Leverage adds return boost to PE, real estate

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.

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."

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.