To me, the most striking thing in this article ISN'T that there's a vast, opaque, multi-trillion dollar shadow stock market for institutional investors and elite individuals.
Instead, it's the fact that over the past 25 years, these vehicles have only managed to beat an S&P 500 index fund by 1-2% after fees. And that over the past 10 years, more than half of them are underperforming a passive index fund.
Even if I had a few extra billion dollars lying around, I wouldn't get involved with private equity firms. This audience comes across like a combination of insolvent pension fund managers desperate for a way out, and wealthy individuals who just enjoy the feeling of being in an exclusive club. With dubious "financial engineers" fleecing them all through fees, and hollowing out thousands of private companies to make the whole system possible.
It's more complicated than that - as the article says PE can be used to diversify an investments. If you have a few extra billion you might not want to tie it all to the performance of the US equity market. So PE doesn't have to beat the S&P to be attractive if the ups and downs happen at different times to the S&P.
Then there is also the question of fees, if the fund is beating the S&P by 1-2% after fees, and their fees are 2 and 20 then the strategy is significantly beating the market. The problem is that there is so much money chasing PE, and that leverage means they don't need that much in client funds, that there isn't a push to lower fees that you see in the equity market.
> "If you have a few extra billion you might not want to tie it all to the performance of the US equity market."
Yes, but... Vanguard's S&P 500 fund isn't the only index fund on the planet, either. You can include a broad international fund, a region or country-specific fund, or any other number of factors. Diversification and passivity are orthogonal.
> "if the fund is beating the S&P by 1-2% after fees"
Yes, but:
1. You're taking on a higher degree of risk, because the information available to you is much more opaque and unregulated (e.g. EBITA as a valuation metric, when it's so easy manipulated). Bubbles are hard to time, even when you do have decent data available. But investors in that world are just completely flying blind. And historically received only a small net premium for that additional risk.
2. Even that historical premium seems to be gone now. As I pointed out from the article, that "1-2%" is looking back over a quarter-century timeframe. Over the past 10 years, half of PE has UNDERPERFORMED the market. The direction of the trend does not look favorable.
Hey Steve, while you are correct I think the confusion is related to what cmdkeen (and the article authors) mean by diversification.
Whilst your comments are valid for public equity - this is simply one of several types of "asset classes" someone with billions of dollars has access too. Different, non-public asset classes can have properties distinct from bubble risks or liquidity.
One of the key benefits of holding a variety of asset classes, particularly the more exotic ones - is that their performance can be uncorrelated with the performance of the stock and debt markets.
Some examples of PE asset classes:
- Venture Capital (very high risk, but over a long period of time is supposed to generate 20-30% rates of return)
- Angel Investing (higher risk still, and you need many companies but also generating 20-30% returns with a big enough portfolio)
- Commercial real estate (uncorrelated to global equity market performance - rather its connected to local market performance, pretty sure around 10% can be typical for offices)
- Infrastructure projects (uncorrelated again, lower rates of return but you are locking in those returns for decades)
There are tonnes of course, but when you start talking about personally investing such large sums of money - diversification means a lot more than just buying investments in the public markets (either bonds or stocks).
Seen it referenced a few times, some digging around will get you there. Also an angel investor spoke at my university about how they invest, and mentioned returns of 23%/24% annualized if I recall - but this was asterisked with "your portfolio of companies must be greater then 20 - any less and you risk losing everything". And, your money is essentially "locked" for 5-10 years (can only get your cash when there is a liquidity event - if one happens at all)
But given there are many different flavors, sizes, vectors etc of VCs, and given many keep their numbers hush, hush - I wouldn't even know where to look for any kind of "official" numbers on it.
If you add the averages of each category(75x for the last category) in this source, you'll end up with an annualized return of 9.4% over the 10 years mentioned in the image.
That is not far of the average return of the SP500.
Regarding 1. the risk can also be substantially lower for PE firms, because A. Extensive FVDD (Financial Vendor Due Diligence) and other types of risk assessment are carried out over the negotiation phase, and you are far less susceptible to stock market movements. Also, unlike investing in public companies, the PE fund is almost always the sole investor in the business alongside a small management tie-up, meaning you actually have full control over the business financially and strategically
You can increase your returns by diversifying into uncorrelated assets even if that other asset has returns that underperform the market.
That's why you see the 80/20 stock/bond split recommended so often. Even though bonds underperform stocks, the 80/20 split regularly rebalanced outperforms 100% stocks. Rebalancing is an automatic "buy low / sell high" strategy. After a stock market crash your 80/20 split might be 50/50 so you take that 30% and buy cheap stocks...
Actually, the 80/20 portfolio will decrease returns vs the market. It will outperform on a risk adjusted basis, ie have a higher sharpe ratio (maybe). But the highest return portfolio will always be the one that allocates 100% to the highest returning asset - in this case all to stocks.
No matter how much you diversify your long-only strategies, you will still not even be close to market neutral, which is probably what you really want at that scale.
With LBOs, much of the outperformance is due to leverage. If you could lever up the s&p 500, say 25%, you’d likely get much better returns. Because PE firms don’t aggressively revalue assets, they don’t have to face margin calls the same why someone would with an asset that is priced daily.
If you want to get into well managed private equity, buy Berkshire Hathaway.
Most private equity companies use substantial debt leverage to acquire companies and flip them as fast as possible. Berkshire is just the opposite. They use mostly their own capital and leverage from insurance float. They buy businesses permanently. They hire good managers, enforce good corporate governance and the business is free from short term performance goals.
Wow. That sounds like a downright responsible way to do business.
Hedge funds always love to claim that they fix companies and make them healthier, but most of them have a reputation for looting them, loading them with debt, and then dumping them at a temporary profit. It's good to see that Warren Buffet actually tries to make businesses healthier.
Hedge funds and private equity are slightly different. Private equity is the leveraged buyout business that got rebranded after its callous performance in the 80s. Hedge funds are usually long/short in public equities (stocks, bonds, etc). Those guys haven't been performing well, and they have had a secular decline in their ability to charge high fees to clients. 2/20 doesn't exist for the vast majority of HFs anymore, more like 1/15, etc.
There are a small number of funds that do growth equity (where they buy a small business and grow it), but so much of it just depends on financial engineering in the way you mentioned in your comment.
Yeah, a handful of funds do focus on growth. But it's a small part of the industry, and they typically have longer exit timelines than the "mega-bucks" PE firms.
Berkshire is one of the best run organizations in America.
Most private equity that uses leverage actually destroys businesses. Just look at what happened to toys r us for example. That's extremely common.
The problem is that when private equity buys a company, it usually uses lots of loans to do so. Then the most experienced people in the business are removed or deincentivized (the previous owners). Finally, this now poorly run and heavily in debt company struggles to survive and goes bankrupt in the next recession.
You will see this pattern repeated over and over with private equity.
They self-deal. The loans are used to pay management and other fees from affiliates entities.
When the parasite finishes the digestion of the host and it goes bankrupt, they get to write down the losses against the money made on those fees, and the actual losses are distributed amongst the partners in the syndicate.
Companies that may go bankrupt are paying higher interest than normal, stable SP500 companies. This is attractive to people who want to get higher returns at the expense of additional risk. In other words, the existence of these loans is a necessity due to the way the market operates.
Alternative view (not necessarily my view): Hedge funds are able to buy companies that are already in trouble. They do a lot of up-front financial engineering to free working capital for last-ditch efforts. Frequently, those last-ditch efforts don't work and the companies fail anyway.
Obviously, this isn't universally true, but, not all troubled companies can be saved, or really, need to be saved. The standard pivot model just doesn't work on most businesses, while deferred investment and cash flow problems are always fatal.
Hedge funds always love to claim that they fix companies and make them healthier, but most of them have a reputation for looting them, loading them with debt
The genius of PE is convincing the public that all the bad things they do are actually done by “hedge funds”.
Yeah, you've gotta hand it to them, they really commit to the long-term hollowing out of the economy and the wringing of money from poor stones: none of this short-term loot 'em and flip 'em mentality for BH!
Why pull the race card here? It has nothing to do with the situation.
From a follow up article by [one of the] same writer:
> Buffett said the interest rates are influenced by things such as credit score, down payments, earnings and whether the customer owns land. It has “nothing to do with your religion or your color or anything of the sort,” he said.
> Yeah, you've gotta hand it to them, they really commit to the long-term hollowing out of the economy and the wringing of money from poor stones: none of this short-term loot 'em and flip 'em mentality for BH!
People investing in things can yield higher effective returns because the private equity funds are also tax shelters. In the most simple scheme, your billion dollars of income in an S&P 500 ETF will generate $20M of taxable dividends. Wrapping it in the fund can be used to make that a long term capital gain, and the partnership structure has other positive taxation features. (Like avoiding gift or estate taxes)
In general, if you see some complex/bullshit sounding financial vehicle that doesn't make sense to you, it likely exists to avoid taxation.
Your logic can be reduced to "If I can't understand something then it must be a tax dodge." This is extremely reductionist and too simplistic...
The main driving force behind private equiy are the returns where the best funds have out performed the S&P 500...private equity funds are typically limited partnerships where the investors pay tax on income.
The venture capital economic model is very different from that of private equity. VC makes relatively small investments in many extremely risky firms, hoping for a few massive blowout hits which return the entire fund by themselves. PE buys firms with proven economic models, cuts costs and tries to improve management in some form, whether by bringing in real estate expertise for franchises (think Starbucks or McDonald’s) or doing bog standard MBA stuff like KPIs and improving staffing, hiring or internal IT.
At the high end of VC you get some overlap with PE, like SoftBank investing $X00 million in hot “startups” but PE does not chase 100x returns on investment. They’re in the business of taking a company worth $100 million and turning it into one worth $500 million.
Venture Capital is a strict subset of the Private Equity industry. They are not outside it, they are deep within it. PE firms do exactly what VC firms do (though often with different sorts of businesses), plus a lot more.
Only because they can't. Leverage requires steady cash flows, fixed assets, etc. If VCs could increase their potential return while also increasing financial risk to their portfolio, they absolutely would.
Across private equity there is a spectrum from small cap to large cap with increasing leverage. The small cap funds do a combination of the leverage tricks available to PE investors as well as the deal structure tricks available to VCs (preferred, etc).
It sounds like you're conflating asset class (PE) with capital structure (how asset ownership is financed).
Private equity is just an investment of capital in a non-public company in exchange for equity. YC makes capital investments in non-public companies in exchange for equity.
The structure of PE deals can vary from the simple cash investment in exchange for company stock all the way up to incredibly complex leveraged buyouts and everything you could imagine in between.
> only managed to beat an S&P 500 index fund by 1-2% after fees
From the article: "Over the 25 years ended in March, PE funds returned more than 13% annualized, compared with about 9% for an equivalent investment in the S&P 500"
When you are dealing with exponents small differences become enormous over time. Remember: y = y0*e^kt where y is money later, y0 is money now, e is 2.71, k is the interest rate, and t is time. So assuming 9% annualized return in the SP500, after 10 years, your million dollar PE investment will yield 2.5 million in the stock market, but 3.7 million in PE or a 1.2 million dollar difference. In addition, they maximize y0 by leveraging.
Ignoring the terrible social costs (e.g., Shopko from the article) and the fact that their accounting and tax practices are suspect, I'll take the PE any day.
I assume you can't hand Electra one of their shares and get back its constituents. And I assume because it's private equity, you can't do the obverse either, or do a long/short type trade.
Investment trusts themselves are publicly traded, they're closed-ended funds with capital raised once on launch - sort of like pooling private equity, but you can then sell your stake.
The public listing is of the company, whose business happens to be investing, so though I've never looked I don't see why CFDs & derivatives wouldn't be available.
Venture Capital Trusts (VCTs) are similar (perhaps a subset?) but focus on earlier stage companies (clearly) in exchange for a tax advantage for the initial investors - but not for those who subsequently purchase shares in the VCT itself from them.
You buy when the trust is at a larger discount than normal in a bear market or look for trusts where there is corporate action going on and the shares will be rerated or trust will be wound up.
You presumably could short a quoted trust or us CFDs or buy warrants but that's a bit rich for me.
That is not what is traditionally referred to as arbitrage. You are betting on an unknown variable (correct discount), not noticing pricing for the same asset being different in the same moment. Arbitrage is “sugar being sold at $2 at shop A, and bought at $3 at shop B, and the shops are next to one another”
> have only managed to beat an S&P 500 index fund by 1-2% after fees
"Beating" the S&P500 doesn't necessarily mean earning higher returns. Earning the same returns with lower risk/volatility would also be widely accepted as "beating" it as most people are more afraid of losing their fortune than they're ambitious to increase it.
I'm curious whether taking that into account changes how many private equity firms beat the S&P 500.
Given your money is tied up for 10 plus years and there’s a lot of leverage involved, you need to have a much higher hurdle rate to want to invest. Say 3.50% or more after fees.
Is any hedge-fund trying to index private equity? Some of the unicorns, for example, probably merit(ted) being ranked among the fortune 500, but are not part of the S&P 500 index. It would be interesting to see index investing make it's way into private equity.
Honest question - how would you actually go about doing this?
The phenomenon you're describing is definitely true to some extent. Look at when in their lifecycle companies went public prior to 2008 compared to now: far more of the value created is now captured by private capital. This is why, ironically, PE is the largest source of alpha to vehicles like pension funds - they can't capture the same kind of yield in public markets anymore and have mandates about the
types of investment they can make.
Figuring out a better way to democratize access to the potential yield that used to be available in public markets would be excellent, but I'm not sure how to do it without pretty massive side effects.
Why would you expect a magic “beat the S&P” button to exist at all? That would be a gross violation of the EMH. If it has indeed beat an index fund by 1% in a risk adjusted manner that would be a miracle in itself.
He’s not talking about on a risk adjusted basis. Moreover, EMH is a framework for understanding, not some magical law. There are funds who’s returns over time are like a 10 sigma event.
The S&P isn’t a reasonable benchmark to PE in the first place. Your argument is like saying: “US Teasuries underperform the S&P by 8% every year, people and countries buying treasuries are stupid and just want to be part of some secret club.”
There’s a couple of things wrong with this argument so let’s go over it:
1) Low or uncorrelated return streams are very valuable due to the central limit theorem. As you add these return streams together, they form an increasingly tighter normal distribution. This gives us two advantages: we can convert non-normal distributions into normal ones, and we reduce our standard deviation with every stream we add as long as the correlation is less than one.
2) Returns aren’t the defining factor of whether a strategy is worth it. Instead institutional investors measure investments by their Sharpe ratio: the slope of the line between return and risk (the axis is the risk-free rate). The reason for this is that since these kinds of investors can not just lend, but borrow at the risk-free rate, they can lever up their returns to anything they want. This is called risk-adjusted returns.
4) The biggest risk in investing is exposure to Beta, “the market,” which in the US is usually measured by the S&P 500. Reducing exposure to Beta is often goal #1 of institutional investors. Maybe not a 100%, you should definately not be exposed to a 1.0 Beta coefficient. This is especially important for endowments, pensions, and other funds that have monthly or yearly pay-outs. The auto-workers would be super pissed if the economy tanked and they no longer got their retirement pensions. After all, that’s one of the things that pensions are supposed to hedge against.
Before I started working in finance, I definately had the same questions and theories as you. After all, the field is very baroque and complicated and the explanation of the industry being stupid is very simple and straightforward. Chesterson’s Fence is a good way to view a lot of things. Understanding is always a prerquisite for change.
Instead, it's the fact that over the past 25 years, these vehicles have only managed to beat an S&P 500 index fund by 1-2% after fees. And that over the past 10 years, more than half of them are underperforming a passive index fund.
Even if I had a few extra billion dollars lying around, I wouldn't get involved with private equity firms. This audience comes across like a combination of insolvent pension fund managers desperate for a way out, and wealthy individuals who just enjoy the feeling of being in an exclusive club. With dubious "financial engineers" fleecing them all through fees, and hollowing out thousands of private companies to make the whole system possible.