Debunking Private Equity Performance

Researchers from the Abu Dhabi Investment Authority and the Canada Pension Plan Investment Board suggest a better benchmark for evaluating buyout funds.

Private equity outperformance may just be a figment of bad benchmarks, a CFA Institute report has suggested.

While buyout funds have outperformed the S&P 500 by more than 3% annually, that outperformance disappeared when funds were compared to an index that more closely resembles private equity holdings, according to Abu Dhabi Investment Authority’s Jean-François L’Her and Rossitsa Stoyanova, and Kathryn Shaw, William Scott, and Charissa Lai of the Canada Pension Plan Investment Board.

To more accurately evaluate the performance of private equity, the researchers used a risk-adjusted benchmark “fairly representing the size, sector composition, and leverage of portfolio companies in buyout funds.”

Specifically, they determined that private equity portfolio companies have, on average, smaller market capitalizations than their public counterparts. Sector compositions of buyout funds were also “materially different” than the market as a whole, with financial, health care, and information technology companies underweighted. Leverage was “significantly” higher, the authors found.

“After making these risk adjustments, we find no significant outperformance of buyout fund investments versus the public market equivalent on a dollar-weighted basis,” they wrote.

But even without the outperformance, the researchers argued that buyout funds still serve a “valuable role in an institutional investor’s portfolio.”

“They provide small-cap equity exposure and broaden the opportunity set available to public equity investors—an important portfolio addition, especially where small-cap equity markets are thinner,” they wrote.

Additionally, private equity presented a “more attractive opportunity for exercising manager selection compared with public equities,” the researchers wrote, as well as the ability to diversify over vintage years.

Finally, the authors highlighted direct investments as a prospect for true outperformance.

“Large institutional investors make direct investments, which—with appropriate security selection, portfolio construction, and fee/carry structuring—lead to higher overall private equity returns,” they concluded.

Read the full paper, “A Bottom-Up Approach to the Risk-Adjusted Performance of the Buyout Fund Market.”

Related: Doing Private Equity in Public Markets