The Place of Private Equity in a Diversified Investor’s Portfolio

The recent Chapter 11 bankruptcy protection filing of Energy Future Holdings Corporation — once the subject of the world’s largest leveraged buyout, and now the biggest private equity bankruptcy since the demise of Chrysler — casts an unflattering light on the rarefied sphere of private equity (PE) investment. We take the opportunity to review recent research on the place of private equity in a diversified investor’s portfolio.

Conventional optimization models feeding risk and return data into the capital asset pricing model (CAPM) often produce recommended private equity (PE) weightings as high as 60% of portfolios. One new study from a pair of researchers at the Columbia University Business School casts doubt on these optimization models. Because market prices of underlying investments are only available at the time private equity managers exit their positions, the result is overrepresentation of the winners in performance measures, disproportionately ignoring the losers. Private equity has many  underlying frictions, as well as less transparency and liquidity than other assets, which considerably hampers comparability.

Do private equity fund managers earn their fees? This pertinent question is the subject of a comprehensive new survey of 837 private equity funds by David T. Robinson at Duke University and Berk A. Sensoy at Ohio State University. They find that private equity fund managers charging higher fees do actually produce higher gross returns, but that agency costs exist in the form of the “waterfall effect” and in situations in which funds are kept open solely for the dubious purpose of collecting fees.

One of the most celebrated and widely imitated investors claiming long-term success from investing in private equity is the Yale University Investments Office. Their performance claims may not necessarily be quite so clear, according to one author. In “Yale’s Endowment Returns: Case Study in GIPS Interpretation Difficulties,” Ludovic Phalippou of Oxford University’s Said Business School notes several interpretation difficulties associated with using the since-inception IRR model that could produce highly misleading performance results. He suggests several alternative approaches to ameliorate these difficulties.

Modern portfolio management techniques often account for abnormal returns from alternative assets by estimating an illiquidity factor. The authors of a new study demonstrate that private equity investments are different from investments in public firms and identify a new way of understanding private equity returns. Inefficiency in the private equity market can be beneficial to the general partner of a fund, who can acquire specialized information and identify a better return, or expected IRR, than what is forecasted.

Investor interest in private equity suffered sharply from cyclical over-allocation to the private equity asset class before the financial crisis period and the deleterious impact afterwards of contractual lock-ins trapping investor capital. But private equity firms have recently been more successful in raising capital. According to a new survey, Single Family Offices (SFOs) have emerged as an important investor base to help make up the lack of demand from traditional funding sources. In a recent survey of 139 investment professionals from SFOs, nearly 80% said they were looking for greater participation in private equity. More than 17% were interested in allocating more than a quarter of their funds to private equity.

This suggests that even despite doubts about the measurement of private equity performance, the self-evident cyclicality of both the entry and exit prices for the underlying investments, and the volatility of investor demand for private equity funds, some observers continue to believe they will see a windfall from their illiquid alternative assets. A forthcoming study in the Financial Analysts Journal by Niels Pedersen, Sébastien Page, CFA, and Fei He, CFA, suggests the lack of mark-to-market data lures investors into the misconception that alternative asset classes and strategies represent a “free lunch.” The authors propose solutions to measuring mark-to-market risk in alternative and illiquid investments and describe how to estimate risk factor exposures when the available asset return series may be smoothed. They suggest that ultimately alternative investments are exposed to just the same risk factors that drive stock and bond returns.

These recent CFA Digest summaries and related resources of interest to readers are summarized below:

• Risks, Returns, and Optimal Holdings of Private Equity: A Survey of Existing Approaches: There is substantial disparity in performance estimates as reported by studies on the risks, returns, and optimal holdings of private equity portfolios. Moreover, the traditional risk and return measures need to be modified because they are not applicable to this asset class. Fee levels in private equity investments tend to be high, and optimal holdings for private equity portfolios are much smaller once frictions are introduced into the traditional models of asset allocation.
• Do Private Equity Fund Managers Earn Their Fees? Compensation, Ownership, and Cash Flow Performance: To determine the relationship between performance and management fees, the authors study data from 837 private equity funds from 1984 to 2010. They conclude that funds with higher costs do not produce lower overall net returns, which implies that private equity fund managers charging higher fees produce higher gross returns. Agency costs are found to still exist, however, in the form of the “waterfall effect” and in situations where funds are kept open for the purpose of collecting fees.
• What Really Drives Risk Premium and Abnormal Returns in Private Equity Funds? A New Perspective: Given that private equity investment takes place in nonpublic markets, previous work using public-market techniques appears to be incomplete and inconsistent. The use of an illiquidity factor attached to models used for publicly traded firms does not capture how private equity investors view investments and can also potentially hide a number of other pertinent factors. So, the authors suggest a conceptual framework for understanding private equity returns.
• Yale’s Endowment Returns: Case Study in GIPS Interpretation Difficulties: The Global Investment Performance Standards require the use of the since-inception internal rate of return as a performance metric for private equity and real estate funds. Unfortunately, there are problems associated with the use of this metric, and alternative approaches may be better.
• PE Firms Find Quality Investors in Single-Family Offices: The importance of single-family offices (SFOs) to private equity firms continues to grow. According to the authors, SFOs are increasingly interested in allocating client capital to private equity firms. They explain how private equity firms can reach these seemingly diverse investors.
• Private Equity Funds and Pension Plans: A Changing Dynamic: “It is in everyone’s best interest to evaluate the extent to which a potential or existing fund investor could be affected by further developments along the lines of Sun Capital Partners where investors were held liable for an investment’s employee pension liabilities.”
• Performance Measurement in Private Equity: Recent accounting rules have tried to address the challenges of measuring and disclosing the fair value of illiquid investments, including private equity investments. Previous research has shown that the value of private equity investments may not reflect current movements in the public markets. The author reprises previous research to determine whether these new accounting rules have reduced the impact of stale pricing in private equity valuations.
• Asset Allocation: Risk Models for Alternative Investments: Often, the lack of mark-to-market data lures investors into the misconception that alternative asset classes and strategies represent somewhat of a “free lunch.” This article proposes solutions to measuring mark-to-market risk in alternative and illiquid investments. The authors describe how to estimate risk factor exposures when the available asset return series may be smoothed (owing to the difficulty of obtaining market-based valuations). They show that alternative investments are exposed to many of the same risk factors that drive stock and bond returns.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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