Critics of private equity have warned that investors shouldn’t expect the historical outsized returns of the asset class to continue forever. By one measure of private equity performance — how it has performed relative to listed stocks — those critics have been proven right.
According to a report by J.P. Morgan Asset Management, private equity is still out in front of its public counterparts, but there’s been a change.
“The private equity industry is still outperforming, but the margins are very thin,” Michael Cembalest, JPMAM’s chairman of market and investment strategy, told Institutional Investor.
Using data and analysis from a number of academics, including Steven Kaplan from the University of Chicago’s Booth School of Business, JPMAM looked at private equity fund vintages from 1991 through 2017, excluding fund vintages after 2017 because not enough time has passed to accurately analyze those funds’ investments. The firm evaluated what’s called the public market equivalent ratio, which compares private equity to investments in public equity markets at the same time, as well as direct alpha, which converts PME into an annualized performance figure.
Among other findings, JPMAM determined that private equity funds since 2009 have delivered between 1 and 5 percent in excess annualized returns (net of all fees) over the S&P 500 index, the benchmark the firm used for public markets. That compares to excess annualized returns for the average buyout fund of about 1 to 10 percent between 2000 and 2008.
“You’ll find investors and academics who say that’s not enough relative to the illiquidity risk, and you’ll find LPs, who are underfunded, who say, ‘I need every basis point I can get,’” Cembalest said.
According to Cembalest, the buyout industry “did very well” in the ’90s and early 2000s. “It’s no coincidence that the numbers started to narrow after the financial crisis because the cost of money went to zero,” he said. “Look at the spread between high-yield and investment grade — everything has narrowed.”
Cembalest pointed to the recent flood of money into the industry, once the sole playground of institutional investors and defined benefit plans. With more money to invest, private equity firms have had to come up with new and better investment ideas outside their core strategies and intensely compete for deals.
In fact, according to the report, “buyout acquisition multiples have increased as the food fight over private companies continues, propelled further by the SPAC boom. So higher buyout purchase prices and better-performing public equities have reduced buyout outperformance.”
The buyout purchase price multiple was 12x average EBITDA — earnings before interest, taxes, depreciation, and amortization — in the first quarter of 2021, up from about 10x in 2015. In the years before the financial crisis, the multiple ranged from 6.5x to a little over 8x.
“If I’m an institutional investor, my takeaway is I’m still probably making money in private equity relative to public equity,” Cembalest said. “But I hope things go back to where they used to be.” Cembalest added that despite the complexity and illiquidity of private equity and narrow excess returns over stocks, which are fully transparent and cheap to invest in, the asset class is still worth it. Private equity firms have the ability to restructure companies and, at some point, public stock valuations will come back to earth, according to Cembalest.
Cembalest was encouraged by the more consistent outperformance of the venture capital segment of the private equity industry compared to public markets. For the study, JPMAM looked at venture capital performance since 2004, adjusting for the late 1990s technology bubble and bust, which the firm believes skews the data. After 2004, excess returns of the median manager rose steadily and then plateaued around 2011. The average VC manager, meanwhile, has produced steadily higher excess returns since 2004. The firm report cautioned that this gap between the average and the median reflects the dramatic returns of a small number of star venture firms.
Still, Cembalist said, “the lowest quartile VC funds didn’t get destroyed,” commenting that venture firms may lose money when an individual deal goes bad, but they’re doing a good job of preserving the financials of the fund as a whole.
Even the gap between the best and worst buyout manager has narrowed. Historically, the average and median managers have consistently outperformed over time. But since 2010, JPMAM said the gap between the top and bottom quartile managers has gotten smaller and bottom-quartile managers are only modestly underperforming. Money flooding into markets may be papering over the mistakes of less skilled managers.