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Is This the End of the ‘Fiery’ Public Versus Private Equity Debate?
A PitchBook researcher put himself in an institutional investor’s shoes. Here’s what he found.
Including a private equity allocation in an otherwise balanced portfolio can lead to outperformance, new data shows.
PitchBook released a new piece of research on the topic Wednesday, aiming to end the long debate on the value of including private equity in an investment portfolio.
The data is specific to 60/40 portfolios: when private assets are included within the equity allocation, the fund’s performance is stronger than its private equity-less counterparts. This is true even when underperforming funds are involved.
The author of the piece, PitchBook senior data analyst Andrew Akers, said that Ludovic Phalippou’s 2020 paper entitled “An Inconvenient Fact: Private Equity Returns & The Billionaire Factory,” sparked the idea for his own research.
Phalippou’s paper concluded that by paying exorbitant fees, limited partners helped build tens of billionaires’ fortunes, despite the asset class performing on par with publicly traded companies. According to Akers, it “reignited the fiery debate” on public versus private performance.
So he started looking into other research on the subject, and noticed researchers, as much as investors themselves, are torn on whether private equity is worth it.
He also noticed that some of the measures used by researchers did not account for how institutions are investing in the asset class. “What I wanted to do was take a different angle and ask a different question that is more relevant for institutional investors: What is the actual value add of adding an allocation to private equity in a broader portfolio?” Akers said.
Researchers typically measured public market performance using a time-weighted return — that is, compound growth of a portfolio over time, adjusted to remove cash flows. But that doesn’t work for private market performance measurement because cash flows do affect outcomes. So private investments usually use internal rate of return, also known as the money-weighted return.
“In addition to not being comparable to time-weighted returns, even for the same investment and cash flows, IRRs are harder to interpret because they do not reflect the actual value or benefit an investor receives,” the paper said. “The reason for this is primarily caused by the key assumption in the IRR calculation that the capital distributed to investors during the life of the fund is reinvested immediately at the same rate as the IRR.”
With these challenges in mind, some researchers used a measure called public market equivalents, which represents an adjusted cash multiple based on a public equity index. When it’s greater than one, it means that a private equity fund outperformed an investment in the benchmark. These researchers end up reporting on an average or median private equity fund. The problem? No institution could invest in a simulated average fund.
“I don’t think the researchers have stepped back and put themselves in the shoes of institutional investors,” Akers said. “It's always come off as private equity on one side, public equity on the other.”
Akers said he wanted to create an analysis that was different: he wanted to compare the time-weighted performance of a typical 60/40 portfolio with one that had invested 20 percent of that equity allocation to private assets.
“At the end of the day, that’s what institutional investors — and all investors — should care about,” Akers said. “It’s the compound growth of your portfolio over time.”
For the research simulation, PitchBook used cash flow and net asset value data from 1,044 U.S.-based buyout funds with vintage years between 1997 and 2020 that were sourced from both managers and limited partners. The funds were randomly selected for inclusion in the private equity portfolios, and simulated commitments were made over time. For the remainder of the portfolio, PitchBook used the Russell 3000 Index and the Bloomberg Barclays US Aggregate Bond Index.
PitchBook included controls for portfolio rebalancing, the cash allocation necessary to ensure liquidity for capital calls, and quarterly contributions and distributions for the private equity portfolio.
The data revealed that investing in private equity is, indeed, worth it. Over the full simulation — which accounted for 23 years — private equity added an average of 0.6 percent to annualized returns relative to the benchmark. For the best performing funds, the excess return of private equity funds was 0.9 percent, while for the worst funds, it was 0.4 percent.
“In almost every one of the simulations, [private equity] did add value,” Akers said. “For allocating to just one asset class, [it] is a pretty significant difference.”