Are Private Equity Returns Overstated?

Top quartile private equity performance is something every institutional fund aspires to. Of course, every single PE fund claims to be top quartile, which would seem to be mathematically impossible.

David Swensen and his team at Yale have put together one of the most enviable track records in this space. This passage comes from the most recent Yale Endowment Fund update:

Yale’s private equity program, one of the first of its kind, is regarded as among the best in the institutional investment community and the University is frequently cited as a role model by other investors. Yale’s private equity strategy emphasizes partnerships with firms that pursue a value-added approach to investing. Such firms work closely with portfolio companies to create fundamentally more valuable entities, relying only secondarily on financial engineering to generate returns. Investments are made with an eye toward long-term relationships—generally, a commitment is expected to be the first of several—and toward the close alignment of the interests of general and limited partners. Over the past twenty years, the private equity program has earned 36.1 percent per annum.

Using the handy rule of 72 would tell us that Yale would double their money every other year with 36% annual returns. Not bad.

Unfortunately these numbers don’t tell the whole story. Twenty years ago Yale’s Endowment was roughly $4 billion. Let’s assume 20% of that was in private equity (the allocation is now 33%). Earning an annual return of 36.1% would have turned that $800 million allocation into $380 billion. The funny thing is the current endowment value sits at just $23 billion, a fraction of the potential stated PE growth.

Why is this the case?

Here are a few caveats that rarely get mentioned when discussing private equity returns:

IRRs are not compounded returns. There is a huge difference between an internal rate of return (IRR) and a compounded rate of return. IRRs tell you how well the investor did with the capital they employed, but not when they employed the capital or how much of the capital they used.

The magnitude of the cash flows matters. Let’s say your pension fund makes a $10 million commitment to a private equity fund. It’s highly likely that just $6-$7 million of that capital will be invested by the PE fund. This is because, on average, PE funds only call roughly 60-70% of committed capital (another issue is that many funds still charge fees on the $10 million of committed capital, so investors are paying much more than a 2% management fee, but I digress).

This means that while investors may be receiving decent returns on their PE investments, it’s being earned on a smaller capital base than they may realize, thus diminishing the impact of the returns on the overall portfolio.

The timing of the cash flows matter. IRRs are used because they are meant to take into account the timing of cash flows. When our hypothetical pension fund makes its $10 million commitment to a PE fund, they don’t simply hand over that money all at once. It gets invested as opportunities arise. The investment period for a PE fund can last up to 10-15 years. But the IRR stat places a lot of weight on the earliest cash flows. When you invest and how quickly you get your money back can have a huge impact on the IRR calculation.

In the Yale example, the high IRRs they earned in the 1980s are probably accounting for the majority of their enormous reported return. From year-to-year, that return probably hasn’t changed much over time. Short-term successes and failures can distort IRRs and don’t tell the whole story. IRRs also don’t take into account the opportunity cost of sitting in cash or other investments for a number of years as investors wait to have their capital deployed by PE firms.

They’re not benchmarked correctly. A number that far too few investors or funds use is a multiple of capital. A 2x multiple would mean that an investor in a fund doubled their money (although, to be fair, venture capital funds pay more attention to these numbers). The multiple of capital is much more tangible than an IRR.

Also, when making private to pubic market comparisons, many PE funds use a constant public market index, such annual S&P 500 returns. A more apples-to-apples comparison would compare private investments and public investments on a cash-flow weighted basis as PE investments are made. So it would look at how that investment would have done in the S&P 500 during the same time frame the cash was put to work. It levels the playing field, so to speak. And this doesn’t even take into consideration the leverage or illiquidity involved in a PE fund.

Everyone does things a little differently. Because of all of these issues, there really are no standards in the institutional investment world to account for private equity returns in a portfolio. Compounded returns would probably understate returns, while IRRs overstate them. The numbers you see from most PE firms and institutional investors alike are not what they appear to be at first glance.

I’m not trying to suggest that Yale is over-stating returns purposely here. David Swensen and team’s track record speaks for itself. It’s unmatched in the institutional investment world and private equity has played a large role in their success. But the return numbers that you see from certain funds aren’t always what they’re cracked up to be.

Investors are often far too believing of statistics without placing them in the correct context.

Further Reading:
6 Reasons For David Swenson’s Success at Yale
Is Venture Capital Rigged?

 

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What's been said:

Discussions found on the web
  1. Ryan commented on Oct 29

    Frankly I’m not even sure why the Global Investment Performance Reporting Standards (GIPS) even allows IRR. Almost all existing PE reporting standards exist to inflate returns and confuse investors.

    The most complete data available has shown PE returns have lagged public markets by roughly 5%/yr over the past several decades. Meanwhile they run around marketing 30%+ IRR gross of fees.

    • Daniel Phillips commented on Oct 29

      Ryan – Can you reference a report that contains that public data (i.e. PE returns lagging public markets by 5%/yr? I don’t doubt it, but I would be interested in reading the full report. Thanks.

    • Ben commented on Oct 30

      I didn’t even think about that. I never realized IRRs were GIPS compliant.

  2. Nick commented on Oct 30

    I’m curious if you calculated the CAGR that would take the fund from $4B to 23B over the 20 period? Do the two values take into account asset flows into and out of the fund?

    How much does David outperform other investors with a public track record? I apologize if all of this is documented somewhere, if you have a link, I would be happy to follow it.

  3. RobotandFrank commented on Oct 30

    In the quote you gave of Swensen, he doesn’t mention IRR. I think the annualised return he mentions of 36% is his CAGR, similar to how we say Buffett has done 20% a year for 50 years.

    Also when you said “IRRs are not compounded returns. There is a huge difference between an internal rate of return (IRR) and a compounded rate of return. IRRs tell you how well the investor did with the capital they employed, but not when they employed the capital or how much of the capital they used.”

    This is correct, but over time (say 10 years) the average IRR of an investment within a portfolio would converge towards the CAGR of the portfolio as a whole, would it not?

  4. 10 Friday AM Reads | The Big Picture commented on Oct 30

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  5. nwberger commented on Oct 30

    The valuations of these assets are massively subjective and they do not take into account the discount needed for their illiquidity. Just today the WSJ shows how the valuation of Uber and other per-market price companies differ, some are 50% apart. This is not unlike the ‘letter’ stock scandal of the late 1960’s. 37% per year? Give me a break.

  6. ST commented on Oct 31

    I worked for a private equity firm for a while because I believed in PE, or at least I thought I did.

    Their marketing package was terrible, it relied heavily on touting Ivy League endowments to show the power of PE, yet didn’t show that the investment opportunities of those same endowments were far more expansive and worlds apart from what the firm could offer. I basically had to deviate heavily from their show & tell and develop my own realistic conjecture to share with clients.

    After a few years of PE research, I think I’m content to say that within the realm of PE, it’s not going to be the retail investor who sees those market-beating returns. Investing in a PE fund (of any composition), is not the same as investing in or having actual ownership in the underlying company. To reap the true and highest benefit from PE, you have to invest in the actual company, the more levels between your money and the actual centre of profit, the more diluted your return.

    Onex (OCX) is a great example. As a private company the owners saw 50% annual returns. Since going public, the shareholder has received 9% annual returns — under the exact same business model.
    (Within my firm, the management stated the average return of their products was ~8%/yr…so why not just buy a listed PE for equivalent returns AND liquidity!?)

    Touted as being the most successful business deal in US history, was the Dodge brothers’ investment in Ford. Over 17 years they made an astounding 150%/yr (in addition to building their own $200 million with Ford dividends). A Ford shareholder, buying and holding from the IPO (1956, all dividends re-invested), would be enjoying a 10% annual return. This is a good demonstration of the difference between investing and allocating savings.

    PE does have positive aspects, but it requires the investor to be exceptionally and brutally realistic about its function.

    • Ben commented on Oct 31

      Well said. Thanks for sharing. I think you’re right about the whole direct co-investment angle. My sense is this is where the majority of the outperformce come with many of these Ivy endowments. They have actual deal experts looking at these things. Not many people realize this or realize how difficult it is to pull that off.

  7. Strategic1 commented on Oct 31

    Well, since we are on the subject of returns, it might be worth pointing out that actually the rule of 72 does not refer to annual returns, but rather continually compounded growth rates.
    It takes a continuously compounded growth rate of 36% to double in 2 years, not an annual return of 36%. If you don’t believe me take 1*1.36^2 and see what your result is (it is 1.8496, not 2). A continuously compounded 36% generates a return of about 44%, which gets you to 2.
    Since you have spent lots of time arguing that most growth metrics overstate, you shouldn’t fall victim to the same trap.

  8. msk1 commented on Nov 04

    @ Ben – thanks for writing about this. The topic should matter to investors and I also spend a bit of time writing about it in my http://www.thedarcroom.org blog. It’s interesting we noticed the same thing… I wrote about beeing fooled by IRRs

  9. Stock Soup commented on Nov 04

    And what about valuing illiquid investments? I’m sure they don’t low-ball ’em.

    Are not almost all PE holding illiquid prior to exit?

  10. Stock Soup commented on Nov 04

    And, on the topic of Yale, how do they value those timber investments?

  11. Managing Risk vs. Managing Returns commented on Feb 23

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