Paul J. Davies
1. Private Equity vs. Public Markets
The above chart shows a comparison method that looks nice and simple—it is like calculating the value of $100 invested in a theoretical average private-equity fund over time versus the total return of the S&P 500 index.
Developed by research firm Preqin, this index is a theoretical construction, and that underscores the difficulties in comparing public and private investing. Private-equity firms lock up your money for years and the assets it invests in don’t have an easily observable price like a stock does. Further, private-equity firms measure how their funds perform using something called an internal rate of return, a complex calculation of cash flows—how much you put in and how much you get out over the life of a fund. Public market returns are simpler: you put your money in and then watch day to day whether it grows in value over time.
THE RISE OF PRIVATE INVESTING
The column is part two of a Heard on the Street series on the explosion in demand for private assets.
- Part 1: Why Private Equity Risks Tripping on Its Own Success
- Part 2: Does Private Equity Really Beat the Stock Market?
- Part 3: The New Wizards of Wall Street
- Part 4: The Rise of Private Assets Is Built on a Mountain of New Debt
- Part 5: Does Private Equity Really Beat the Stock Market? Readers React
- Part 6: Dangers Lurk in Private Lenders’ Public Cousins
- Part 7: How Gargantuan Can Private Equity Get?
To get around that, Preqin crunches quarterly reporting of thousands of private-equity funds: their valuations, the money they pull in and the cash returns they pay out, to estimate the total value gains (or losses) at any point in time.
Private-equity returns are tricky because investors don’t put all their money in when they decide to invest in a fund, but when the fund manager needs it for specific deals. Also, they can’t pull money out of a private-equity fund when they want, they must wait until the fund manager sell assets from the fund and returns profits, minus fees. And unlike stocks investors can only get into the funds during specific fundraising windows.
That gets into the idea of vintage, or when a fund began investing.
2. Taking Into Account ‘Vintage’
Like wine, a fund’s vintage, or the year it started making investments, has a big impact on the returns investors see in the real world. And like wine, you get good and bad vintages. Private-equity firms calculate internal rates of return for their funds, based on the year they started investing. So, funds that began investing in 2000, for example, generated a combined 15% return a year over their lives.
An internal rate of return, or IRR, isn’t a straightforward number. It takes profits after fees generated by the fund, plus the current valuation of any assets the fund still owns. It compares that value to the initial money investors put in. It is further complicated because investors put money in, and take money out, at different times depending on when the fund decides to invest in a specific asset and when the manager decides to return the cash as profits, for example after it sells a company the fund owned.
To compare these private equity returns with stocks, consultants Cambridge Associates create a hypothetical public portfolio using the same amount of money at the same time as investors put into and get out of private-equity funds, except it puts the money into the S&P 500. The idea is to see whether you would have been better off in the stock market than locking money up in a given vintage of private-equity fund.
3. The Real World: How Did Individual Funds Do?
Here are the results for some of the biggest funds from the biggest firms, compared with the broader private-equity industry and to public stock markets since the same vintage year.
The picture is quite mixed.