A Textbook Performance Chase

As of the end of 1999, it’s estimated that there was roughly $400 billion in assets under management in hedge funds. Fast forward to today and there’s almost $3 trillion in AUM, a compounded annual growth rate of almost 14% (much higher than the returns earned).

I think the real turning point for the huge flows into hedge funds was the 2000-2002 bear market, which saw the S&P 500 get cut in half. Stocks were down three years in a row and hedge funds came out of this period relatively well because so many value-focused funds were able to bet against over-priced large cap and growth stocks and bet on under-priced small cap and value stocks. Investors hadn’t really seen anything like the prolonged bear market and were looking for an outlet to vent their frustration with lack-luster results.

Enter hedge funds.

Institutional and high net worth investors alike flooded hedge fund managers with cash and thousands of new funds opened in the following years. This continued through the financial crisis and the ensuing increase in assets and number of funds has led to both an increase in the competition for alpha and a terrible stretch of performance for the majority of investors in these funds.

These investors are now starting to get antsy because they see the enormous fees they’re paying for subpar performance and also (hopefully) understand that low interest rates are not conducive to higher expected returns going forward for a portion of their portfolios. So in an effort to “juice returns” many of these investors have turned to private equity funds. My sense is this move is a textbook performance chase by investors who are trying to mask problem areas in their portfolios by swinging for the fences.

In many ways, private equity funds are the new hedge funds in terms of investors looking for that elusive silver bullet.

Here are a few stats and figures from a recent article at Chief Investment Officer:

Dry powder hit another all-time high despite private equity funds returning a record $443 billion to investors in 2015, according to Preqin.

Cash allocated by investors but yet to be deployed rose sharply in the first nine months of the year, Preqin said, from $757 billion at the end of 2015 to $839 billion at the end of September 2016.

Meanwhile, 56% of institutional investors polled by Preqin said they intended to increase their allocation to private equity, with just 7% saying they would decrease it.

Private equity markets are likely to face the same challenges that hedge funds have run into in recent years — namely, the increase in assets and funds means greater competition for investments, thus making it more difficult to add value, especially for the late entrants into the space.

Yale endowment CIO David Swensen wrote the book Unconventional Success: A Fundamental Approach to Personal Investment in an effort to explain to individual investors the difficulties in trying to emulate Yale’s success in private investments. The book was written in 2005, long before many new investors began piling into these funds, but his warnings are still relevant today:

Buyout funds constitute a poor investment for casual investors. The underlying company investments in buyout funds differ from their public market counterparts only in degree of balance sheet risk and in degree of liquidity. The higher debt and the lower liquidity of buyout deals demand higher compensation in the form of superior returns to investors. Unfortunately for private equity investors, in recent decades buyout funds delivered lower returns than comparable marketable securities positions, even before adjusting for risk.

As with other forms of investment that depend on superior active management, sensible investors look at buyout partnerships with a high degree of skepticism. Unless investors command the resources necessary to identify top-quartile or even top-decile managers, results almost certainly fail to compensate for the degree of risk incurred. 

The new entrant into the world of private entrepreneurial finance faces an obstacle quite apart from the barriers hampering investment success in other asset classes. The top-tier venture partnerships, essentially closed to new money, enjoy superior access to deals, entrepreneurs, and capital markets. Exclusion from the venture capital elite disadvantages all but the most long-standing, most successful limited partners.

Suppliers of funds to the venture capital industry generally realize poor risk-adjusted returns.

Institutional investors are attracted to private investments since they assume they should have higher expected returns because of the illiquidity and leverage they are accepting in these investments. They are also fans of the fact that the volatility of these investments is masked by the fact that they are only priced on a quarterly basis, making them appear less risky than they actually are (private markets are far riskier than investments in the public markets).

The issue here is that increased competition has driven down the illiquidity premium and driven up the valuations of these companies. The only funds that are worth investing in are the top quartile or even top decile performers. Most of those funds — especially in the venture capital world — are closed to new investors because of capacity constraints. The average results in these funds leaves much to be desired, especially to the “casual investors” as Swensen calls them. If you’re investing in this space you better know what you’re getting yourself into — extremely long lock-up periods for your cash, uneven cash flows, illiquidity, leverage, a lack of transparency, a huge spread between the best and worst performers, etc.

My guess is that today’s new private equity investors will be disappointed in their future results.

Private Equity Breaks More Records (CIO)
Unconventional Success

Further Reading:
Are The Private Market Are Getting Too Crowded?


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