Oregon's $3 billion in commitments in 2016 were in buyout funds.

The report said the system “cannot achieve the desired, strategic PE target without investing heavily in large, buyout-focused, developed market funds.”

Private equity managers note the asset class is less volatile and consistently outperforms the public markets over the long term. Many managers cited the Cambridge's Buyout & Growth Equity index net return was 12.72% for the 20 years ended Sept. 30, outperforming a dozen public indexes including the S&P 500 and the Russell 2000 indexes.

However, Cambridge's U.S. Private Equity index, which also includes private equity energy and mezzanine funds, had a net return of 8.54% for the year ended Sept. 30.

Returns have been disappointing compared with previous years, said Cambridge's Ms. Auerbach.

Even though the median return of the private equity universe since 1986 is around 11%, it does not tell the whole story. “The dispersion of the return is massive,” she said. “The median is the middle of the pack of thousands of funds.”

Institutional investors' private equity portfolios can perform better than the median, she added. “You just have to know where to look.” n

This article originally appeared in the February 6, 2017 print issue as, "Waning returns have some doubting private equity's value".