Is private equity too good to be true?

Is private equity too good to be true?

Private equity may look enormously promising for investors, but how do its returns really compare with those of ordinary public stocks, and does it live up to the hype? It's one of the most talked-about asset classes of recent years, traditionally the preserve of institutional investors but increasingly available to individuals too.

In this video, investment analyst Nicolas Rabener examines whether private equity is as good as it appears. He starts with why investors are drawn to it: after the tech bubble of 2001, the global financial crisis of 2008 and the COVID-19 crash of 2020, many are keen to reduce their exposure to volatile public equity markets. An asset class that appears to behave differently from public equities is naturally appealing, which helps explain the huge inflows private equity has attracted.

You'll learn how the returns actually stack up. Comparing private and public market returns is genuinely difficult, because they're calculated differently, but data providers such as Cambridge Associates offer decades of figures that allow a meaningful comparison. Historically, private equity has delivered much higher returns than public markets, once roughly 400 basis points a year, an attractive premium. But over the last four or five years, that excess return has shrunk almost to zero. That raises an obvious question: why lock up your capital for seven to ten years and pay high management fees for an asset class that increasingly returns much the same as public markets?

The video also tackles one of private equity's biggest selling points: its apparent low volatility. Rabener explains why this is largely an illusion. Private equity is valued only quarterly, and valuers tend to smooth those figures rather than make dramatic changes, so on paper it looks far steadier than the stock market. But when researchers value private equity companies daily, using the same public-market multiples applied to listed firms, the volatility turns out to be higher than that of public markets, not lower.

The takeaway: however appealing it may seem, private equity's core advantages, higher returns and lower volatility, look far weaker under scrutiny. The industry can be extremely persuasive, but with its shrinking return premium, long lock-ups, high fees and illusory stability, many investors may be wise to treat its promises with real caution.

Chapters / Key points

• Why private equity has become so popular
• Why investors want to avoid public market volatility
• The challenge of comparing private and public market returns
• How private equity's historic return premium has shrunk toward zero
• Why long lock-ups and high fees raise hard questions
• Why private equity appears less volatile than the stock market
• How quarterly, smoothed valuations create an illusion of stability
• What happens when you value private equity like public companies
• Why investors may be wise to treat the hype with caution

Transcript

Is private equity too good to be true?

Robin Powell: One of the most talked-about asset classes in recent years has been private equity. It's traditionally seen as an asset class for institutional investors. But individual investors increasingly have access to it as well. One of the reasons investors like private equity is that they're keen to avoid too much exposure to public equity markets.

Nicolas Rabener: You had the implosion of the tech bubble in 2001, you had the global financial crisis in 2008, and you had the COVID-19 crisis in 2020. So, from an investor perspective, it's great if you have an asset class that does look different to equities, and that explains the interest in private equity, and why you've seen so many inflows in the last few years.

Robin Powell: So, private equity has become very popular. But how do returns compare with those of publicly quoted stocks?

Nicolas Rabener: It is worth highlighting that, in general, it's difficult to compare the returns of private asset classes, like real estate and private equity, and public market returns, because they are being calculated differently. Now, there are some data providers, one is Cambridge Associates Investment Consultancy, that do provide effectively private market returns that you can compare with public market returns, and they give you 20 or 30 years of data. Now, what you do see is that private equity historically has achieved much higher returns than public markets. And it used to be about 400 basis points per year, which is actually quite attractive in terms of getting an additional return from an asset class. Having said that, over the last four or five years, that additional excess return has continued to shrink, and over the last few years has been almost zero. And that naturally does make you question why investors do allocate to an asset class that effectively returns the same as public markets but does require you to lock up capital for seven to ten years, and charges high management fees.

Robin Powell: One of the attractions of private equity is that it appears to be less volatile than the stock market. But, says Nicolas Rabener, it's largely an illusion.

Nicolas Rabener: So, effectively, if you look at public markets, they tend to be very volatile, from quarter to quarter, day to day, month to month. That does not get reflected in private equity, because valuations are on a quarterly basis, and they tend to be smoothed, simply because the valuers don't like to change valuations too dramatically, because they look like fools, simply said. So effectively, private equity does seem to be lower from a volatility perspective on paper. Having said that, there's no reason why you shouldn't be using public market multiples to value private equity companies on a daily basis. And researchers have done that, and that shows if you do look at private equity companies exactly like you look at public companies, then the volatility is actually higher than that of stock markets.

Robin Powell: So, however appealing it may seem, investors are probably wise to avoid this asset class altogether. The private equity industry can be very persuasive, but the benefits are just too good to be true.