By Brad Neuman, director of market strategy at Alger
Private market investment allocations have soared in recent years. According to a BlackRock survey, institutions now allocate 24% to private markets on average.
These allocations are often justified by the robust and diversified returns private equity is perceived to offer over public equities.
However, we argue that private equity falls short relative to stocks on a number of attributes such as transparency, liquidity, and fees, as well as returns, making public growth equity a potentially more attractive asset class.
Timing, lockups, and liquidity
Private equity has been lauded for its strong historical performance relative to public markets. Its internal rates of return (IRR) are typically utilized for comparison, but IRRs are not representative of reality given private equity investors must often wait years before their capital is fully deployed, which of course is not the case in public equities.
One study found that more than half of funds’ IRR can be attributed to timing capital calls and distributions. A particularly egregious form of timing manipulation occurs when a private equity fund borrows against investor commitments to delay capital calls, thereby increasing the IRR, all else equal.
While some private equity return data tries to account for the timing of cash flows through so called public market equivalent accounting, where public equity investments are made on the same cadence as the private equity cash flows, that is simply handicapping public equities in our opinion.
Public equity investors do not have to tie up their capital and wait to make investments and they have much fewer liquidity constraints in exiting their investments as well. We question the value of private equity investments with significant illiquidity and durations of 10 years or longer.
Taking a closer look at performance
To illustrate our point, we analysed industry data from PitchBook and found that the S&P 500 has outperformed cumulative private equity returns in nearly three quarters of the vintages—defined as the year when the initial capital is invested—since 1996.
If we look at only the past 20 years, that public equity outperformance increases to 85% and if we look at large cap growth stocks as represented by the Russell 1000 Growth, it rises to 90%.
Another issue with private equity is that the dispersion in returns between managers is extremely wide. The variance is so large that Mark Anson, CEO of CommonFund, called private equity as much of an “access class” as an “asset class”.
His paper showed that the median private equity returns over the past 10, 20 and 30 years ending 2021 were less than half that of pooled returns.
These median buyout private equity funds underperformed the S&P 500 over every time period, from 5 years to 30 years, ending 2021 by approximately 500-900 basis points annually.
An illusion through leverage
Further, we believe the risk and subsequent increased return from high leverage in private equity is not correctly accounted for in many investors’ analysis vis-à-vis stocks.
First, private equity risk in terms of volatility is generally smoothed as reported and is actually in-line with large cap public equity indices when adjusted. Second, private equity returns benefit from significant leverage.
Using historical data from PitchBook that shows private equity funds have employed 54% debt with a 5.9% cost of borrowing, we calculate that leverage has contributed over 400 basis points to private equity annual returns over the past ten years, ending September 2023.
With interest rates now significantly higher, private equity returns may decline as less and more expensive debt is employed.
So while private equity is often touted for its high returns, our analysis reveals that, after accounting for factors like illiquidity and the timing of cash flows, the dispersion of manager returns and the weak long-term performance of the median manager, private equity may not be as compelling as it is commonly perceived.
In our view, public growth equities not only mitigate many of the burdens associated with private investments but also capitalize on the rapid innovation and scalability that drive modern economies.
