Private Equity has become one of the most controversially discussed asset classes in Norway and beyond. It lures investors with promises of high returns.
Yet two years ago, Chris Flood from the Financial Times asked the question where the jets of the investors into private equity are – given that he could not find them:
Where are all the Ferraries of the investors into PE?
Indeed, recent research shows that PE funds seem to create value overall, yet it seems that most of the surplus of investing into Private Equity end up with the managers who run these funds and not their investors. The predictable outrage that followed his article was notable for what was left out of the discussion: what should investors actually get?
Economists agree on the fact that those that possess an asset in short supply (like computer chips or hydro power plants) will be able to charge prices that exceed what would be possible in a competitive market – an iPhone costs more than a no-name Android phone. Why should financial markets differ in this respect?
What exactly is the “surplus”? In finance, one definition is, given the same risk, performance that beats a benchmark. The idea here is simple: Imagine that you invest NOK 100. The risk of the investment suggests that a 10% return is required. You should invest then if you can expect to get back at least 110 NOK next year. What happens if your fund manager consistently can turn your NOK 100 into NOK 120?
Most of us would expect to gain this “out performance” or excess return. But why should the fund manager give up the 10 NOK? She will only pass on this benefit to their investors if the market forces her to do so, say through competition. If she is the only person that has this skill, competition for her skills suggest that she will keep all the outperformance via fees and profit-sharing agreements.
Private Equity, in contrast to index investing, is a much more demanding asset class. It requires not only sound financial skills but also a good understanding of operations and good interpersonal skills. It is a rare combination to be found and not a skill that is easily acquired. On the other hand, there are plenty of investors that want to commit funds to private equity suggesting that the benefits of private equity will end up with the party that is in short supply, namely the fund managers. Hence, we should not be surprised to see high fees and a large success component in PE.
What does the data tell us? On average the average investor in Private Equity can expect a return, net of fees, that is slightly higher than what the S&P 500, the leading US index, would have yielded (Brown and Kaplan, 2019). I don’t believe this is an accident – in fact I believe the S&P 500 is what many would consider as the go-to alternative investment, though many argue that PE is riskier than the S&P 500. PE is also more illiquid. This outcome is exactly what we would expect if we believed that all excess performance accrues to PE fund managers – investors get enough to make them indifferent between investing or not but nothing else.
Does this make PE superfluous for investors? PE investments can still be an interesting asset class if you believe that it exposes investors to markets segments that cannot be reached through investing into the public market or if you believe that you are better at selecting PE fund managers, so this does not preclude investing into PE. You should just do it with realistic expectations.