Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Investors can’t get enough of private equity. According to research firm Preqin, private equity firms’ assets under management ballooned from $580 billion in 2000 to $2.4 trillion by June 2015 (the latest date for which numbers are available).

Private equity investing has become de rigueur for big money managers ever since The Yale Endowment made piles of money in the funds years ago -- making private equity a fixture for money managers trying to emulate Yale's model.

Current expectations for low returns on U.S. stocks and bonds, at a time when many hedge funds are stumbling, has also left many investors seeking private equity returns to breathe life into their portfolios.

Chasing Privates
Private equity assets have ballooned in the last ten years.
SOURCE: Preqin

But some investors, according to my Bloomberg News colleagues, are bypassing private equity firms and fishing for deals directly in order to sidestep the firms’ steep fees – 2 percent annually on assets and 20 percent of the profits. This appears to be wealthy families seeking alternatives, so that may be a narrow -- while still crucial -- portion of PE firms' clientele.

Even so, investors focused on getting such exposure more affordably, might ask themselves whether this is the right time to rush headlong into private equity at all.   

Private equity has historically delivered a boost to portfolios, and with less volatility than public markets to boot. Cambridge Associates’ U.S. Private Equity Index returned 13.4 percent annually net of fees from April 1986 to December 2015, with a standard deviation of 9.4 percent (the longest period for which data is available), while the Russell 3000 Index returned 9.9 percent annually over the same period, with a standard deviation of 16.7 percent (including dividends).

Lower volatility doesn’t necessarily mean less risk, of course. In fact, it’s widely believed that the higher return from private investments is compensation for more risk (and for locking up your money for years or even decades).

Private investments are less volatile simply because they aren’t subject to the daily gyrations of stock markets. Still, the effect of higher returns with smaller bumps is irresistible to private equity investors.

Envy of Investors
Private equity delivered a boost to portfolios from 1986 to 2015.
SOURCES: Cambridge Associates, Bloomberg

Now imagine how much more irresistible private equity would be without those pesky management and performance fees. Those fees are even more costly than they appear. Private equity funds generally charge a management fee on all money committed by investors, not just money that the fund actually collects for investment. In other words, investors pay a management fee on money that sits in their bank accounts awaiting a call from the fund.

Also, private equity funds only get paid a performance fee on investments that they’ve sold, which incents funds to sell winners that might otherwise have continued to make money for investors. So now you have some investors seeking alternatives to private equity funds.

Private equity investors may have a bigger problem than fees, however: Private equity’s golden age may be in the rear view mirror. The ever greater dollars chasing private investments are driving up private asset valuations and dragging down expected returns. According to Preqin, 70 percent of investors point to valuation as “the biggest concern in operating an effective private equity program.”

Private equity returns have also historically benefited from liberal use of leverage and 30 years of declining interest rates – a potent combination that is coming to an end.

Trending Down
Rolling ten-year returns for the U.S. Private Equity Index have trended downward since inception in the second quarter of 1986.
SOURCE: Cambridge Associates

It’s unlikely that interest rates can go meaningfully lower. And banks are increasingly more discriminating due to stricter capital requirements, which means less lending to private equity firms. Tighter lending has already started to change the structure of domestic buyouts. According to research firm PitchBook, for example, the median equity in U.S. buyouts rose from 35 percent in 2013 to 45 percent this year.

By one measure, private equity returns are already in decline. The rolling ten-year returns of the U.S. Private Equity Index last peaked in 2013 and have been downhill ever since. Most recently, the Index returned 11.3 percent annually from 2006 to 2015, well below its long term return and approaching the long term return from public markets.

So while investors may be able to pick up private equity on the cheap, it’s no longer clear whether that's a wise move.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in New York at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Timothy L. O'Brien at tobrien46@bloomberg.net