Skip to main content
MENU
Subscribe
  • Sign Up Free
  • LOGIN
  • Subscribe
  • Topics
    • Alternatives
    • Consultants
    • Coronavirus
    • Courts
    • Defined Contribution
    • ESG
    • ETFs
    • Face to Face
    • Hedge Funds
    • Industry Voices
    • Investing
    • Money Management
    • Opinion
    • Partner Content
    • Pension Funds
    • Private Equity
    • Real Estate
    • Russia-Ukraine War
    • SECURE 2.0
    • Special Reports
    • White Papers
  • Rankings & Awards
    • 1,000 Largest Retirement Plans
    • Top-Performing Managers
    • Largest Money Managers
    • DC Money Managers
    • DC Record Keepers
    • Largest Hedge Fund Managers
    • World's Largest Retirement Funds
    • Best Places to Work in Money Management
    • Excellence & Innovation Awards
    • WPS Innovation Awards
    • Eddy Awards
  • ETFs
    • Latest ETF News
    • Fund Screener
    • Education Center
    • Equities
    • Fixed Income
    • Commodities
    • Actively Managed
    • Alternatives
    • ESG Rated
  • ESG
    • Latest ESG News
    • The Institutional Investor’s Guide to ESG Investing
    • ESG Sustainability - Gaining Momentum
    • Climate Change: The Inescapable Opportunity
    • Impact Investing
    • 2022 ESG Investing Conference
    • ESG Rated ETFs
  • Defined Contribution
    • Latest DC News
    • DC Money Manager Rankings
    • DC Record Keeper Rankings
    • Innovations in DC
    • Trends in DC: Focus on Retirement Income
    • 2022 Defined Contribution East Conference
    • 2022 DC Investment Lineup Conference
  • Searches & Hires
    • Latest Searches & Hires News
    • Searches & Hires Database
    • RFPs
  • Performance Data
    • P&I Research Center
    • Earnings Tracker
    • Endowment Returns Tracker
    • Corporate Pension Contribution Tracker
    • Pension Fund Returns Tracker
    • Pension Risk Transfer Database
    • Future of Investments Research Series
    • Charts & Infographics
    • Polls
  • Careers
  • Events
    • View All Conferences
    • View All Webinars
    • 2023 Defined Contribution East
    • 2023 ESG Investing
Breadcrumb
  1. Home
  2. INVESTING & PORTFOLIO STRATEGIES
December 24, 2018 12:00 AM

Leverage adds return boost to PE, real estate

Correlations to public market more similar than many think

Arleen Jacobius
  • Tweet
  • Share
  • Share
  • Email
  • More
    Reprints Print
    Neeto da Silva
    Alexander D. Beath said leverage accounts for much of the outperformance.

    Private equity and real estate are more correlated with their publicly traded counterparts than many investors would think. And the volatility differences aren't as great, either.

    Investors have been trying to determine for some time if alternative investments in general — and private equity and real estate, in particular — are worth the lockup periods and high fees.

    It begs the question researchers and investors are struggling to answer: Are alternatives worth it?

    "The difference between listed and unlisted assets is not nearly as large as people in the industry would expect you to believe," said Alexander D. Beath, Toronto-based senior research analyst at CEM Benchmarking Inc., a global benchmarking company.

    Without accounting for leverage, the average U.S. buyout fund generally has been shown to outperform the S&P 500 by about 2.5% to 3% per year over the life of the fund. But when calculations account for leverage, institutional investors' private equity returns from 1998 through 2016 were similar to the S&P 500, he said.

    A substantial portion of the outperformance is attributable to leverage, he noted. The average buyout fund is levered with debt equal to two times equity, whereas the embedded leverage of S&P 500 portfolios including manager and underlying company debt is about 1.25 times equity invested, Mr. Beath said.

    The delevered private equity return is about 4.89%, compared to 5.39% for large-cap equity during that same period, Mr. Beath explained.

    The difference reflects private equity's higher cost of debt as well as manager skill, sector bias and geography bias, he said.

    Private equity and public equity "continue to track along with one another," he added.

    After adjusting for reporting lags, private equity was the most volatile asset class at 26.8%. The large volatility reflected both market risk — the standard deviation of average returns over a period of years — and idiosyncratic risk, the dispersion of returns among funds. Private equity's market risk, 20%, is similar to U.S. small-cap stocks at 19.4%, the CEM study shows.

    There are few research papers on the correlation between private equity and public equity because private company information is not public, said Steven N. Kaplan, the Neubauer Family distinguished service professor of entrepreneurship and finance at the University of Chicago.

    "It's hard to measure ... because it's not public information," Mr. Kaplan said. "People have tried and it's hard to do. You have to make a lot of assumptions."

    It has been argued that private equity is less correlated than it used to be because there are more private companies and fewer public companies than ever before, he said.

    This means that private equity can offer a diversification benefit, Mr. Kaplan said.

    "With fewer public companies, private equity gives investors exposure that is not moving exactly like the S&P 500," Mr. Kaplan said.

    Worth the cost?

    In addition to its correlation work, CEM studies are adding to a growing pool of research on whether alternative investments are worth the cost and illiquidity.

    Mr. Kaplan has co-authored a number of papers on the subject. Indeed, research by Mr. Kaplan, Robert S. Harris of the University of Virginia and Tim Jenkinson of the University of Oxford showed that, on average, private equity funds earned 3% per year over their lives. The study was based on 598 buyout funds and 775 venture capital funds from 1984 to 2008.

    Recession era funds' performance, 2006 to 2008 vintages, matched the S&P 500. Funds raised since the recession that are somewhat mature, 2009 to 2014 vintages, outperformed the S&P 500 by 2% to 3% a year.

    These results did not include leverage, Mr. Kaplan said.

    Overall funds raised since the financial crisis "have done pretty well … not as well as funds raised in 2005 and before, which were spectacular, but the funds continued to perform," Mr. Kaplan said.

    "Anybody who put money in private equity from 2010 to 2015 wouldn't complain," he added.

    But he cautioned: "What private equity is going to do going forward God only knows because (general partners) are paying a lot."

    Private equity is not the only private asset class correlated to the public markets. Real estate investment trusts and equity real estate are also highly correlated, but REITS offered higher returns than equity real estate between 1998 and 2016, according to a soon-to-be published CEM study focusing on U.S. defined benefit plan asset allocation and performance.

    The study looked at investment allocations and realized investment performance of about 200 public and private pension plans for the 19-year period ended Dec. 31, 2016. This time period include the dot-com bubble and global financial crisis, with the resulting bull run.

    After accounting for reporting lags in equity real estate, CEM found a 0.92 correlation between REITs and equity real estate.

    REITs and equity real estate are not highly correlated to other asset classes. What's more, REITs outperformed private real estate. CEM research shows REITs failed to outperform equity real estate in only five years since 1998.

    In a separate paper, CEM found that equity REITs' average arithmetic annual net was 11% compared to 8.3% for equity real estate, in part due to lower costs. REITs did show a bit more volatility, 19.8% compared with 18.3% for equity real estate from 1998 and 2016.

    "To me, what is so important about the CEM (real estate) report is that it's one thing to see the results out of indexes, which is how academics are going to work ... it's another to see what pension funds' actual historical performance is," said John Worth, Washington-based executive vice president, research and investor outreach at Nareit, which commissioned the real estate study. "It throws into sharp relief performance. It's not a theoretical case. It's the actual performance of over 200 pension plans."

    REIT highlights

    The paper highlights the comparative outperformance of REITs, which has been reflected in academic studies but is not well known among investors, Mr. Worth said.

    Consultants and real estate investment managers say that although the two strategies are correlated and REITs can outperform equity real estate, REITs aren't a big seller with investors.

    "Our view is ... that REITs and core (real estate) funds own the same types of assets but you have to hold REITs for a long period of time for the volatility to be smoothed out and for it to look like core real estate," said Andrew Brett, Boston-based director of real assets research at consultant NEPC LLC. "After 10 years, REITs will feel more like real estate but it will be a bumpy ride to get there."

    Overall, the broadest group of highly correlated asset classes was public equities, private equity, hedge funds and tactical asset allocation strategies, CEM's asset allocation study showed. However, the high correlation of equities and private equity emerged after CEM accounted for reporting lags in private equity. Correlations of equity and private equity ranged from 0.79 to 0.92.

    What the findings mean is that alternative investment indexes are not good predictors of what returns an investor will achieve nor are they helpful in constructing an asset allocation, Mr. Beath said.

    "They are OK for past performance," he added.

    Related Articles
    Managers seek edge with better data, tech experts
    Cambridge Associates: Investors might see more risk, less return in 2019
    Investors warned to prepare for 'volatility event' in LaSalle report
    U.S. venture investment hits record in fourth quarter
    Colorado school fund looking for core real estate manager
    Recommended for You
    More funds testing water on crypto-related assets
    More funds testing water on crypto-related assets
    Money managers eager to make leap to opportunity zone investing
    Money managers eager to make leap to opportunity zone investing
    Index investing: Not as passive as you might think
    Index investing: Not as passive as you might think
    The Institutional Investor's Guide to ESG Investing
    Sponsored Content: The Institutional Investor's Guide to ESG Investing

    Reader Poll

    January 25, 2023
    SEE MORE POLLS >
    Sponsored
    White Papers
    Show Me the Income: Discovering plan sponsor and participant preferences for cr…
    The Future of Infrastructure: Building a Better Tomorrow
    Outlook 2023: Opportunity in a volatile world
    Research for Institutional Money Management
    View More
    Sponsored Content
    Partner Content
    The Industrialization of ESG Investment
    For institutional investors, ETFs can make meeting liquidity needs easier
    Gold: the most effective commodity investment
    2021 Investment Outlook | Investing Beyond the Pandemic: A Reset for Portfolios
    Ten ways retirement plan professionals add value to plan sponsors
    Gold: an efficient hedge
    View More
    E-MAIL NEWSLETTERS

    Sign up and get the best of News delivered straight to your email inbox, free of charge. Choose your news – we will deliver.

    Subscribe Today
    December 12, 2022 page one

    Get access to the news, research and analysis of events affecting the retirement and institutional money management businesses from a worldwide network of reporters and editors.

    Subscribe
    Connect With Us
    • RSS
    • Twitter
    • Facebook
    • LinkedIn

    Our Mission

    To consistently deliver news, research and analysis to the executives who manage the flow of funds in the institutional investment market.

    About Us

    Main Office
    685 Third Avenue
    Tenth Floor
    New York, NY 10017-4036

    Chicago Office
    130 E. Randolph St.
    Suite 3200
    Chicago, IL 60601

    Contact Us

    Careers at Crain

    About Pensions & Investments

     

    Advertising
    • Media Kit
    • P&I Content Solutions
    • P&I Careers | Post a Job
    • Reprints & Permissions
    Resources
    • Subscribe
    • Newsletters
    • FAQ
    • P&I Research Center
    • Site map
    • Staff Directory
    Legal
    • Privacy Policy
    • Terms and Conditions
    • Privacy Request
    Pensions & Investments
    Copyright © 1996-2023. Crain Communications, Inc. All Rights Reserved.
    • Topics
      • Alternatives
      • Consultants
      • Coronavirus
      • Courts
      • Defined Contribution
      • ESG
      • ETFs
      • Face to Face
      • Hedge Funds
      • Industry Voices
      • Investing
      • Money Management
      • Opinion
      • Partner Content
      • Pension Funds
      • Private Equity
      • Real Estate
      • Russia-Ukraine War
      • SECURE 2.0
      • Special Reports
      • White Papers
    • Rankings & Awards
      • 1,000 Largest Retirement Plans
      • Top-Performing Managers
      • Largest Money Managers
      • DC Money Managers
      • DC Record Keepers
      • Largest Hedge Fund Managers
      • World's Largest Retirement Funds
      • Best Places to Work in Money Management
      • Excellence & Innovation Awards
      • WPS Innovation Awards
      • Eddy Awards
    • ETFs
      • Latest ETF News
      • Fund Screener
      • Education Center
      • Equities
      • Fixed Income
      • Commodities
      • Actively Managed
      • Alternatives
      • ESG Rated
    • ESG
      • Latest ESG News
      • The Institutional Investor’s Guide to ESG Investing
      • ESG Sustainability - Gaining Momentum
      • Climate Change: The Inescapable Opportunity
      • Impact Investing
      • 2022 ESG Investing Conference
      • ESG Rated ETFs
    • Defined Contribution
      • Latest DC News
      • DC Money Manager Rankings
      • DC Record Keeper Rankings
      • Innovations in DC
      • Trends in DC: Focus on Retirement Income
      • 2022 Defined Contribution East Conference
      • 2022 DC Investment Lineup Conference
    • Searches & Hires
      • Latest Searches & Hires News
      • Searches & Hires Database
      • RFPs
    • Performance Data
      • P&I Research Center
      • Earnings Tracker
      • Endowment Returns Tracker
      • Corporate Pension Contribution Tracker
      • Pension Fund Returns Tracker
      • Pension Risk Transfer Database
      • Future of Investments Research Series
      • Charts & Infographics
      • Polls
    • Careers
    • Events
      • View All Conferences
      • View All Webinars
      • 2023 Defined Contribution East
      • 2023 ESG Investing