US private equity (PE) firms had their best fund raising year ever – reaching $185 billion in 2015. But is this eagerness to invest in new PE funds warranted? A new report from the Center for Economic and Policy Research (CEPR) says no.
CEPR Senior Economist Eileen Appelbaum and Cornell University’s Rosemary Batt report that the typical private equity buyout fund launched since 2006 hasn’t beaten the stock market– according to the most recent evidence.
In the report, “Are Lower Private Equity Returns the New Normal?”, the authors review new research showing that most private equity buyout funds fail to deliver outsized returns to investors, and it’s unlikely they will in the future. That’s because the competitive landscape has changed. Too many PE buyout shops compete against too many large corporations with cash on hand for too few good opportunities, making it difficult to buy out companies and sell them later at higher prices. While the industry claims it has bounced back from the financial crisis, the heydays of the bubble years are unlikely to return.
The industry claims that it continues to reap outsized returns because it relies on a widely discredited performance measure, the “internal rate of return” (IRR). By contrast, most finance economists measure fund performance using a metric known as the “public market equivalent” (PME) – a measure that compares returns from investing in private equity with returns from comparable, and comparably timed, investments in the stock market, as measured by the S&P 500 or other stock market indexes. This measure provides limited partners with more reliable information about two things: how much money they get back at the end of their 10-year investment in a private equity fund relative to their initial investment, and how that compares with the return they would have earned if they had invested in some other asset, such as shares of companies that trade on the stock market.
Rosemary Batt pointed out, “High returns may have served as a compelling reason for employee pension funds and university endowments to invest in private equity funds in the past. But now that PE returns more or less match the market, the negative impacts of many private equity leveraged buyouts on workers and Main Street companies – including lower wages and employment growth and the higher likelihood of financial distress and bankruptcy – should loom larger in the investment decisions of these investors.”
The evidence reviewed in this report is in addition to new evidence that a surprisingly high share of private equity funds charge excessive and possibly fraudulent fees to investors – practices that have come to light via examinations by the Securities and Exchange Commission and are documented in a previously-released CEPR report by Appelbaum and Batt (2016). These two reports are critical for private equity investors to consider.
As Eileen Appelbaum noted, “Pension funds, which are responsible for investing the retirement savings of millions of Americans, as well as other institutional investors continue to pour money into private equity funds despite excessive fees and recent poor performance. They should be more cautious: promises of high returns are likely to be disappointed. The typical PE fund launched since 2006 has yielded returns that just mirror the stock market.”