Practical analysis for investment professionals
03 December 2018

Private Equity: The Emperor Has No Clothes

From Bust to Boom

The private equity industry had an abysmal outlook in 2008 and many portfolio companies were at the brink of collapse. Carlyle Capital, a listed affiliate of the US buyout giant The Carlyle Group, defaulted on its debt.

Fast-forward to 2018 and such global financial crisis–related difficulties seem almost forgotten and private equity is flourishing. Indeed, alternative investment firms have $1.8 trillion in “dry powder” waiting in reserve and more than half of that is held by private equity funds.

Subscribe Button

The fondness for private equity among institutional investors is easy to explain: It comes down to high returns, low volatility, and a lack of correlation to traditional asset classes. Of course, such attributes also evoke some skepticism: Don’t they sound just too good to be true?

To explore that question, we set out to replicate private equity returns with public stocks.

Private Equity Returns vs. The S&P 500

Private equity returns in the United States have outperformed various equity and bond benchmarks over the long term, according to data from Cambridge Associates. Private equity returns are compiled from 1,481 US private equity funds and are available net of fees on a quarterly basis.

Using this data, we construct a US Private Equity Index that has outperformed the S&P 500 by a significant margin since 2000.

US Private Equity Returns vs. The S&P 500

US Private Equity Returns vs. The S&P 500

Source: Cambridge Associates, FactorResearch. Private equity returns are only available as IRRs and not CAGRs, so should be viewed as an approximation when comparing to public equity returns.

Not only has it outperformed, the US Private Equity Index also has much lower volatility than the S&P 500. This no doubt has an appeal for institutional investors. Unfortunately, it is more illusion than reality. After all, private equity portfolio companies are typically valued on a quarterly basis so lack a daily time series. In addition, most portfolio company valuations are smoothed as they are conducted by external appraisers using business plans from the private equity firms.

If private equity firms valued their portfolio companies on a daily basis using public market multiples, volatility would be much higher and more reminiscent of the S&P 500.

Explaining Private Equity Returns

Bryan Burrough and John Helyar immortalized the private equity industry in Barbarians at the Gates, their account of the 1988 buyout of RJR Nabisco. The deal, which involved many prominent Wall Street characters, was valued at a then-unprecedented $25 billion.

Although private equity today is renowned for enormous buyouts, take-over targets historically were much smaller simply because private equity funds held much less capital. The average transaction size was much more in line with small-cap equities.

Based on this data point, we create an index of the 30% of the smallest US public companies with market capitalizations over $500 million. As it turns out, the small-cap equity index and the US Private Equity Index have almost identical returns. The performance profiles also demonstrate that private equity returns are not as uncorrelated to public equities as institutional investors might like them to be.

Replicating Private Equity with Small-Cap Stocks

Replicating Private Equity with Small-Cap Stocks

Source: Cambridge Associates, FactorResearch

Maybe the US Private Equity Index only represents average returns and not those of the top-performing funds. But ample academic research shows that fund selection is challenging across all asset classes. Choosing the funds with the best historical returns is rarely a winning strategy. Therefore, average returns are likely reflective of the actual returns that investors should expect from private equity allocations.

Liquid Private Equity Alternatives

In addition to their smaller size, private equity target companies have also tended to share other characteristics, among them lower valuation multiples and the ability to carry debt.

Companies trading at lower valuations often have temporary or structural issues that private equity firms see as opportunities. By swooping in and addressing them, the private equity firm can unlock value.

Although much less leverage is applied in private transactions today than when the sector got rolling in the 1980s, recouping the initial equity investment quickly through a dividend recap financed by additional debt remains a popular strategy. Companies with proven cash flows and the ability to take on debt are still popular targets.

So we create two portfolios: one with small and cheap stocks and another with small, cheap, and levered US stocks. Cheap stocks have low EV-to-EBITDA multiples and levered stocks high debt-to-EBITDA multiples.

What did we find? From 1988 to 2018, the liquid private equity alternatives portfolios outperformed the US Private Equity Index. They provide daily liquidity and require minimal initial due diligence and ongoing monitoring. They can also be rebalanced quarterly and managed internally or outsourced to any asset manager for a few basis points.

Liquid Private Equity Alternatives

Liquid Private Equity Alternatives

Source: Cambridge Associates, FactorResearch

Further Thoughts

Exposure to small caps likely explains private equity returns. Liquid alternatives to private equity can be created simply by buying small, cheap, and levered stocks.

Some have reached similar conclusions and proposed that the nature of locked-up capital is what makes private equity so advantageous. It keeps investors from redeeming their funds at market lows and helps private equity firms weather storms like the global financial crisis. But the same fund structure can be replicated through public equities at a fraction of private equity fees.

Furthermore, with $1.8 trillion sitting on the sidelines, too much money may end up chasing too few deals, creating high acquisition multiples that don’t augur well for expected returns.

Of course, high valuations are now the rule in both private and public markets. And corporate debt levels are at all-time highs.

Small, Cheap, and Levered Stocks: Valuation and Debt Multiples

Small, Cheap, and Levered Stocks: Valuation and Debt Multiples

Source: FactorResearch

Neither of these developments bode well for expected returns. So investors might be wise to reconsider direct private equity allocations and their liquid alternatives altogether.

For more insights from Nicolas Rabener and the Factor Research team, sign up for their email newsletter.

If you liked this post, don’t forget to subscribe to the Enterprising Investor.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: Stamps of Germany (DDR) 1975

Professional Learning for CFA Institute Members

CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker.

About the Author(s)
Nicolas Rabener

Nicolas Rabener is the managing director of Finominal, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Previously, Rabener worked at GIC (Government of Singapore Investment Corporation) focused on real estate across asset classes. He started his career working for Citigroup in investment banking in London and New York. Rabener holds an MS in management from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km Ultramarathon, Mont Blanc, Mount Kilimanjaro).

30 thoughts on “Private Equity: The Emperor Has No Clothes”

  1. Sylvia van de Kamp-Vergeer says:

    I would like to know if the returns presented in the analyses are net or gross.

    1. Hi Sylvia, the private equity returns are net of all fees (fees, expenses and carried interest). The public equities are net of transaction costs. Other fees are marginal for the replication strategies given the simplicity and quarterly rebalancing.

      1. Peer Borsky says:

        Hi Nicolas,

        How did you model transaction costs for public equities?

        1. Hi Peer, we modelled 10 basis points for each stock transaction. The public equities indices can be rebalanced on a quarterly or less frequent basis and transaction costs do not have a significant impact.

  2. Mike says:

    Interesting article. With regard to the last chart, is there a secondary y-axis missing for the debt/ebitda multiple? Not sure how it can be higher than EV/ebitda for so many year. thanks

    1. Nicolas Rabener says:

      Hi Mike, thanks for pointing out the issue with the chart, where you were naturally correct. We fixed the chart.

  3. Jamie says:

    Nice article. Merrill Lynch used to have a PE proxy index in the 1990s that focused on the performance of small cap stocks. I think they discontinued it after the tech bubble burst. It is true that the average PE fund performance is just that and for most investors in PE, the desire to diversify reduces overall returns. The way to win in PE as an investor is through good timing and selectivity and concentration. Throw in a healthy dose of good luck. Have you checked to see what percentage of the small cap stocks that you screen still have PE funds on the board and or have a large PE shareholder? Is there any evidence to suggest that you are screening for publicly traded PE-backed companies and you may actually be picking up PE exposure?

    1. Nicolas Rabener says:

      Hi Jamie, I wasn’t aware of the ML PE proxy index, thanks for sharing. You make good suggestions for further analysis, but we currently don’t have the data for systematically screening for PE involvement in the small cap stocks. However, skimming the latest portfolio doesn’t seem to indicate a large proportion of PE ownership.

      1. Jit Hoong Lim says:

        Thank you for sharing this Nick. very interesting article. I would throw in a bit of skepticism in this. If I throw in a good dose of logic , then I am questionning about survivorship bias. Since PE requires heavy leverage, so during the two big market corrections (dotcom and Great Recession), many of these firms would have gone bust. The fact that this is not reflected (much) in the lower IRR returns during recessions makes me a skeptic. So the lack of variability in the PE valuations simply means the Lack of transparency (or efficiency) of this asset class.

        1. Nicolas Rabener says:

          Hi Jit, the PE data from Cambridge Associates includes liquidated partnerships, but reporting of IRRs is voluntary and often stops when funds go under, so your concerns on survivorship bias are valid. The same concerns apply to hedge fund returns, which are also overstated.

  4. Kevin Collins, CFA says:

    Thank you for the article. This makes sense intuitively.

    Can smaller investors replicate the two-part strategy described? One can come close with one of many small cap funds – active or index. But a diversified
    “levered” portion seems difficult for smaller investors to replicate. I would be interested in observations or suggestions in this regard. Thanks

    1. Hi Kevin, the liquid private equity alternatives can be replicated efficiently via small cap value-focused smart beta ETFs (or funds), which are available at very low cost. The portfolio that sorts for small, cheap and levered stocks could be easily replicated via stocks, but is perhaps more difficult to find as an ETF or fund. However, the analysis also highlights that most PE returns were already captured by screening for cheap and small stocks, adding leverage did not contribute significantly more.

  5. Emilian Belev says:

    Hi Nicolas,

    Interesting idea. One critical point is, as your article points out PE returns are an estimate, not an observation. The CA index uses the PME methodology for calculating “PE” returns, the math of its calculation can make any time series appear correlated with the stock market, or a subset by picking the appropriate public market “discount rates”. Using the PME approach, one can make e.g. the sale of Taylor Swift records appear highly correlated to the stock market. The point is that PME should be used and compared to with high caution.

    I was wondering how this inherent bias is treated in your work.


  6. Hi Emilian, I’m not sure if you’re referring to index we constructed based on CA data or one from CA directly. The CA index featured in this article is one we created by using quarterly IRR data from CA. Naturally we’re aware (and also noted) that transforming IRRs and comparing them to public market indices can be challenged easily. Thanks.

  7. JC Berkindale says:

    interesting article , thank you. Two other points relevant for most investors: 1. few non-institutional (large) can replicate the PE returns due to the timing and amounts needed to diversify among managers, and 2. the drag of returns on cash required to be held while awaiting the capital calls can materiallt reduce return.
    Furthermore the tax efficiency of PE for taxable investors is essentially not manageable. The suggested small cap alternative is advantaged further in taxable situations.

  8. Well done. Thank you for sharing your research. Timing and luck are critical performance variables for PE funds. The fund’s vintage, relative to the economic cycle, determines much of a fund’s performance. As one PE fund managing director shared, “People think I am a rockstar for the returns the fund is generating today. The reality is the returns are on investments we made at the time of the crisis several years ago. Yeah, it took guts to buy then, but we got the tailwind of growth plus multiple expansion when we exited.” What I heard was the following: market-timing (which can be difficult), concentrated bets, illiquid and long-term positions. For these reasons, I appreciate the proxy, alternative strategy of small cap stocks presented in article.

  9. Jonathan says:

    Great article and analysis. Just out of interest did you mean companies with a market cap of less than $500m? And if you meant more what was the reason for that cut-off?


    1. Hi Jonathan, we only selected stocks larger than $500 million in market capitalization as companies below that to tend to be more problematic, i.e. are fallen angels, recently IPOed stocks, etc, and don’t represent typical PE targets, i.e. stable cashflows that can be levered . Naturally $500m today are far less than $500m in 1990, so we could enhance the analysis by adjusting for inflation.

  10. Ming says:

    What was the total leverage of the PE index vs the small and cheap stock index over time?

    It would be interesting to know if it was more, the same or less.

    My instinct tells me that the PE index leverage should be greater than the small and cheap stock index as PE is just a levered play on small caps. If this were the case, it can be argued that PE firms add leverage (which adds additional risk) but it does not translate to greater returns to investors net of fees. Any additional returns from this added leverage risk is probably skimmed off via high fees anyways, so the end investor takes on additional risk for no additional return.

    Also, can you clarify, ‘30% of the smallest US public companies with market capitalizations over $500 million’ – Is this the smallest 30% of the entire US equity market or smallest 30% of a US small cap index like the Russell 2000?

    I’m unsure if any smart beta product exists that constructs a portfolio like that. Are there any?

    What about a 3rd option where you take the entire small caps index like the Russell 2000 and gear it to the same as the total gearing of the PE index? How would have this worked out?

    1. Hi Ming, thanks for your questions. The following responses:

      1) The index itself was not levered, but simply selected stocks with high debt-over-equity ratios, in addition to these being small and cheap. We used the sequential model for the stock selection.

      2) We defined the universe as all US stocks above $500 million market cap and selected the 30% smallest companies of that universe.

      3) There are mutual funds that replicate this strategy (small, cheap & levered) and smart beta ETFs that focus on small and cheap stocks. Including leverage as a factor is somewhat marginal.

      On an unrelated note, adding a factor like high cashflow stability, which many PE target companies feature, and then leveraging the index would be an interesting follow on analysis.

  11. Hey Nicolas! Great article. Very interesting are their any ETFs which currently pursue this strategy? Looks like VISVX would have underperformed the PE funds.

    Also, what was the vol in the fund you created versus the S&P500?

    -Phillip Ng, CFA

    1. Hi Phillip, thanks for your comments. I’m not aware of any ETF that is specifically designed to replicate PE returns, although there are mutual funds that precisely do that. However, given the immense interest in this area, I would suspect that there are ETFs in the pipeline.

      The volatility of the S&P 500 was 14.67% vs 16.59% for the PE replication index over the last 30 years.

  12. Norbert says:

    Judging from the rather high number of comments, this article about a rather ineffective approach for improving risk-adjusted returns, seems to excite much interest. However, the recent article ( about a much more effective approach proven for decades, using Managed Futures/CTAs with Crisis Alpha excited much less interest. Why so?

    1. Hi Norbert, I believe it’s partially explained by performance chasing and envy. PE has delivered attractive returns since the GFC and is in high demand by institutional investors. Mutual fund managers, who have been consistently losing market share to ETFs, would be delighted to capture part of that market as there is very little magic in PE from an equities perspective.

      In contrast, managed futures/CTAs have been basically flat since the GFC and AUM has stalled at $300bn. Although I do believe that an allocation to CTAs make sense, most investors struggle with assets that might provide occassional attractive diversification benefits, especially when central banks seem to be directly supporting equity markets.

  13. John Gilligan says:

    It is worth making some methodological and presentational observations:
    Firstly graphs are appealing ways to attract the reader’s attention but need care. Yours are log graphs, which flatten the trends to be more linear – that’s sort of the point of log linear graphs.
    Second reported IRRs are poor measures indeed, DPI or TVPI are almost always needed to make sense of the data. It is worth saying that in even the most comprehensive data sets, over 25% of the data is missing.
    Third you don’t deal with fund leverage, a massive issue when looking at IRR/DPI/TVPI trends in PE these days. Apple & Pears and all that.
    Fourth you only look at LPs returns in funds, not in co-invest or secondary trades. low cost direct investing and portfolio balancing are more available these days, and.;
    Finally, you note that the results are net of fees, but do not take the logical step of pointing out that PE is a high fee business that still at least matches a risky small cap portfolio after costs. Therefore the investment strategy is out performing the market, but most of the out performance within a traditional fund is being paid to the GP. That is a pricing problem, not a performance one.

    The data has been crawled over many, may times. It always says the same thing: Gross performance is, on average, better than quoted comparable companies (or indeed unquoted comparable companies). Net performance is about the same or a bit better. This just shows that the fund manager captures most of the value they seem to create.

    1. Nicolas says:

      Dear John, thanks for your suggestions on how to improve the analysis. We agree that the analysis can be enhanced, which is largely a data issue. We used CA for PE data and they only provide IRRs on a quarterly basis, DPI and TVPI only annually, which is less attractive. If you have better data sources, please get in touch via [email protected]. We would be interested in exploring this further. It seems overall that you agree that there is not much magic in PE returns, at least on a net basis. Best regards, Nicolas

  14. Diego Bergheim says:

    Thank you for sharing your results. The conclusion is in line with that of other studies. Unfortunately, the current PE-hype is likely to overshadow any objective data. Not only that but funds like Softbank’s Vision Fund represent a trend towards even riskier PE investments.

  15. Jason says:

    Are you aware of other studies/papers that have tried to reproduce this type of analysis?

  16. Young Polish M&A Analyst says:

    Incredibly interesting, thank you so much for this. Very impactful (for sure on my view and investing decisions).

Leave a Reply

Your email address will not be published. Required fields are marked *

By continuing to use the site, you agree to the use of cookies. more information

The cookie settings on this website are set to "allow cookies" to give you the best browsing experience possible. If you continue to use this website without changing your cookie settings or you click "Accept" below then you are consenting to this.