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Reassessing Private Equity

By Steven N. Kaplan
Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance

Steven Kaplan

Steven N. Kaplan View Bio
Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance

Reassessing Private Equity
Investors in buyout funds have been earning higher returns than previously thought

One of the controversies surrounding private equity is whether investors are getting a good return on their investment, particularly when compared with investing in the overall stock market. Private equity firms are not required to disclose their funds' returns and they invest only in companies that are not publicly traded, making it harder to get an accurate picture of their performance. Some pundits have even accused private equity managers of exaggerating their true performance numbers.

Part of the problem is the lack of quality information from the data companies that try to fill the gap. These companies do not collect data for all funds, nor do they always disclose information on fund cash flows or the cash paid to investors-key components in calculating various measures of performance. Their sources often are obscure and the data stale, which could lead to biases in the results.

But a new dataset of fund cash flows taken entirely from institutional investors of private equity may shed light on the industry's performance. Data provider The Burgiss Group sources its data from institutional investor records that track the exact cash amount made by the investors to private equity fund managers as well as the amount returned by the fund managers to the investors. Given the need for quarterly reporting by most investors, the data is more likely to be up-to-date and complete, a significant advantage over other commercial sources that rely in part on voluntary and Freedom of Information Act disclosures from private equity firms. It is possible, for instance, for a private equity firm to strategically stop reporting its returns.

Armed with this new data, Chicago Booth professor Steven N. Kaplan, with Robert S. Harris of the University of Virginia and Tim Jenkinson of the University of Oxford, reassesses the performance of private equity in a recent paper, "Private Equity Performance: What Do We Know?" They find that buyout funds - those that buy mature companies, attempt to improve them, and then sell them later for a profit - have performed much better than previously thought. Unlike in venture capital, which is the private equity arm that focuses on start-ups, the merits of buyouts are more hotly debated. The result of the analysis of the new data is favorable for buyouts - the authors find that US buyout funds have outperformed public markets for a very long time.

COMPARING PRIVATE RETURNS WITH PUBLIC RETURNS
Several papers have attempted to measure private equity returns to investors, including a frequently cited study by Kaplan and Antoinette Schoar of the Massachusetts Institute of Technology. Though this study mostly was concerned with whether the performance of private equity managers persisted from one fund to the next, Kaplan and Schoar also measured whether buyout funds and venture capital funds outperformed the stock market. They did this by calculating a performance measure called the "public market equivalent," which is a ratio of how much a private equity investor earned after paying fees to what the investor would have earned on an equivalent investment in the public market. This can be thought of as a market-adjusted multiple of invested capital.

Kaplan and Schoar found that investors of buyout funds earned a slightly lower return than if they had invested in the S&P 500 instead. Another study by Ludovic Phalippou of the University of Amsterdam and Oliver Gottschalg of HEC Paris, using an updated version of Kaplan and Schoar's data, found a somewhat more negative result for buyouts. Both studies used data from Venture Economics.

But a recent paper by Ruediger Stucke of the University of Oxford identified a significant bias in the Venture Economics data: many of the funds had not been updated since 2001 and yet had been retained in the database, opening up the possibility that returns to private equity investing have been understated in previous studies all along.

A reassessment of private equity performance also allowed Harris, Jenkinson, and Kaplan to include newer funds, particularly for 1995 to 2008. The earlier papers focused on funds with vintage years prior to 1997. (The "vintage year" marks the first year that a fund makes an investment in a project or company.) Subsequent years have seen a huge increase in the number and size of private equity funds. Almost $670 billion was raised in vintage years 1996 to 2004, compared with less than $150 billion from 1980 to 1995. The private equity boom period 2005–08 saw almost $800 billion raised.

The new Burgiss dataset gives researchers a chance to more accurately measure whether private equity investors are better off putting their money in a simple index of stocks. "We think it is a better dataset than anyone has ever used," Kaplan says.

Using cash flow data from 598 buyout funds and 775 venture capital funds from 1984 to 2008, the authors calculate the average public market equivalent ratio for each vintage year. They find that buyout funds did better than public markets in most vintage years since 1984. The average US buyout fund outperformed the S&P 500 by at least 20 percent over the life of the fund, or by at least 3 percent per year.

The average venture capital fund, on the other hand, did better than the S&P 500 in the 1990s but not in the following decade. Kaplan thinks this is not surprising. The tremendous success of venture capital funds in the 1990s attracted a huge amount of capital in the early 2000s that subsequently contributed to lower returns. This boom and bust cycle has been a recurring feature of private equity- returns tend to fall with more capital but go back up again when less money is invested in private equity.

A FIRM RESULT
If the study's results could be compared with the same performance measure using other sources of data, the authors would be able to arrive at a stronger conclusion. One of the main drawbacks of data from other sources is the lack of information on cash flows or the cash paid out each period to investors. Without those cash flows, it is not possible to compare the returns of private equity investing with the alternative of investing in the stock market.

To solve this dilemma, Harris, Jenkinson, and Kaplan estimated the relationship between the public market equivalent ratios they calculated earlier and two other performance measures that also are available in the Burgiss dataset: the internal rate of return (IRR) and the investment multiple or multiple of invested capital (MIC). The IRR is the annualized rate of return of the fund, while the MIC is the ratio of the cash paid to investors and the estimated value of the remaining investments to the amount of capital invested in the fund.

The authors find a very strong statistical and economic relationship between the public market equivalent and the IRR and investment multiples within a given vintage year. The authors use this relationship to transform the data on IRRs and investment multiples from other data sources, particularly from Preqin and Cambridge Associates, into comparable public market equivalent ratios.

The estimates using the Preqin and Cambridge Associates data indicate that buyouts throughout the 1990s and 2000s outperformed the S&P 500 by at least 20 percent over the life of the fund, similar to the results using the Burgiss data. Applying the same exercise to Venture Economics data likewise implies that the average buyout fund outperformed the S&P 500, but by only 10 percent. This is consistent with, and expected from, the likely downward bias in the Venture Economics data. The consistency in results extends to venture capital activity - in all of the datasets, venture capital outperformed public markets in the 1990s, but not in the decade that followed.

That the results are consistent across datasets, despite being based on very different selection criteria and methods of gathering information, is compelling evidence that investments in buyout funds have outperformed the public markets (after fees) for a very long time. The returns are even higher before fees, suggesting that private equity firms have been adding substantial value to the companies they buy. "There is no guarantee about returns going forward, but looking backward the picture is certainly positive," Kaplan says.

“Private Equity Performance: What Do We Know?” Robert S. Harris, Tim Jenkinson, and Steven N. Kaplan. Working paper, February 2012.

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